Short Sale Promissory note

Michael Kornitzer
mikek@bknegotiate.com

Preface:  In most cases, I am a huge fan of the promissory note.  If negotiated correctly there is nothing wrong with a promissory note as the end result of your short sale.

What is a Promissory Note?
Just like it sounds, it is a promise to pay. Not legal tender but a document from one party to another promising to pay money. Most banking institutions use more elaborate forms of promises to pay.  Like a credit card application fine print has the terms of repayment for any charges.  Same with collateralized loans like automobile and real estate.  The promises have specific payment terms and penalty for nonpayment.  The promissory note is important in mortgaged real estate and connects the individual borrower to the money that is borrowed.  The mortgage is a lien against the collateral while the promissory note is the individuals commitment (promise) to repay the money. 

The mortgage and the promissory note are usually recorded together in a Lien theory state.  Relating to the present day short sale of real estate, some lenders are attempting to separate the promissory note from the mortgage.  That in a short sale the lender would release the mortgage lien against a property and allow it to be sold, but that the promissory note or debt is still owed and in effect. 
Opinion:  This theory has never made sense to me and seems like double dipping for the lender.  Yes the money is owed, but if the best financial outcome is the sale of the property the relationship between lender and borrower should end.  If a hardship exists and the borrower can not pay the mortgage how could anyone reasonably expect they could pay their bills and pay for a property they do not own?

What is Private Mortgage Insurance (PMI)?
PMI is an insurance policy that a lender buys to protect a portion of the money they lend.  Confusing because it is a relationship between the lender and PMI but the borrower pays for it.  It is usually purchased as a percent of the money lent 10%, 20%, 30%.  Most lenders require it for mortgages where the borrower puts less than 20% as a down payment.   This protects the lender against default in a normal real estate market where fluctuations in value is within the insured amount.    For example: on a $100,000.00 loan with 20% PMI.  When the borrower defaults and the lender takes the property back through foreclosure, the lender will sell the property.  If the net proceeds do not cover the entire loan plus collection fees, maybe it  gets a NET of $80,000.00  The lender would file a claim with the insurance company for the 20% that they lost.

Why is PMI asking me for a promissory note? 
PMI does not have to pay a claim until there is a foreclosure and a documented loss to the lender.  In a short sale you are trying to negotiate the sale of the property prior to foreclosure.  When the short sale package is submitted to the lender they in turn submit it to PMI and request that they pay the claim early.  PMI is under no obligation to pay the claim early and can elect to wait and see if it actually goes to foreclosure sale.  In most cases, the lender will not agree to the short sale unless they are getting some portion of the insurance claim.  So, in many cases the PMI agrees to pay the claim early but only if the borrower agrees to make some kind of contribution.
Opinion:  This  make logical sense to all parties involved.  The seller should take some responsibility and in many cases is not left with many options.  PMI is paying the claim no matter what.  There is NO advantage to paying the claim early.  The lender is not going to go against PMI and risk their claim being denied.

Case study: The seller lives in another state with a second home in Florida.  The Florida property is in active foreclosure.  The Seller owes $175,000. This is a lot more than the property is currently worth.  If the property goes to foreclosure the Deficiency Judgment against the seller will probably be close to $225,000 after interest, attorney and court fees.  The property has  Private Mortgage Insurance (PMI) and the lender cannot agree to the short sale unless the PMI agrees to the Short Sale.  After 6 weeks of negotiations with the PMI they have demanded a $25,000 promissory note, payable over ten years interest free.

Should the owner sell the property?
Yes, the loan to value makes this a tough property to keep and recover from.
Is this a good deal for the owner?
Yes, trading $225,000.00 of secured debt for $25,000.00 in unsecured debt is probably the best financial decision anyone could make.
What are some other options?
1)Most states and mortgages allow you to reinstate your mortgage at any time before the sale.  Contact your lender or their Attorney for the payoff and terms to bring your mortgage current.  

2)Foreclosure (just walk away) is very bad for your credit and will result in a court judgment against you for much more than you thought you owed. 

The objective and premise of a short sale is for the owner (seller) to “get out of”  their mortgage obligations without paying any money.  This is only effective because the lender is choosing the best financial path for themselves and their investors.  It has very little to do with the borrower, except their inability or unwillingness to pay the mortgage.

However keep in mind, that if you borrowed the money YOU OWE THE MONEY!  Blame the economy, mortgage company, mortgage broker, realtor, spouse etc.  but nothing has changed, you borrowed the money.  As I explain this theory to every one of my clients, I always have a handful of clients who in the end exclaim “you said this wouldn’t cost me anything”. Among many others, I have had the following scenarios/situations in the past month:

1) Seller getting out of $150,000.00 in mortgage debt free and clear.  Refuses to pay a $300 water lien at closing.  “I am not paying a penny on this property” was her stance. Resolution: I paid it myself to get the deal done.
Opinion: Seller  is a chronic investor always looking to cheat and needs to take some responsibility.

