Chapter 2

Promissory Notes and Mortgages

When borrowing money to purchase real estate, the borrower signs a promissory note (or bond) that creates the debt. The lender disburses the money, and the borrower provides the promissory note in return. This note is sometimes called a mortgage note. The mortgage serves as security for the debt. Mortgage and trustee are synonymous and are used as security for the debt.

Lien Theory vs. Title Theory

In lien theory states, the homeowner holds the title, and the lender has a mortgage lien against the property. In title theory states, the lender holds the title until the debt is fully paid.

Mortgage vs. Trust Deed

Mortgages and trust deeds serve the same purpose: security for the debt. About half of the states use a mortgage form, operating under the lien theory within this half. The other half operates under the title theory and uses a trustee for the security.

Mortgage States (Lien Theory)

Mortgage states involve two parties:

• The lender (mortgagee).
• The borrower (mortgagor).

Mortgagee

The mortgagee receives the mortgage document as security for the debt. The term mortgagee has two "e's" matching the word lender. The mortgagee receives interest on the loan and has the right to foreclose if payments are not made.

Mortgagor

The mortgagor gives the mortgage document to the lender. The term mortgagor has two "o's" matching the word borrower. The mortgagor retains full use of the property, maintains it, and pays taxes and insurance.

Foreclosure in Mortgage States

In mortgage states, judicial foreclosure is required, meaning the lender must go to court to foreclose. This process takes more time and money.

Trust Deed States (Title Theory)

Trust deed states involve three parties:

• The lender (beneficiary).
• The borrower (trustor).
• A neutral third party (trustee).

Beneficiary

The beneficiary (lender) is the legal holder of the promissory note. The lender receives the note and gives money to the borrower.

Trustor

The trustor (borrower) retains full use of the property, maintains it, and pays taxes and insurance. The trust deed is security for the debt and is given by the borrower to the trustee.

Trustee

The trustee, often an attorney for the lending institution, handles legal issues related to the trust deed and can foreclose without going to court (nonjudicial foreclosure). The trustee is the receiver of the trustee document

Foreclosure in Trust Deed States

In trust deed states, nonjudicial foreclosure is used. If the borrower (trustor) misses payments, the trustee can foreclose, sell the property, and pay off the lender (beneficiary) without court intervention. This process is quicker than judicial foreclosure.

Redemption

Redemption refers to the right to buy back a foreclosed property.

Equitable Redemption

This is the right to redeem the property before the foreclosure sale.

Statutory Redemption

This is the right to redeem the property after the foreclosure sale. The property must be purchased for the sale price plus any costs owed.

Deficiency Judgment

If the foreclosure sale does not cover the full debt, the lender can seek a deficiency judgment against the borrower for the remaining amount. A deficiency judgment is a general lien that applies to all of the person's assets, both real and personal.

Example

A lender is owed 100,000 on a property, but the foreclosure sale yields 90,000. The lender can pursue a deficiency judgment against the borrower for the remaining 10,000.

Foreclosure Sale Payoff Order

1. Real estate property taxes (general and special assessment taxes) take priority, with the older tax taking precedence if two are owed.
2. Other liens are paid in order of recording date.
3. The defaulting borrower receives any remaining funds (rare).

Example

A defaulting borrower owes:

• 2,500 in real estate taxes.
• 75,000 on a first mortgage.
• 10,000 on a second mortgage.
• 3,000 on a mechanic’s lien.

If the property sells for 85,000, the liens are paid off in this order:

1. Real estate taxes: 85,000 - 2,500 = 82,500
2. First mortgage: 82,500 - 75,000 = 7,500
3. Second mortgage: 7,500 - 10,000 = -2,500

The borrower still owes 2,500 on the second mortgage and 3,000 on the mechanic's lien. Creditors can convert these debts to a judgment lien and pursue the borrower's other assets. The purchaser at the foreclosure sale buys the property free of all debts.

If the property sold for 95,000, the defaulting borrower would pay off the entire 90,500 owed and keep the remaining 4,500 as equity.

