Assume Loan or Take Subject To?
In the purchase and sale of a property encumbered by an existing loan, parties may structure the transaction for buyer either to specifically assume the existing loan or take title to the property “subject to” this loan. Whether buyer takes “subject to” or “assumes” an existing loan has significant and different consequences for the lender, the original borrower (seller) and buyer.
A typical reason for parties to have buyer either assume or take subject to existing financing is to avoid paying prepayment penalties. Commercial loan documents routinely contain a due-on-sale provision that the loan becomes due upon sale of the property which is collateral for the loan. Many loans additionally require that if the loan is paid before its maturity date, then, in addition to paying the principal loan balance, borrower pays lender a prepayment fee. The amount of the prepayment fee is often a percentage of the loan amount or enough to maintain the lender’s yield after the loan is paid. Saving prepayment fees, which can be hefty, sometimes means the difference between making and breaking a deal.
An advantage for buyer in retaining the existing financing is that buyer does not then need to obtain a new loan, which can save time and shorten the escrow period. If buyer takes subject to existing loan, closing will not be contingent on buyer obtaining financing and the parties may be able to more expeditiously close the escrow. Also, by assuming or taking subject to the existing loan, buyer saves new loan fees and charges, although lenders typically charge a fee for buyer’s assumption of an existing loan.
Another financial benefit to buyer in keeping existing financing may be to retain the interest rate of an existing loan which is more favorable than current market rates. Additionally, buyer may wish to take subject to an existing loan if buyer will not qualify for the financing due to poor credit, lack of verifiable income and similar other reasons.
But neither the assumption nor the “subject to” alternatives may be available if the existing loan documents contain a due-on-sale clause which prohibits a sale or other transfers. Some due-on-sale provisions absolutely prohibit a sale or transfer while others permit a sale of the property to a buyer that is approved by the lender. When buyer proceeds to obtain the lender’s consent, buyer is usually required to pay an assumption fee and meet the lender’s financial qualification requirements and creditworthiness standards. If the due-on-sale provision is violated, then the borrower is in default and the loan may be accelerated, which means the loan must be fully paid off.
Seller should be very careful when permitting buyer to take title to the property “subject to” existing financing because, without an assumption by buyer and release by lender, seller is not exonerated from the debt; and, if the loan is recourse, seller remains personally liable for the loan obligation notwithstanding the sale. From buyer’s perspective, a major disadvantage to buyer assuming a loan is that buyer will be contractually bound to the lender; by contrast, a buyer taking title “subject to” is not contractually (or otherwise) bound to pay the existing debt. By buyer assuming the loan, the lender will then gain direct recourse to buyer for any loan defaults.
From seller’s perspective, it is critical at minimum to have buyer assume existing financing and lender agree to exonerate seller from future liability on the loan. Even if buyer assumes the loan, without lender releasing seller, lender can claim buyer’s assumption of the loan simply created an additional, second obligor, and seller was never exonerated.
When buyer takes title “subject to” an existing loan, buyer does not assume the loan and is not contractually liable to seller or lender for defaulting under that loan. But, seller is still liable to the lender under the loan. So, at minimum, seller should require buyer to agree in writing with seller to pay the loan and/or indemnify seller against post-closing loan breaches. These protections will provide seller some recourse against buyer for post-closing loan breaches by buyer and ensure buyer has some personal liability as against seller, even if not against lender.
In case buyer takes subject to existing financing and then defaults, buyer’s down-payment is at risk. Also, if the existing loan had a due-on-sale clause, and the lender discovers the property was sold in violation of due-on-sale provision, the lender will have the right to declare a default and accelerate the entire loan balance by reason of the sale. This would mean buyer would lose buyer’s down-payment and equity unless buyer either refinances or comes to an understanding with the lender.