Question. After a flurry of activity when our house first went on the market, there were four serious potential buyers. They each tried to outbid the other, and we finally accepted the highest offer. However, our purchaser has just been advised that the house appraised for $25,000 less than the contract price. The purchaser still wants the house, but since the lender will not loan more than 80 percent of the appraised price, there is a gap. The purchaser has asked us to take back a second trust. Are there risks involved? How can we protect ourselves?

Answer. A second trust is a potential selling tool, but there are risks.

Let's look at this example. Suppose your contract sales price was $300,000, and your purchaser was going to obtain a loan in the amount of $240,000. This would have been 80 percent of the purchase price and thus the purchaser would not have been required to pay Private Mortgage Insurance (PMI). However, the appraisal came in at $275,000, and now the lender is only prepared to loan $220,000. Your purchaser is now short $20,000 ($240,000 - 220,000) and has asked you to take back a second trust in this amount.

A first trust puts a lender in top priority position. If the mortgage (deed of trust) is recorded among the Land Records, the house cannot sell without the lender's permission and without having the loan paid in full. If the borrower goes into bankruptcy, the lender has a secured position and unless the house significantly drops in value, should be protected against loss. Obviously, bankruptcy will delay getting the money, but ultimately under most circumstances a first trust lender will be relatively secure.

A second deed of trust means that you would be in second position behind a first trust lender. If the first trust lender forecloses, and there is not enough equity in the house to pay off your second trust, your trust will be wiped out. In other words, in this example if the property only fetches $220,000 -- enough to pay off the first-trust holder -- there would be nothing left to pay off the second trust holder -- you. Because second trusts represent more risk, lenders typically receive higher interest rates.

While you still have the right to sue the persons who bought your house under the promissory note, obviously if they are in financial difficulty, this right to sue will be meaningless. There is no cash register at the back of the courthouse, so that even if you get a judgment against the notemaker, the chances of collection will at best be slim.

Obviously, many people want to sell their house, and are willing to take some risk. Clearly, a second trust can be a very effective tool in marketing your house, and may be the only way that you will be able to sell it at the increased price. Let's face it; if you do not go along with the second trust concept, your buyer can walk away from the deal.

While it appears that there are other potentially interested purchasers, they may have the same response from their lender.

Thus, a second trust might make sense -- but only if you have adequate protections spelled out in the legal documents relating to that second trust.

It is important that the second trust be properly prepared. Every state has different rules affecting second trust financing, and you must check with your attorney about such matters as usury laws, recording details, and other requirements that state law may impose on a second trust.

To protect yourself, you must first investigate the credit-worthiness of your buyer. Find out what your buyer's income is, and obtain written permission to do a credit search with a local credit bureau. If that credit bureau reports a history of slow or delinquent payments to such places as department stores, credit card or oil companies, you may want to reject extending further credit to an already over-extended purchaser.

You also want to make sure that there will be more than adequate security in the property in the event of a foreclosure. In our example, you are selling your house for $300,000, and your buyer will obtain a first trust of $220,000. You are being asked to take back a second trust of $20,000, which means that your buyer will be putting down $60,000 of his own cash (or 20 percent of the full purchase price) to close the deal. ($300,000 - $220,000 - $20,000). In my opinion, this is sufficient equity, and your buyers will be very reluctant to walk away from the house and lose this money.

More importantly, should your buyers have financial trouble, the house could likely be sold for enough money -- $240,000 in this example -- so as to pay off the first trust holder as well as your second trust.

You do not want to be in a situation where the first trust lender forecloses, and you end up losing your second trust because there is little or no equity left in the property. There must be some restriction on the amount of the first trust that will be loaned ahead of your second trust financing.

When you take back financing -- whether it is a first or a second deed of trust -- you are lending money to your buyers. They will have to sign two pieces of paper. One is promissory note in which the buyer states that he or she has borrowed a certain sum of money and agrees to pay that amount, with interest, in monthly or quarterly payments. You have to figure out whether you want the payments amortized equally over a period of years, or whether the buyer will be permitted to pay interest only, until the loan becomes due. With an interest-only note, the monthly payments are smaller than with a self-amortizing loan -- but a "balloon payment" is due at the end of the loan term.

You also want to negotiate -- before you agree to take back the second trust -- all of the terms, including the due date of the note.

This promissory note must contain provisions for default, so that you will be able to call the note in the event the purchaser misses a payment or two. You have to take a tough position in connection with your buyer. If one payment is missed, and you are lenient, you may end up having to foreclose because your buyer will get too far behind in payments to ever catch up.

Finally, the promissory note should contain language to the effect that should the borrower go into default, you -- as note holder -- will be able to recover reasonable attorneys fees should you have to retain legal counsel to assist in the collection of the debt.

Additionally, to secure the promissory note, the buyer will sign a deed of trust (the mortgage document), which must be recorded among the Land Records in the jurisdiction where your house is located. By recording the trust, it puts what lawyers refer to as a "cloud" on the title to the property; you are putting the world on notice that you have an interest in that real estate.

You must select trustees whom you respect and with whom you have confidence. You have the right to select any person of your choosing, and it can be a relative, friend, business acquaintance or your attorney. It is advisable to have at least two trustees and you also must have absolute discretion to substitute trustees.

When your buyer signs the deed of trust, in effect the buyer is authorizing the trustees to sell the property at a foreclosure sale should the borrower become delinquent and be in default of the terms of the promissory note. On the other hand, if the buyer pays the promissory note in full, the trustees will have to record a release of that trust on the land records.

You should fully advise the trustees whom you select as to their responsibilities so that they fully understand their functions.

The deed of trust is also an important legal document. It must be prepared carefully, and must reflect the true legal description of the property. The original note, signed by the borrower, must be given to you at closing. Do not rely on the title attorney to keep that note in the files. It is a valuable piece of paper, which should be kept in a safe place.

The deed of trust will be recorded in the office of the Land Records where your property is located. Make sure that your name and address is written clearly on the original deed of trust so that the Recorder's office will be able to mail it make to you after recordation.

Here are some provisions which must be included in the papers which will be prepared:

• The promissory note and deed of trust should contain a very tightly drawn due-on-sale clause. You may be prepared to lend this buyer money to purchase your house, but you do not want that loan to be assumed by a third purchaser later on. The general rule is that in the absence of a specific non-assumption clause in your note and deed of trust, the note and deed of trust are freely assumable.

• A "cross-default provision." Language should be contained in the deed of trust that, in the event the borrower is in default on the terms of the first trust, this will automatically trigger a default on your note also.

You want to make sure that the first trust lender will advise you, in writing, if the borrower is in default on the first trust payments. After settlement, send a letter -- certified mail, return receipt requested -- to the lender advising them that you hold a second deed of trust on the property.

Finally, make sure that someone visits the property periodically. If the property is rundown, its value may be diminishing, thereby impairing your security. If significant repairs are needed, you may want to insist that your borrower take care of these matters promptly. Most standard deeds of trust specifically require that the borrower maintain the property in decent condition.

Second deeds of trust can be a valuable tool for a seller. But a poorly drafted legal instrument is of no use to anyone, and can cause you to lose your valuable investment.

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