Deed in Lieu of Foreclosure

A defaulting borrower may offer the lender the property instead of going through foreclosure. This is called a deed in lieu of foreclosure. It is still an involuntary alienation. The lender must agree to this arrangement.

Advantages

• For the lender: Saves foreclosure costs and allows for quicker resale.
• For the borrower: Less damage to credit rating compared to a foreclosure.

Analysis of a Note

A promissory note is negotiable, meaning it can be bought and sold, often at a discount (less than face value).

Example

A lender provides a 100,000 loan at 7% interest. The lender might sell the note to another institution for 95,000 to receive immediate cash.

Payment Timing

Real estate payments are typically made in arrears, meaning at the end of the period. For example, a May 1st mortgage payment covers interest for April. This differs from rent, where a May 1st payment prepays for May.

Debt Service

Debt service refers to the combined payment of principal and interest.

Reduction Certificate

A reduction certificate is a document issued by the lender stating the current loan balance, often used when a property is listed for sale.

Interest and Payment Plans

Interest is a charge for using the lender's money, usually a percentage of the loan balance. Leverage involves using borrowed money to make money.

Straight Note (Term Loan)

With a straight note or term loan, payments are applied to interest only. Typically used for short-term construction loans. At the end of the loan term the entire principal must be repaid in a balloon payment, which is a final payment that pays off the loan balance in full.

Example

Borrowing 200,000 to build a house over six months and paying only interest on the funds withdrawn. At the end of six months, a balloon payment of 200,000 is due.

Partially Amortized Note

With a partially amortized note, payments are applied to both principal and interest, but a balloon payment is still required at the end of the loan term to pay off the remaining balance. Partially amortized loans are common in commercial real estate and sometimes even residential real estate. A lender might say to a borrower, if you're going to be in this property in this house for example for less than five years rather than a full thirty years straight fully amortized note that's normal we can set you up on a partially amortized note which means that your interest rate will be lower for the first five years of the loan for example than a normal thirty year fixed rate would be.

Example

Let's assume that a thirty year fixed rate would be 6 1/2%, where a partially amortized would be 6%. So the borrower is saving 5%. And the big advantage is the borrower gets a 6% interest rate versus 6 \frac{1}{2}. So the partially amortized note would work for a borrower who will be there in a short amount of time.

Fully Amortized Note

A fully amortized note involves payments applied to both principal and interest, fully paying off the loan balance over the entire term.

Constant Mortgage Payment Plan

Most fully amortized notes use a constant mortgage payment plan, where the borrower pays the same amount each month. The amount going toward principal increases each month, while the amount going toward interest decreases.

Example

With a 900 monthly payment, in month one 100 might apply to principal and 800 to interest. In month two, 110 might apply to principal and 790 to interest, keeping the total at 900.

Principal and Interest Amortized Note Examples

If given that the loan is 60,000 at 10% interest for thirty years and the payment is 526.54 per month, principal and interest, the principal can be computed for a given number of months. To compute the principal and interest we solve the following for the 1st payment period:

1. Compute annual interest: \$60,000 \times 0.10 = \$6,000
2. Compute 1st months interest: \frac{\$6,000}{12} = \$500
3. Compute amount towards principal: \$526.54 - \$500 = \$26.54
4. Subtract the amount towards principal from original loan amount: \$60,000 - \$26.54 = \$59,973.46

Total Interest Paid Over the Loan Term

To compute the interest paid over the life of the loan:

1. Compute annual payments: \$526.54 \times 12 = \$6,318.48
2. Compute payment over life of loan: \$6,318.48 \times 30 = \$189,554.40
3. Compute the amount of interest paid: \$189,554,40 - \$60,000 = \$129,554.40

Equity Increasing Loan

With an equity increasing loan, borrowers make extra payments toward principal to build equity faster and shorten the loan term.

Graduated Payment Note

The payments start low, increase yearly, and then level off. This is aimed at people with increasing income over time so that they are able to get into a house right away.

