When a seller-financed buyer stops paying, what does the note holder actually hold?

Question

The idea that a buyer who stops paying simply means the seller takes the house back is far too simple. Take a duplex carried on a note with the buyer putting 12 percent down. On default, the instrument decides the path. A note and deed of trust typically requires foreclosure, judicial or non-judicial depending on the state, which takes time and money. Contract for deed can move faster in some states, but it carries legal risk, and some courts treat it as a mortgage anyway. Throughout, property taxes and insurance do not pause. Whoever holds legal title is generally still responsible for taxes, and coverage depends on how the policy is structured and who is named on it. Settle that in the financing documents before the first payment is due.

Rena Guide · Accepted Answer

Two separate documents, two separate jobs. The note is the borrower's promise to pay. The security instrument, a mortgage or a deed of trust depending on the state, is what attaches that promise to the real estate and gives you a remedy if the promise breaks. Without the second one you're an unsecured creditor holding an IOU.

Getting the house back means foreclosing, and the process is set by state law. Some states use nonjudicial trustee sales, which can run a few months. Others require a court case, which takes considerably longer and costs more in legal fees. A contract for deed, also called a land contract, is sometimes pitched as a faster remedy because you keep the deed until the buyer pays in full, but several states treat a substantially performed land contract like a mortgage and require you to foreclose anyway. Which category your state falls in is a question for a local real estate attorney before you choose the instrument.

On taxes and insurance, the mechanism you want in writing is either an escrow arrangement where the servicer collects and pays them monthly, or a monitoring service that tells you the moment a payment is missed or a policy lapses. Unpaid property taxes can create a lien that sits ahead of yours, and an uninsured loss can destroy the collateral your whole position rests on. You should also be named on the buyer's hazard policy as mortgagee or loss payee so the insurer notifies you and the claim check isn't handed over without you.

During a default you'll often be the one advancing those taxes to protect your lien position. Budget for that rather than being surprised by it.

stephen_ok9 · Answer

"Just take the house back" is doing an enormous amount of work in that sentence. In a nonjudicial state a trustee sale can move in a few months. In a judicial state you're filing a lawsuit and the calendar belongs to a court, which can mean a year or more with no payments coming in.

marcus_hale41 · Answer

Order a lender's title policy at closing and read the exceptions. I've seen carry deals where an old judgment lien sat in front of the seller's new lien and nobody noticed until they tried to sell the note. The premium on the lender's side of a simultaneous issue is small, a few hundred in a lot of states.

nataliehsu · Answer

Do the servicing companies handle the default piece too, or do they just stop collecting and hand you a file? Trying to understand where a servicer stops and a lawyer starts.

dpatel_re · Answer

12% down means your note is 88% of value on day one. Foreclose and resell and you are likely looking at legal and holding costs, and a sale that nets somewhere in the low 90s of value at best. Add six months of missed payments plus taxes you advanced and the cushion is gone. Underwrite the borrower as if the cushion does not exist, because at 88% it barely does.

raj_mehta14 · Answer

Find the power of sale clause in your deed of trust. That is the sentence where the borrower agrees in advance that the trustee can sell without going through a court, and it is what makes a non judicial default process possible at all. It may be the most important sentence in the document, and it tends to sit somewhere around page nine.

sonia_alvarez · Answer

Agreed, @dpatel_re, which is why most of these end in a modification rather than a foreclosure. Extend the term and capitalize the arrears, and the lender keeps a paying borrower. It is usually the higher recovery even though it feels like losing an argument.

nicole_adeyemi · Answer

On land a contract for deed still makes sense in the states where forfeiture actually works, since there is no structure to insure and the whole value is the dirt. A duplex is a different question. You have tenants and habitability duties, and a court that will look at whether the buyer built up equity.

jessreyes12 · Answer

Here's the one I've never understood. If I foreclose and the house sells for more than the balance, do I keep the extra? Or does the buyer get his payments back somehow?

wendy_park48 · Answer

@jessreyes12 surplus over the debt and costs generally goes back to the borrower, and the exact waterfall is set by state law. @carlos_nunez the clause worth adding to your read-through is the default interest rate and how late charges accrue, because six months of arrears at a default rate changes the payoff figure considerably, and some states cap what can be charged.

hannah_west29 · Answer

Running quarry's numbers. Say a $250k duplex, $30k down, $220k note. Six missed payments, $6k in advanced taxes and insurance, legal and trustee costs at 3% of value, resale costs at 7%. You need roughly $250k of value at sale just to break even on the balance, and you started with $30k of cushion. Any softness in the market and you are negotiating with the borrower whether you like it or not.

When a seller-financed buyer stops paying, what does the note holder actually hold?

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