Pledging a Residence to Secure a Commercial Loan
When a borrower requests a commercial loan for a new business or a business acquisition, lenders frequently require the borrower to secure the business loan with a mortgage on a personal residence. The residence may be taken as additional collateral, or because of the insufficiency of other business collateral to secure the loan. Using a residence as additional collateral frequently is the best way to meet a lender's collateral requirements.
When a residence serves as collateral for a commercial loan subsequent issues may arise for the borrower and lender. The borrower may be (a) selling and moving to another home, (b) refinancing to obtain better home loan terms, or (c) refinancing the commercial loan. After allowing sufficient time to complete the necessary title, judgment, and lien searches in order for the lender to have the required lien priority to secure the commercial loan, the borrower and the lender will confront a number of issues.
Does the Commercial Lender Still Need to Have a Mortgage on the Residence?
The borrower now may have sufficient assets such that the lender no longer requires the security interest against the residence to secure the commercial loan adequately. Generally, this is not the case, and the commercial lender will continue to require a lien against the residential property.
Who Must Weigh in on the Credit Issues?
If the Small Business Administration guarantees the loan, additional factors will arise. In most instances where a residential property is being refinanced, a commercial lender will want to ensure that, other than the funds needed to pay off senior liens and closing costs, all of the residence's refinance or sale proceeds will be used to purchase a new residence (or to pay down the business loan). Where one home is being sold and another purchased, lenders will want to ensure that the available equity in a new residence will be the same as or greater than the equity in the existing residence. Typically, the lender will have to obtain credit approval and possibly SBA approval for the transaction.
The borrower will have to arrange with the closing title agent or company to conduct the necessary title, lien, and judgment searches to ensure that the commercial lender has the required lien position after the residence is refinanced or a new residence is purchased (and the existing residential collateral is released). In addition, the lender will have to confirm the borrower has homeowner's insurance on the residence and that the required insurance certificates are provided to the commercial lender.
Lenders should be aware that releasing and re-filing the lien presents possible “consideration” issues. For example, when a bank lends money to a borrower, the consideration for doing so might be a mortgage on a piece of property. However, when the borrower in the situation described above asks the bank to release a lien and then to re-file against either the same residence or a replacement property, it is unclear whether there is any new consideration for doing so. This issue can be addressed through a letter of agreement where the borrower requests the substitution of the lien position.
Moreover, there may be significant transactional costs involved. When analyzing whether to release and re-file the lien, the lender should consider whether this will incur additional recordation taxes. Depending on which jurisdiction the bank and borrower operate in, the rules may differ.
Finally, a lender should consider whether it will need a new title insurance policy for the residential collateral. If the bank required title insurance for the collateral when the loan was first made, the lender likely would require a new policy after the lien is re-filed because the original policy will no longer cover the collateral. Where the residential collateral is being substituted, usually a lender will require a new title insurance policy.
Avoid “Mortgage Amnesia”
To facilitate a smooth experience with the bank, the borrower should not wait until the last minute to start the discussions with the lender about subordinating its lien to a refinance lender or releasing and re-filing the lien. Allowing sufficient lead time gives the bank the opportunity to analyze the situation, and address potential issues and obstacles that might put the borrower at risk of not being able to refinance or sell the home. Pledging a personal home as collateral for a business loan is a great way for small business owners and startups to secure financing, but banks and borrowers should begin the conversation as soon as possible in order to avoid potential financial pitfalls.
Arnie Spevack is a commercial transactions attorney who represents individuals, businesses, lenders and borrowers in financings, closings, negotiations and in the courts. For more information on using a residence as business collateral, contact Arnie at (301) 657-0749 or email@example.com.