Though most real estate purchases will require the use of a formal lender, there are several ways to become the owner of a property without working directly through them. In fact, when navigated correctly, using a “subject-to” agreement can help real estate investors close on sales faster and even secure a better interest rate.
In theory, using a “subject-to” loan in real estate is a way to cut out the middleman and facilitate a more direct sale between the seller and buyer. However, these agreements can sometimes be complicated, so it is crucial for both parties involved to be fully aware of what they agree to.
Subject-to agreements have become increasingly common over the past two years. In this brief guide, we will discuss the most important things you need to know about subject-to lending in real estate. By taking the time to understand the dynamics of these agreements, you will be able to decide if subject-to loans are right for you.
What is a “Subject-To” Agreement in Real Estate?
When someone initiates a “subject-to” agreement, that means that upon buying the home, they will be “subject to” the existing mortgage. In a typical real estate transaction, the buyer will secure a new loan, and the seller will pay off the existing loan and related closing costs using the sale proceeds. In a transaction with a “subject-to” agreement, however, rather than initiating a new loan, the mortgage will simply be transferred from the seller to the buyer.
Let’s look at an example of how this might work.
Suppose the current homeowner has a 30-year fixed-rate mortgage. The initial balance for the mortgage was $300,000, and the current owner has paid off $200,000, meaning that there is $100,000 that still needs to be paid.
Through a subject-to purchase agreement, the buyer will take over the existing mortgage and pay off the remainder of the mortgage under the current terms. In this particular situation, there will be no formal (legal) agreement between the buyer and the lender, meaning the mortgage will remain in the original owner’s name. This is different from a mortgage assumption, which involves a formal transfer from one party to another.
Types of Subject-To Options
It is important to keep in mind that there are three types of “subject to” options.
Cash-to-Loan Subject To
This is the most common and straightforward type of a subject-to agreement, where the buyer simply pays the seller for the difference between the existing loan balance and purchase price in cash. For instance, if the purchase price is $200,000 and the seller’s existing loan balance is $150,000, the buyer will pay the seller $50,000 in cash to cover the difference.
Seller Carryback Subject To
A seller carryback subject-to is also known as “owner financing” or “seller financing.” Under this type of agreement, the seller essentially becomes the lender to the buyer. The seller and buyer will sign a promissory note that outlines the loan amount, interest rate, and terms. Once the sale is executed, the buyer will be making payments directly to the seller based on the agreed-upon terms. If the buyer later fails to submit payments, the promissory note is legally binding, and the seller has the right to foreclose and take the property back.
You can also utilize a seller carryback agreement as a second mortgage, which is often known as seller-carry seconds. A seller-carry second mortgage usually occurs when the buyer has trouble securing the total amount needed to close. Suppose the purchase price is $300,000 and the bank is only willing to finance $200,000 instead of $240,000 (based on the typical LTV of 80%). In this case, the seller and buyer could enter a second loan to bridge the difference of $40,000.
Wrap-Around Subject To
This option is very similar to a seller carryback, but instead of an arbitrary interest rate the seller and buyer agree upon, the interest rate of the loan will be based on the original mortgage interest rate.
This type of agreement is often used to ensure that the buyer pays the seller enough per month to cover interest payments. If the current loan has an interest rate of 3%, the wrap-around subject-to might have an interest rate of 4% to allow the seller to cover the monthly interest and make some additional cash.
When Does it Make Sense to Use a Subject-To Loan?
In most cases, a subject-to agreement will only occur when the home is either already in a state of foreclosure or will likely enter into a foreclosure state in the near future. These agreements do not—or at least should not—occur when a home is up to date with payments and is otherwise in good standing.
People who are having trouble making their mortgage payments will often be enticed to enter into a subject-to agreement because it can help them potentially avoid adverse financial consequences, such as foreclosure or bankruptcy. At the same time, investors—many of whom look through country records to identify homes that are likely to be foreclosed upon—might want to enter into these agreements because they can accelerate the process and secure better terms.
What are the Benefits of a Subject-To Loan in Real Estate?
From an investor’s perspective, the most apparent benefit of initiating and executing a subject-to purchase agreement is that they can earn a considerably higher return on their investment. If the current homeowner has a low interest rate (say, 3%), they will be able to keep making payments using that rate. Considering mortgage rates have jumped from about 3% to over 5% over the past few months for 30-year fixed-rate mortgages, these sorts of agreements will likely become even more common.
Additionally, through a subject-to purchase agreement, the buyer and seller can avoid a lot of closing costs that come with selling through a traditional lender. These costs include origination fees, appraisal fees, and others, which can easily add up to $10,000 or more.
When executed correctly, these agreements can undoubtedly be mutually beneficial. After all, if the current homeowner is on track to lose their home to foreclosure, the subject-to arrangement might be able to provide them with a much-needed lifeline in a shorter timeframe. However, there are also some risks involved in the process, which is why both parties will need to be careful.
What are the Drawbacks of a Subject-To Loan in Real Estate?
Subject-to agreements do come with some disadvantages. For one, lenders don’t really like this kind of transaction, as it complicates the situation and exposes the lender to additional risks. Some mortgage contracts will have a clause giving the lender the right to “call” the remaining mortgage in the event of a transfer. This means that if the lender were to find out about the subject-to agreement, they could consider this event to be a transfer and demand that the remaining mortgage is paid out.
Keep in mind, in this situation, the lender will often have the right to call the mortgage, but they will not have the legal obligation to do so. If payments keep getting paid in full and on time, the lender might allow the informal subject-to purchase agreement to stand. But even still, the very possibility of the lender exercising their right creates a degree of risk for both parties.
Additionally, if the seller, who’s still responsible for the loan, fails to make payments to the bank and therefore enters bankruptcy, the investor may still lose the property. In the case of a seller-carry second scenario, it might also be difficult for the buyer to keep track and submit payments to both the lender and the seller. The complexity of subject-to loans is why most people engaging in this type of transaction are often investors with multiple sources of income and resources to manage different payments.
Whether a subject-to purchase agreement should be considered “good” or “bad” will depend on your perspective. In some situations, these agreements can generate lucrative opportunities for investors while also helping the current homeowner avoid foreclosure. But the general structure of these agreements also creates a level of risk for both parties that should not be overlooked.