Throughout the 1970s, the economy in the United States was hurting due to skyrocket inflation rates. In many instances, interest rates went above 20 percent, causing loss of earnings, investments, and a retraction in the economy. The government had to act to address the crippling effects this was having on the economy. The government passed the Germain Depository Institutions Act of 1982, also known as the Garn Act to help alleviate the negative economic conditions. This legislation was enacted into law by congress and signed into law by former president Ronald Reagan. The whole purpose of the act was to predominately reduce the burden imposed on banks and insurance fund agencies.
A due-on-sale clause is a mortgage provision that requires a borrower to repay the full principal loan amount plus interest upon the sale or conveyance of the property.
Purpose of Garn Act
Due-on-sale clauses protect lenders in a rising interest rate market. Sellers with low interest rate loans may try to arrange for a buyer to assume his or her original loan at the same low rate. With a due-on-sale clause, however, a lender can collect the full loan amount from the seller, and subsequently lend the recouped capital to other borrowers at higher interest rates.
Such clauses also prevent a seller from transferring his or her mortgage to a buyer. A buyer who assumes a seller’s mortgage via seller financing or a wraparound trust deed is not pre-qualified using a lender’s specific standards and has a higher likelihood of defaulting on the loan. This puts a lender’s financial interests at risk. Therefore, a lender uses a due-on-sale clause to prevent seller financing or a wraparound trust deed whereby the buyer takes over the existing promissory note.
The following are exceptions to a due-on-sale clause:
The creation of a lien or other encumbrance subordinate to the lender’s security instrument which does not relate to a transfer of rights of occupancy in the property;
The creation of a purchase money security interest for household appliances;
A transfer by devise, descent, or operation of law on the death of a joint tenant or tenant by the entirety;
The granting of a leasehold interest of three years or less not containing an option to purchase;
A transfer to a relative resulting from the death of a borrower;
A transfer where the spouse or children of the borrower become an owner of the property;
A transfer resulting from a decree of a dissolution of marriage, legal separation agreement, or from an incidental property settlement agreement, by which the spouse of the borrower becomes an owner of the property;
A transfer into an inter vivos trust in which the borrower is and remains a beneficiary and which does not relate to a transfer of rights of occupancy in the property; or
Any other transfer or disposition described in regulations prescribed by the Federal Home Loan Bank Board.
Pros vs Cons:
Pros
Many previous government imposed regulations and restrictions dating back to the Great Depression were removed to incentivize smaller asset managing companies to generate bigger profits.
Cons
Although the intent of the act was to save banks and thrifts from going out of business, ultimately in many cases this did not occur. There were many instances where insurance depositors tried to salvage struggling banks from going out of business at virtually any cost. This kind of recklessness increased Insurers losses which led to a good number of these banks not surviving as a result. Eventually these losses led to another legislative bill being enacted known as the the FDIC Improvement Act of 1991.
