Q&A #5: Differences between Ownership Interest, Credit Obligations and Debt Ratios in Divorce-Lending

…and that’s the short title.
Sounds like the title to one of those long, boring articles in an obscure economics journal, eh? But, you divorce lawyers and divorcing clients will likely know exactly what I’m talking about. Here’s real time solutions on a case I received a couple of days ago.

The facts
Husband in a divorce action was referred to me. He wanted to purchase a house of his own, his wife remaining in the marital residence for the sake of the children. But, he was concerned that he would not qualify for another house purchase while the debt on the existing marital residence was still “in his name.” He was correct. His ratios would have been too high with both house payments. [He, along with many real estate and mortgage professionals, did not know a secret to qualifying which I share in this article.]

The question before the parties was whether or not he should retain joint ownership and enjoy some of the net proceeds from a future sale or to relinquish ownership (convey his interest in the property) and, perhaps, receive a buyout from his wife soon after final divorce. Surprisingly, in either scenario, it was possible for him to qualify for mortgage financing by excluding the existing house debt. I explain how

Here is the analysis I sent husband and his attorney

Analysis
Husband is divorcing. His wife is to be either awarded the marital residence subject to a buyout (with some sort of provision for a recovery of funds should future equalization of business debts warrant; more on that later) or the parties will retain ownership with an assignment of housing expenses to wife (with the possible exception of a sharing of the tax expenses between the parties).

Providing for both contingencies will require some special language, no doubt, to accommodate both the legal needs and loan qualifying guidelines.

It is not super-complex from the financing perspective. Mildly complex, maybe; but, doable. [Remember, I eat, sleep and dream about these solutions….they almost come naturally to me now.]

Recommendation
It may sound like crass capitalism or commercialization but, I would very much like to take a look at wife’s potential financing needs. It is not just so that I can get more business. But, in order to make sure she is prepared to refinance the home mortgage, there would be certain suggestions I would make in order to help her gain qualifying status. This is obviously in the interest of both parties. In any case, I offer myself to help.

First, whether the house is awarded as property to wife or she is granted exclusive use, I assume that the housing debt will be assigned to her. This will effectively allow us to exclude Emmanuel’s credit obligation (for the mortgage) in qualifying him for financing. If these obligations are correctly listed as assigned to wife, it will be as if Emmanuel does not have these debts.

The parties should be aware that, until this housing debt (mortgage) is paid off (as in a refinance transaction), Emmanuel will be held liable by the creditor for any payment history and for full satisfaction. The decree does not change the actual obligation for debt. The debt assignment simply allows Emmanuel to qualify for his own financing apart from consideration of this debt.

In my view, if wife is going to effectively be awarded the house, it is advisable that she refinance its debt sooner than later.

An option to the parties seems to be that they continue to co-own the house and, upon its sale, each would profit from the net proceeds according to an agreed “split” spelled out in the decree. The same effect could be obtained by Emmanuel conveying his interest while retaining a contractual interest relative to the sale of the house. The difference is that, upon conveyancing of husband’s interest to wife, wife ONLY would have control of the terms of sale (or at least, control as the seller of the property). She alone would be required to execute a listing agreement, the purchase contract, the seller’s warranty deed, etc. She would be bound by the contractual agreements pertaining to such sale and the splitting of net proceeds.

If the house is not awarded to wife, getting the financing for any buyout would be more difficult, expensive and restrictive (perhaps not even possible). In other words, Owelty interest is the surest way to obtain financing for a primary residence. Owelty interest can only be established upon conveyancing of interest; i.e., when one party or the other is awarded the house.

General Notes
I am optimistic that the parties can achieve what they desire in terms of the marital residence, its debt and its disposition (whether awarding to wife or maintaining joint ownership).

The following paragraph is critical.

URGENT and CRITICAL

Please copy me on drafts of the decree before they are executed by the parties. I will pre-underwrite this draft to assure a smooth transaction. Pertinently, divorce decrees are universally underwritten as part of a loan file for any applicant who has been divorced. In any case, the client’s decree will most certainly be underwritten in this instance. ‘Tis better to pre-underwrite than to be caught by surprise.

 

Husband had the following questions upon reading my analysis and recommendations. This is a great exchange that clarifies the three important issues in divorce settlements related to the marital residence. (I inserted my responses in bold blue to his questions within the body of his email).

Husband’s Question:
Noel,

Thank you very much for this thorough analysis. Do I understand correctly that conveyance of my interest into the house to my wife is the only true way to not affect my debt / credit strength for a primary residence mortgage.

