Due-on-sale clauses: One reason transferring a loan is risky

When I look at buy/sell/swap pages on Facebook, I regularly see people trying to sell their cars. Commonly, these ads ask people to pay a bit of cash while also taking over the loan. But I wonder how often these folks think through the potential risks involved in doing so. One of those risks comes from due-on-sale clauses.

What is a due-on-sale clause?
It’s a clause in most loan documents that allows the lender to demand full and immediate repayment of the loan if the borrower transfers mortgaged property to someone else. So, for example, if a person transfers their car to someone else, technically the lender can demand full repayment right away. And if you don’t, they can take back the car and charge you a raft of fees to boot.

Why does the due-on-sale clause exist?
The clause traces back to the 1970s. At that time, interest rates were exploding with the cost of borrowing topping out at 18.6% in 1981. Ouch.

As a result of ever-escalating interest rates, when a homeowner would try to sell their home, the interest rate on their existing loan would be much lower than a buyer could get at the time of sale (assuming the buyer could even get a loan). So, buyers would frequently take over the existing, lower-interest loan rather than getting a new one.

Lenders didn’t like that for a couple reasons. First, it’s bad for business. Just as the buyer wanted to avoid paying existing, higher interest rates, the lenders wanted to retire old, lower-interest loans in favor of new, higher-interest ones. Second, lenders don’t want to give loans to just anyone. They need to make sure the borrower has a fair chance of repaying the loan. Otherwise the lender goes out of business—hence, all the research they do on each borrower before issuing a loan. But what’s the point of doing all that research if a creditworthy borrower can just turn around and flip the loan to an unknown buyer who may be much less creditworthy?

Do due-on-sale clauses only apply to sales?
If you thought yes, I understand why. But, in fact, the due-on-sale clause is much broader. It applies to the transfer of pretty much any interest, so perhaps it should be called a due-on-any-transfer-of-interest clause.

For instance, let’s say you entered a land contract, which is essentially a rent-to-own arrangement in which the buyer leases the property until they’ve paid the seller an agreed-to price at which point ownership is formally transferred. Even though legal ownership did not transfer immediately, a watered-down version of ownership (known as equitable title) did. As a result, the land contract triggered the due-on-sale clause as soon as the parties signed the land contract. It doesn’t matter that full ownership was transferred much later.

Do banks have to enforce a due-on-sale clause?
No. It’s optional. And for now, lenders seldom do as long as they receive loan payments on time and in full. But if interest rates start creeping up, then lenders will have the same incentives as they did in the ’70s to retire old, lower-interest loans in favor of new, higher-interest ones.

But just because lenders rarely activate the clause these days doesn’t mean there’s no risk. What if, for example, you go through a divorce and your less-than-happy ex-spouse tells the bank that you’ve transferred the property? It’s one thing for the bank to ignore a transfer while they are getting paid, it’s another thing for them to not act when they’ve been formally notified, especially if the bank personnel like your ex more than you.

When can you ignore a due-on-sale clause?
While the due-on-sale clause is broad, some exceptions exist. For instance, federal law blocks most lenders from enforcing a due-on-sale clause in a variety of situations, which can be found at 12 U.S.C. § 1701(j)(3)(d). The main four are transfers to a borrower’s living trust, transfers to a borrower’s kids or spouse, transfers arising from a divorce decree or separation agreement, and transfers to a relative due to the borrower’s death. In addition to these, for newer loans involving Fannie Mae (and perhaps Freddie Mac), you may also transfer the property to a limited liability company that you control or own a majority interest in under certain circumstances.

Regardless of whether you think one of these exceptions exist, if you are thinking about transferring or receiving property secured by a loan with a due-on-sale clause, have a lawyer look at the loan documents and walk you through the risks of moving forward. Sometimes it’s a smart risk; other times it’s a silly gamble.

This column is for informational purposes only and is not intended to be taken as legal advice. For your specific case, consult a lawyer.