What is "Subject To" in Real Estate?
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What does it mean to buy a property "Subject To"?
A subject-to sale is a quick process with few upfront costs, potentially lower interest rates, and an opportunity for higher profits. Of course, it carries its own unique risks and challenges to counterbalance the rewards.
There are a lot of “subject to” clauses you can put in a sales contract but in this case “subject to” refers to the existing mortgage. When you buy a property subject to the existing home loan, the existing mortgage (originally extended to the seller) remains in place and the new buyer simply assumes the position of the original borrower and continues making payments.
In a nutshell, “subject to” real estate works like this:
Joe is behind on his $150,000 mortgage and is facing the possibility of foreclosure. An investor discovers the opportunity, evaluates the home and determines it’s actually worth $175,000 as-is.
Joe agrees to sells the property subject-to the investor taking on the existing mortgage payment. At closing, the investor gives Joe $25,000 (less any costs they negotiated in the contract), Joe deeds the house to the investor, and the investor takes over Joe’s mortgage payment.
Joe is happy because his default is cured, he avoided a catastrophic credit hit of foreclosure, and he gets the benefit of continued regular monthly payments on his credit report.
The investor is happy because they got a low-interest loan on the property without the hassle and expense of obtaining a new mortgage.
How is subject-to different from assuming a mortgage?
When you assume an existing loan, the seller’s name is removed from the mortgage and the new buyer becomes financially responsible to the lender.
The new buyer has to go through loan qualifications as they would for any other mortgage. They are also required to pay closing costs, although they are usually much lower. Most lenders require a title search during a loan assumption, but an appraisal isn’t usually necessary, depending on the loan to value ratio.
On the plus side, since the investor is taking over an existing loan, they get to keep the original interest rate and term. The amortization schedule does not reset but continues in place from where the original borrower left off.
Several government loan programs (e.g. – FHA, VA, SBA) do allow for loan assumptions under certain circumstances, but many traditional lenders will not provide this as an option, which leaves subject-to as the only way to “take over” a conventional mortgage.
What are the subject-to advantages for the buyer?
Some real estate investors will intentionally seek out opportunities to buy properties from motivated sellers subject to financing.
They do this because a subject to sale allows them to obtain lower-interest long-term financing without ever dealing with a bank. Mortgages on owner-occupied homes typically have significantly lower interest rates than those for an investment property.
For example, if current interest rates are at 6.5% and a seller obtained their loan as an owner-occupied buyer, they could easily have a much lower fixed interest rate in place at 4.5%. This kind of 2% difference can have a major impact on what the investor’s monthly payment will end up being.
In addition, if an investor takes over the seller’s original loan several years into the loan’s amortization schedule, most of the monthly payments will go to pay down the principal instead of interest. This takes away some of the sting of not being able to depreciate the house or deduct your interest.
Finally, the investor-buyer will have no personal liability for the debt and since it was originally extended to the seller, this financing “burden” stays off their record. It won’t affect the investor’s balance sheet if/when they need to apply for credit to buy another property later on.
What are the buyer’s risks in subject-to sales?
The “due on sale” clause is a major risk for investors. Most mortgage contracts give lenders the right to accelerate the borrower’s loan in the event that the deed is transferred. This means they can call the loan early (requiring the entire balance due now) and initiate foreclosure proceedings if it isn’t paid in full.
Even though a bank may have this right, many will not exercise their rights. If a mortgage payment continues to be paid on time, the lender has little incentive to accelerate the loan. Doing so will eliminate a source of interest income for the lender, and it’s also time-consuming and expensive for lenders to foreclose a property, so many lenders will turn a blind eye if and when they are notified.
That said, it’s still a huge risk, especially if you don’t have the cash to cover the balance or can’t get refinancing from another lender to pay it off.
Property insurance can also create some challenges. Sometimes a change in policyholders is all it takes to trigger the loan acceleration. Taking out a second policy could also cause problems since each insurer would attempt to pin the cost of the claim on the other.
In most cases, the easiest solution is to retain the original policy and simply add the new owner as an additional insured.
Finally, there is always the possibility that the seller files chapter 7 bankruptcy at some point after the sale. If the home equity is above the exemption limit, the trustee can force a sale.
Why would a seller agree to a subject-to sale?
A subject-to sale might seem like a big risk for the seller. After all, if the new buyer fails to make payments on the property, the lender goes after the seller, and the catastrophic event occurs to the seller’s credit score, not the new buyer’s.
Even so, for some sellers, a subject-to sale is the most attractive option. Subject-to sales typically close quickly and are often structured so that the seller pays no closing costs. The property doesn’t need to meet the bank’s appraisal requirements and there are no bank-required inspections or repairs to delay or derail the sale.
In many cases, the buyer of a subject-to property is a real estate investor, one who is willing to take the property as-is, because they are buying the property at a price below market value. This eliminates many of the hassles and expenses that regularly come up when selling a home.
Imagine an elderly woman who needs to move into assisted living. Her home is in poor repair and her family lacks the time and money to fix it up to list it for sale. In addition, the woman needs the money right now to pay the move-in fee. With a subject-to sale, the investor gets an advantageous price for taking the property as-is and the woman gets her money right away. It’s a win-win for both parties.
3 Ways to Structure Subject-To Sales
For general homebuyers, there may be an element of owner financing in a subject-to sale. This is rarely the case with investors, however.
Here are three possible ways to structure a subject-to deal:
- Simple Cash-to-Loan: The buyer pays the seller cash for the difference between the purchase price and the mortgage balance. This is by far the most common option for investors.
- Subject-to with Seller Financing: In this case, the seller finances the buyer’s cash due. This can take the form of a second mortgage or a land contract.
- Subject-to with Interest Wraparound: This is a sweetener for sellers who provide owner financing. In the case above, assume Joe’s mortgage interest rate is 4.5% and the buyer is putting down $10,000 with $15,000 carryback financing. The sale is arranged with a 5.5% interest rate and wraparound. Joe makes 5.5% on the $15,000 carryback and 1% on the existing $150,000 mortgage balance. If the seller doesn’t like the idea of a carryback, a wraparound could induce him to accept the deal.
Since a conventional lender isn’t involved in these negotiations, it’s up to the buyer and seller to arrive at an arrangement that both parties find acceptable.
Subject To: It's Not for Everyone
A subject-to sale isn’t the right choice for every deal, but it’s a useful strategy for investors to be aware of.
In cases where a property needs a lot of work, for example, subject-to may be better than a land contract or lease option, since the buyer actually becomes the deeded owner at closing (rather than waiting until the loan is paid off).
If you do decide to buy a property subject-to, be sure to find a real estate attorney with experience writing these types of contracts.
If you’re the seller, keep in mind that the mortgage stays on your credit report, not the buyer’s, and you may not be able to qualify for another mortgage until the first mortgage is paid off. Subject-to sales may not be the best option for you if you need to buy a new house in the next several years.
Ultimately, if a real estate investor can get an investment property at a favorable price with a low-interest mortgage, the rewards of subject-to often outweigh the risks.