Noel’s Answer:
Yes and No. Yes, for credit reporting purposes. In other words, so long as the debt remains in your name (between you and the lender for which you signed a promissory note) any activity on that account will still report to the credit bureaus through that lender. For example, if there is default or a late payment, it will report on your credit and affect your scores and pay history.

But, No in terms of your ability to qualify for your next mortgage financing so long as that debt is assigned to your ex-wife in the divorce settlement. Such assignment of debt to her allows us to exclude it from the calculation of your debt:income ratio.

Husband’s Question:
But under this scenario I have no say in the terms of sale; I however still get 50% of the net proceeds (net of brokers or listing fees, etc)?

Noel’s Answer:
Correct. Under the scenario in which you convey your interest to her (this is done in the decree and with a filed document called a Special Warranty Deed or, if a buyout is included, a Special Warranty Deed with Encumbrance for Owelty of Partition), she becomes the sole owner of the property and, therefore, is able to transact it on her own.

In such a scenario, you could still agree that in the event of a future sale, you would share in the *net proceeds (profit) from the sale of the house.

This could be done two different ways. First, by simple agreement in the decree (or by some other legal document like a Rule 11 Agreement, “Agreement Incident to Divorce,” maybe some others). It would be, more or less, contractual. Secondly, it could be done by your affixing a lien (Owelty lien) to the property. This is done by agreement in the decree. The lien would be for a fixed amount. At least, that’s how you make it clear. If you merely state that the lien is for 50% of the net proceeds, you both would still have to agree at some point on exactly what dollar amount that 50% is.

Husband’s Question:
I am not sure I have clearly understood the pros and cons of each of (i) conveyance of interest to spouse vs (ii) co-obligorship until sale of property or equity buyout by spouse.

Noel’s Answer:
There are more pros and cons which you could probably state. But, here are a few:

Retaining ownership
Cons:
1. You retain ownership of an asset with a person you are no longer married to.
2. You must both agree about the terms of any transaction (refinance, sale) of the property.
Pros:
1. At least, you are an owner; and,
2. The property cannot transact without your agreement on terms.

Conveying interest (and no longer being an owner).
Cons:
1. Your ability to profit from a sale is dependent upon your diligence in enforcing the contract. In other words, the only mechanism “out there” is a divorce decree. Typically, the title company transacting the sale of the property will find this decree in their title search, read it and note that there is a “contract” that calls for a sharing of the net proceeds. Personally, I would not trust the system. Title companies are perhaps the most diligent of fiduciaries insofar as the policies they write are dependent upon their not having to pay out money in claims.
Pros:
1. You have no liability for (as in personal injury on, being sued, etc.) events to/on your property.
2. If conveyancing is accompanied by your ex-wife’s refinancing of the debt then you no longer have ANY liability for the property other than what you might agree to (e.g., continuing to pay taxes or a portion of the taxes).

I realize that this can be confusing. If I did not think you were very intelligent and quick of mind, I would have some concern. Here is the key to understanding these issues:

I love understanding the underlying principles. It’s the key to so much in life. Here’s an example. Remember to keep these three issues separate:

1. *Ownership – that is, who has interest in the property.

2. Credit Obligation – that is, who has obligated themselves to the debt. This deals with how the debt reports in the credit world; and, divorce settlements do not change this reporting.

3. Mortgage Qualifying – that is, which debts count against your qualifying ratios and which debts can be excluded from those ratios – unrelated to how they appear on your credit report. Courts have the ability to assign debt, usually by agreement of parties in an “Agreed Final Decree of Divorce” – and, surprisingly, mortgage lenders will take this into account; but, they [district courts; “divorce” courts] do not have the latitude to tell creditors that they cannot collect on debt. That’s called bankruptcy protection. So, while credit obligations are enforceable by creditors to the extent the law allows, those debts can be excluded by a mortgage underwriter in considering your next loan.

*Ownership. A little known fact is a clause in the Deed of Trust which a lender has the borrowers sign. It’s called the “Due on Sale” clause and it basically says that any deed activity (like a Special Warranty Deed or a Warranty Deed) triggers this clause and the lender can call the entire note due and payable. Practically speaking, lenders are happy to let a “sleeping dog lie” or, more accurately, a “paying” borrower. So long as payments are made according to the promissory note, the lender is generally happy to continue as is. But, divorcing homeowners should know about this provision.

Husband’s Response:
Fantastic responses – thank you so much!

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