2) Seller in active foreclosure getting out of $300,000. worth of mortgage debt for a $25,000. promissory note.  Loan to value upside down by $250,000.  A month before the closing consults three attorneys from his prepaid legal network.  All three attorneys advise seller not to sign promissory note claiming  “they can fight the foreclosure”.
Opinion: Attorneys are wrong and not doing their client any service, but they need to make money too.  There is not much of a foreclosure fight when the Judge asks “did you borrow the money?”

3) I receive a text message 15 days before closing “I don’t want to sign a promissory note”. They owe almost $500,000.00 on the mortgage and the property is selling for $225,000.00. The seller is getting out of $275,000.00+ in deficiency mortgage debt for a $25,000.00 Promissory note.
Opinion: Sign and run as fast as you can.   “nobody wants a promissory note”.   The decision here is $275,000.00 in foreclosure deficiency judgment or $25,000.00 in unsecured debt.  The prudent financial decision would be to sell the property as quickly as possible.

4) Week of closing, two weeks before foreclosure auction seller decides not to sell because $60,000.00 second mortgage claims they are not releasing the debt.  Seller was getting out of $150,000.00+ of debt on the first mortgage.  House went to auction and seller has $225,000.00+ worth of judgments against him.
Opinion: Not the best decision the seller ever made.  Bankruptcy if he qualifies will probably be his only recourse.  Then he will have foreclosure and bankruptcy following him forever. Even if the lender claims that they are not releasing the debt it is usually to your advantage to short sale the property.  A foreclosure suit resulting in a Deficiency judgment is very damaging to your credit and ability to get credit in the future.  Payment hearings could follow with asset attachment, wage garnishment etc.   A short sale of the property  removes the real estate attachment and makes collecting money more difficult.

How will they try and collect the Promissory note?
The promissory note is usually an unsecured debt, meaning that there is no collateral like a house or a car attached.  Some other types of unsecured debt would be credit cards, doctor or utility bills.  Unsecured debt is very often difficult to collect.  There is a legal system in our Civil Court (non criminal) for the collection of money.  In most cases, it requires a law suit to be filed from one party, (the Plaintiff) against the other party, (the Defendant).  This costs money and opens the Plaintiff up to a long battle or defense to the suit by the Defendant.  Many of these cases can go on very long and become costly for both parties, often outweighing any advantage to winning the actual law suit.  So, if the PMI company is in California and you are in Florida, PMI would need to hire and pay an Attorney in Florida to initiate suit against you.  Most often unsecured debt is sold repeatedly to collection agencies and collection Attorneys, decreasing in value every time.  In most cases unsecured debt can also be settled for pennies on the dollar, because the likelihood of collection is so slim.  There is also a statute of limitations on the collection of unsecured debt in the court.  Once this time is up the court cannot be used for collection of the debt.

Summary:
Don’t let a promissory note scare you away from completing your short sale.  Take the time to review your options and write them down.  Review each worst case scenario and decide how that decision will affect your life immediately and in the future.  Be unbiased and impersonal about the financial decision you are about to make.  “I don’t want a promissory note” or “I’ll just give the house back” are irrational answers that are not based in sound financial decisions.  Do a cost analysis over 5 or 10 years.  Will the property ever get its value back?  Will you be able to pay the mortgage if your income decreases 10-20%?  Is foreclosure immanent if you do not short sale? Review your objectives and stick to them.  For most clients a promissory note does not interfere with their original objectives.  In fact, most people are relieved, pulled out of limbo and able to get their financial lives back on track.

Consider this :
Although a promissory note sounds like a reaffirmation of a portion of the debt. If your case gets to a Judge and he issues a Deficiency Judgment against you it is like signing a promissory note for all the lenders losses. Except it is much worse, the Judge is signing the promissory note for you with the full extent of the law behind it. Your credit report will reflect a judgment, foreclosure and the entire debt still owed. Judgments are bought and sold with much higher weight and collectability than a promissory note. Your ability to ever get credit again is diminished and more than likely collectors will collect the judgment for the rest of your life.

The information on this site does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind nor should it be construed as such. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action on this information, you should consult a qualified professional adviser to whom you have provided all of the facts applicable to your particular situation or question. None of the tax information on this web site is intended to be used nor can it be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer. The information is provided "as is," with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.