A common feature of legal contracts and real estate dealings is the alienation clause. Another name is a due-on-sale clause. You’ve come to the right place if you have any questions or confusion about ACs, especially for mortgage contracts. In this comprehensive article, we cover:
- What is an Alienation Clause?
- How Do ACs Pertain to Business Contracts?
- Alienation Clauses in Real Estate
- Helpful Examples
- How To Make an AC Work (Tips & More)
- Alienation Clauses vs Acceleration Clauses
- Frequently Asked Questions
- How Assets America® Can Help
What is an Alienation Clause?
An alienation clause can appear in various types of financial and insurance contracts. Generally, it describes what happens when a contract party sells or transfers an asset or collateral. You often use ACs in mortgage contracts, and we will focus on the alienation clause in real estate.
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Alienation Clause in Real Estate
Mortgage lenders rely on alienation clauses for protection against borrowers selling or transferring their mortgaged property. You can define alienation clauses as, “contractual language that ensures the borrower repays the loan when a sale or transfer occurs.” You will find ACs in both commercial and residential mortgage contracts.
To be precise, ACs prevent the occurrence of assumable mortgages. That is, a buyer won’t be able to assume the mortgage from the seller. Theoretically, upon assumption, the buyer could make the remaining mortgage payments on the same terms as previously scheduled.
Although uncommon, sellers sometimes try to use assumable mortgages to keep from disclosing the sale. The seller might also like an assumable mortgage to simplify the property transfer.
Alienation Clauses Protect Lenders
However, note that assumption is off the table when the mortgage has an assignment clause. Under an AC, the mortgage lender must receive repayment immediately if the borrower sells collateral property or ownership rights.
Nowadays, almost all mortgage contracts contain ACs to protect lenders from original borrower’s unpaid debt. This prevents the borrower from squirming out of its debt obligations just because it can’t pay. Additionally, the lender has no idea about the creditworthiness of the buyer, an unknown third party, whom the lender has not run credit or underwritten.
The lender should object to assuming credit risk for a borrower that the lender hasn’t put through scrutiny. After all, the buyer may have a vastly different credit profile than the seller.
History of the Alienation Clause
The AC was a reaction to the creative financing craze of the late 1970s and early 1980s. Indeed, a 1974 court case, Tucker v Lassen S&L, instigated the situation. The court ruled that the lender could not call in a loan because of a land transfer. Understandably, real estate agents began arranging creative financing solutions.
A buyer typically took equitable title to a property through a land contract and assumed the existing mortgage. The buyer also made payments to the seller to acquire equity in the property. Interestingly, high interest rates propelled this kind of activity.
A 1978 court case reinforced the earlier decision. Grandly, it stated that a lender could not call in an assumed loan if the collateral wasn’t impaired. More than ever, assumable mortgages were the rage, as they avoided the 18% interest rates that were prevailing at the time.
Closing times were typically about seven days, with buyers putting down 7% to 10%. Naturally, this paid for closing costs and carryback financing (that is, second or third trust deeds). Obviously, real estate agents made money hand over fist.
Lenders Strike Back
The creative financing craze began to dissipate following the passage of the 1982 Garn-St. German Act. In particular, the Act put the nation’s savings and loans under new regulators. Moreover, mortgage interest rates came down in the late 1980s, making mortgages more attractive.
Indeed, FHA and conventional mortgages made a strong comeback at that time. Note that these loans had enforceable alienation clauses that didn’t conflict with previous court rulings. Today, property buyers must negotiate a new loan due to the prevalence of ACs.
Example Alienation Clause
“In the event the Property or any part thereof or any interest therein is sold, conveyed or alienated by the Trustor, whether voluntarily or involuntarily, except as prohibited by law, all obligation secured by this instrument, irrespective of the maturity dates expressed therein, at the option of the holder hereof and without demand or notice, shall immediately become due and payable.”
Note that “trustor” refers to the holder of the trust deed.
Alienation Clause in Leasing
A lease may include an AC. The clause prevents the lessee from transferring, subletting, or sharing occupation of the lease. The exact terms of the AC depend on the lease. For example, it could prohibit lease alienation, or could require lessor permission before alienating the lease.
How To Make Alienation Clauses Work
Understand that a lender has the right, but not obligation, to enforce an alienation clause. In other words, the lender can decide whether to take action on the clause.
Importantly, sometimes the lender cannot enforce the AC. For instance, a surviving joint tenant can assume the title when the other owner dies. This second-owner can take over the loan without having to repay it immediately. In fact, similar rules apply when title transfers to beneficiaries via a bequest. However, the beneficiary who takes possession must also live in the property.
Furthermore, the lender can’t enforce an AC if the owner has a second mortgage on the property. Specifically, the first lien holder cannot exercise the AC and force the borrower to pay up right away.
Clearly, a lender can only make an AC work when inheritances or second mortgages aren’t involved.