What is a subject-to mortgage?

Most people think there's only one way to buy a home: You save up for the down payment, and you take out a mortgage to cover the rest.

But there's another option called a subject-to mortgage. With these arrangements, the buyer agrees to take over the seller's mortgage payment. Both buyers and sellers might consider this option, since there's no need to make a down payment or apply for a new mortgage — and it speeds up the sale process.

However, as a financial educator and former HUD-certified housing counselor, I would rarely recommend entering a subject-to agreement. Why? Because both parties can do a lot of financial damage to each other, long after the sale is complete.

How do subject-to mortgages work?

With a subject-to mortgage, the sale is "subject to" the condition that the mortgage will stay in the seller's name. In other words, the buyer takes over the seller's mortgage payments. However, the deed for the home is transferred to the buyer, making them the legal owner of the property.

Subject-to mortgages are formalized using a legal contract called a real estate purchase agreement, also known as a real estate sales contract or home purchase agreement. This contract outlines all of the conditions for the sale, including the fact that the buyer will take responsibility for mortgage payments.

However, these arrangements can create a lot of problems for both parties. Why? Mainly because a subject-to mortgage does not override the original mortgage contract. So if the buyer misses mortgage payments, for example, the lender will come after the seller for the money. And if the seller files for bankruptcy down the road, the home could be foreclosed on.

Here's how buyers and sellers are affected by a subject-to mortgage:

Why buyers and sellers might consider a subject-to mortgage

The main benefit of subject-to mortgage agreements is that they make the sales transaction more convenient for both the buyer and seller. Here are some of the main benefits of going this route:

• Lower rates: The seller's mortgage may have a lower interest rate than what's currently available on the market.

• Loan qualification: If the buyer doesn't qualify for a mortgage, this arrangement can help them make the purchase.

• Speed: The sale process can move faster since there's no need for mortgage approval or loan underwriting.

• Up-front savings: There's no need to make a down payment or pay closing costs.

• Financial help: The arrangement can relieve the seller from falling behind on a mortgage payment that's too big for their budget.

Subject-to mortgages come with significant risk, especially for the seller. Here are some of the ways this kind of arrangement can backfire:

• Unqualified buyers: The buyer could have financial or credit issues that make them unqualified to take out a mortgage. These same issues could interfere with their ability to keep up with a new loan payment.

• Legal liability: If the buyer misses payments or goes into foreclosure, the seller will be held liable for the debt, and their credit will be damaged. On top of that, the seller can no longer tap into the home's equity to cover overdue payments.

• Due-on-sale clauses: Some lenders have clauses stating that the full loan balance has to be paid off when ownership changes. If the seller can't pay the balance, the lender may foreclose.

• Title issues: The home may have liens or judgments for debt the owner hasn't paid. In a traditional sale, the seller would use the proceeds to pay off these debts, but they may struggle to come up with the funds in a subject-to arrangement.

• Bankruptcy: If the seller files for bankruptcy, the mortgage lender may discover that they no longer own the property and choose to foreclose.

• State laws vary: The laws regulating subject-to mortgages vary by state. For example, in Texas, you're required to hire a third-party loan servicing company to assist with the transaction.

Ultimately, both parties should be aware that these arrangements are complicated and risky. In fact, the nonprofit agency NC Realtors says subject-to mortgages should be avoided at all costs. If you still want to proceed, I highly recommend consulting with a real estate attorney up front.

Subject-to vs. loan assumption

A subject-to mortgage isn't the only way to become a homeowner without applying for a mortgage. Another way this can happen is through loan assumption.

With loan assumption, you "assume," or take over legal liability for the mortgage payments. This is unlike a subject-to mortgage, since the seller is no longer liable for the loan. However, the terms of the loan won't usually change, meaning the buyer will have the same interest rate and monthly payment as the seller.

Loan assumption can be an option in the following circumstances:

• You become the owner after the mortgagee passes away or through a divorce.

• The home has a VA loan, USDA loan, or FHA loan.

• You want a subject-to mortgage, and the lender allows loan assumption.

When does a subject-to mortgage make sense?

For sellers, I would almost never recommend a subject-to mortgage. These transactions are only worth considering if all of the following are true:

• There's little to no equity in the property, so you won't lose money.

• The lender does not have a due-on-sale clause.

• You have no loans or liens against the property.

• You need to sell the home faster than you would with a traditional sale.

Even if all of these circumstances are present, you're still trading a short-term fix for a long-term liability.

As long as there's a balance due on the mortgage, you're fully liable for the debt, yet you have no rights to the asset. If the buyer stops paying the mortgage, you'll have major financial problems to deal with.

For buyers and investors, a subject-to mortgage can be a better deal, but it can still go awry. Yes, subject-to agreements allow you to purchase a property without taking on a mortgage. However, the lender may foreclose on the property if the seller files for bankruptcy or if they discover ownership was transferred.