Understanding the "Due on Sale" Clause in Texas Deeds of Trust

Many times in today's economy, homeowners will desire to sell their properties to buyers who are unable to qualify for financing through a mortgage loan. Among the factors that contribute to a prospective Buyer's inability to obtain the loan are creditworthiness, tight capital markets, and low appraisal on the property to be bought/sold. Irrespective of the reason, the absence of a mortgage lender presents unique challenges to the Seller and the Buyer. The most common solution to these challenges is some form of Owner Financing.

However, many of the historically-common mechanisms for Owner Financing have come under strict scrutiny by the Texas Legislature and Courts. The most significant of the Legislature's "reforms" are contained in Chapter 5 Texas Property Code which makes lease purchase or rent-to-own agreements very tough. Investors and other sellers intent on making the sale to Buyers who can't get financing tend to favor "wrap-around mortgages." However, utilizing this mechanism may present unreasonable risks to the new Buyer and sometimes even the Seller (who was the original Buyer/borrower under a still-existing mortgage note.

The biggest problem with utilizing a wrap-around mortgage -- a mortgage from the Seller to the new Buyer under which the Seller's underlying mortgage (the first one, held by the original lender) is not being paid off at closing -- is the "due on sale clause" contained in the Deed of Trust associated with the underlying/first mortgage.

The following is a fairly typical DUE ON SALE CLAUSE found in a Texas Deed of Trust:

"If Grantor [Borrower] transfers any part of the Property without Lender’s prior written consent, Lender may declare the debt secured by this deed of trust immediately payable and invoke any remedies provided in this deed of trust for default. If the Property is residential real property containing fewer than five dwelling units or a residential manufactured home occupied by Grantor [Borrower], exceptions to this provision are limited to (a) a subordinate lien or encumbrance that does not transfer rights of occupancy of the Property; (b) creation of a purchase-money security interest for household appliances; (c) transfer by devise, descent, or operation of law on the death of a co-Grantor; (d) grant of a leasehold interest of three years or less without an option to purchase; (e) transfer to a spouse or children of Grantor or between co-Grantors; (f) transfer to a relative of Grantor on Grantor’s death; and (g) transfer to an inter vivos trust in which Grantor is and remains a beneficiary and occupant of the Property."

In plain English, a "Due on Sale" clause like the one above means that in the event that ownership of the property is transferred from the original Buyer (now acting as Seller) the original lender may accelerate its note or "call the note" due in full.

Under a "wrap-around mortgage" the first/underlying mortgage is still in the Seller’s name and monthly payments must still be made to the original lender as if the sale to the new Buyer never occured. If there is a default in those payments or if the first lender accelerates the note, then that lender could foreclose on the property, causing a dominoe effect under which the new Seller’s wraparound mortgage is invalidated or simply pre-empted and the new Buyer loses any and all ownership interest in the property as well as whatever monies he or she has paid against the wrap-around mortgage.

As a Texas lawyer with an active real estate litigation practice, I've seen many wrap-around mortgage situations go sideways. This occurs most frequently in 2 situations:

1. When the new Buyer defaults in payments, causing the Seller to default on his/her mortgage. This frequently results in a foreclosure that ends-up on the new Seller's credit. Sometimes the Seller is even stuck with a deficiency judgment.

2. When the new Buyer timely pays all monthly payments but the Seller (or more likely a middleman "investor") fails to remit those payments to the original mortgage lender. This can result in a foreclosure without notice to the new Buyer (even though he is timely paying everything he is supposed to pay) because the original mortgage lender isn't even aware of that person's existence, much less their claim to an ownership interest in the property.

Wrap-around mortgages, due-on-sale clauses, and other owner-financing mechanisms are complex and highly regulated by the Texas Property Code and the Courts. Buyers and Sellers considering entering into an arrangement that impicates "executory contracts" should ALWAYS obtain the review and advice of separate real estate lawyers. Your home and your credit are far too valuable to leave to chance and/or to negotiate "under the radar."