What’s an alienation clause in real estate?

Have you ever wondered what happens to a mortgage when a property is sold or transferred? One essential term in real estate contracts that directly impacts this process is the alienation clause, also known as the due-on-sale clause. 

If you’re preparing for a real estate exam or looking to deepen your understanding of mortgage agreements, it’s important to recognize that there are various other clauses in a loan or mortgage contract, such as acceleration, subordination, and prepayment clauses. Each of these clauses serves a unique purpose and affects property transactions in different ways.

In this article, we’ll dive deep into the due-on-sale clause, including its exceptions, how it functions, and the types of mortgages that might not include it. 

We’ll also cover wrap-around loans, quitclaim deeds, and its presence in property insurance contracts.

Definition

An alienation clause is a provision in a mortgage agreement that requires the borrower to pay off the remaining mortgage balance when the property is sold or transferred. 

This clause prevents new owners from assuming the existing mortgage unless the lender consents.

Key points:

• Purpose: Safeguards the lender by requiring their approval before the property can change hands, ensuring they maintain control over who is responsible for repaying the loan.
• When it’s triggered: The clause comes into play during property transfers, whether through sale, gifting, or changes in legal ownership structures.

Example:

Imagine Mike sells his home to Sarah. Mike’s mortgage includes an alienation clause, so he must pay off the remaining balance when the sale is finalized. Sarah cannot take over Mike’s mortgage unless the lender approves.

Due-on-sale clause exceptions

The 1982 Garn-St. Germain Act established specific instances where lenders cannot enforce the due-on-sale clause, even if ownership changes hands. Here are common scenarios:

1. Divorce or legal separation: If a property jointly owned by spouses becomes owned by just one spouse due to divorce, the clause cannot be enforced.
2. Transfers to children: When ownership is transferred to the borrower’s children, lenders cannot require immediate mortgage payoff.
3. Inheritance: If the original borrower dies and ownership passes to a children or spouse already occupying or intending to occupy, the clause is not triggered.
4. Living trust transfers: If a borrower transfers property into a living trust and remains the trust’s beneficiary and a property occupant, the clause does not apply.
5. Joint tenancy: A lender cannot take advantage of the clause if a joint tenant (like a surviving spouse) takes over the mortgage.

Why would a lender not invoke a due-on-sale clause?

Although lenders have the right to enforce a due-on-sale clause, there are cases where they may choose not to:

1. Weak housing market: In a slow market, lenders may allow a new buyer to assume the existing mortgage rather than risk foreclosure due to the original borrower’s potential default.
2. Property value decline: If the property’s value has decreased and a sale will not cover the outstanding balance of the loan, the lender might negotiate to accept a lesser amount to recover part of the debt.

What types of mortgages do not have an alienation clause?

While most mortgages loans in the United States include alienation clauses, there are exceptions:

• FHA, USDA, and VA Loans: Mortgages insured by the Federal Housing Administration (FHA), Department of Veterans Affairs (VA), or U.S. Department of Agriculture (USDA) typically do not have due-on-sale clauses. However, new buyers must meet specific eligibility criteria to assume these loans.
• Assumable mortgages: Some older loans or specific mortgage types are assumable, allowing a new buyer to take over the existing mortgage terms.

Do wrap-around loans have a due-on-sale clause?

A wrap-around loan is a type of financing where a seller keeps their existing mortgage and adds a new loan amount on top, which the buyer takes on. Essentially, the buyer makes payments to the seller, who continues to pay the original mortgage. 

This arrangement allows the seller to finance the buyer directly, often at an interest rate slightly higher than the original loan. Wrap-around loans are typically used in situations where traditional financing options are difficult to secure.

If the original mortgage has a due-on-sale clause, the sale of the property to a new owner triggers the clause. This means the original borrower would need to pay off the mortgage in full when he sells the house. If he can’t pay the full balance, or if the lender enforces the clause, the entire wrap-around loan could be jeopardized. That can complicate or derail the sale.

Tip: If you’re considering a wrap-around loan, review the original mortgage documents carefully to see if a due-on-sale clause is present.

Quitclaim deeds and the alienation clause

A quitclaim deed transfers property ownership without money changing hands and is often used between family members. However, if the property has an active mortgage with an alienation clause, the transfer could trigger the clause unless exceptions apply.

Alienation clauses in property insurance

Alienation clauses are not just limited to mortgages; they are also found in property insurance contracts. These clauses release the original account holder from the insurance obligation if ownership changes. The new homeowner must then obtain their own insurance for the property.

Comparing to other mortgage clauses

Understanding the alienation or due-on-sale clause is important, but real estate professionals and exam students should also be aware of how it differs from other common mortgage clauses:

1. Acceleration clause:

• Definition: Allows the lender to demand the full repayment of the loan if some conditions are met, like borrower’s continuous monthly payments defaults or major mortgage agreements violations.
• Key Difference: Triggered by default, not by property sale or transfer like the alienation clause.

2. Subordination clause:

• Definition: Establishes the order of priority for multiple mortgages on the same property.
• Key Difference: Deals with the hierarchy of loans, ensuring one mortgage holds a superior claim over another.

3. Prepayment clause:

• Definition: Dictates whether a borrower can pay off the mortgage early and whether any penalties apply.
• Key Difference: Focuses on early payment terms, whereas the alienation clause focuses on property transfer conditions.

Common questions

What happens if a person violates the alienation clause?

In case the borrower fails to fulfill the this clause, the lender can sue the borrower legally.

Can an alienation clause be included in a lease?

Some leases contain alienation clauses. With a lease, the function of the alienation clause is to stop the lessee from subletting or from making an arrangement for the transfer of the lease.

Summary

An alienation clause prevents new owners from assuming the existing mortgage unless the lender consents. It is an important part of many mortgage agreements. It requires the borrower to pay off the loan when they transfer ownership. Like with many other clauses, it is designed to protect the lender. 

While this clause prevents assumable mortgages, there are exceptions outlined in the Garn-St. Germain Act for cases like divorce or inheritance. 

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