Example

Monthly payments start at 6.25 in 02/2019, increase to 6.50 in 02/2020, to 7.00 in 02/2021, and finally level off at 7.25/month in 02/2023 for the remaining 25 years.

Adjustable Rate Mortgage (ARM)

With an adjustable rate mortgage, the interest rate changes yearly based on an index. These are most popular with short term borrowers because they change yearly and include a cap or limit on the changes.

Example

Interest is 2% above the rates paid on Treasury bills, with a maximum change of 2% in any year and 6% over the term of the loan. Starting with a 3% index and 2% margin to come up with the first year's interest rate for the borrower. So 3% + 2% would give us a 5% interest rate for year one.

Provisions of a Mortgage or Trust Deed

These clauses are typical in the fine print. Make sure that you are familiar with their general application.

Prepayment Penalty Clause

The lender can charge a penalty for paying off the loan early, as the lender expects to receive a certain amount of interest over the loan term.

Acceleration (Due on Default) Clause

The acceleration clause calls the entire loan balance due upon certain events, such as nonpayment of the mortgage. If a borrower misses payments, the lender can demand the full balance.

Alienation (Due on Sale) Clause

This clause calls the entire loan balance due upon the sale of the property, making the loan non-assumable, requiring the buyer to obtain a new loan.

Subordination Clause

This clause changes the priority of liens, where a lender takes a lesser position and waives their rights in favor of another.

Example

A first mortgage is refinanced, but a second mortgage already exists. To ensure the refinanced mortgage remains in first position, the second mortgage lender agrees to a subordination clause.

Defeasance (Null and Void) Clause

This clause voids the security once the loan is paid off, meaning the property is no longer being used as security for the loan. This is when the mortgage is canceled due to the defeasance clause or null and void clause.

Mortgage Release or Deed of Reconveyance

This document is recorded to show the note has been paid off in full, releasing the mortgage or trust deed from the public record. Mortgage release for mortgage states, deed of reconveyance for trust deed states.

Escalator Clause

This clause allows the lender to raise or lower the interest rate, often used in adjustable rate mortgages.

Alterations Clause

This clause requires the borrower to obtain permission from the lender to make major changes to the property.

Additional Terms

It is important to have a working understanding of terminology, especially the difference between hypothecate and pledging.

Hypothecate

The borrower retains the item used as security for the loan (e.g., a house or car).

Pledging

The lender retains the item used as security for the loan (e.g., stocks, bonds, CDs).

Escrow Account

Most lenders have an escrow account for holding prepaid taxes and insurance, known as PITI (principal, interest, taxes, insurance).

Taking Over a Seller's Loan

If a buyer takes has been approved to take over a seller's loan there are two general mechanisms of doing so.

Subject To

The buyer takes over payments on the seller's loan only. The seller remains solely liable to the lender. If the buyer defaults, the lender looks solely to the seller.

Assumption

The buyer takes over payments and primary liability on the loan. The seller remains secondarily liable to the lender. If the buyer defaults, the lender first seeks payment from the buyer, then the seller. If the seller is released from liability by the lender entirely that is called a novation.

Novation

A novation occurs when the lender releases the seller from all liability, making the buyer solely liable, and replacing the old loan contract with a new one.

Types of Mortgages and Trust Deeds

A good test taker knows the vocabulary. Do not get caught up in all the details but rather know the general application.

First Mortgage

The lender was the first to record the mortgage.

Second Mortgage (Junior Mortgage)

Any mortgage other than a first mortgage, with priority established by recording date.

Purchase Money Mortgage

This is typically Owner financing typically where the seller carries back a second mortgage on a real estate transaction seller who is loaning part of the purchase price back to the borrower. It doesn't have to be for a small second. It could be the entire amount. Anytime the seller gives a deed to the borrower at closing to transfer title and then carries back a mortgage, it is known as a purchase money mortgage.

Blanket Mortgage

A mortgage that covers more than one property, often used by developers. It is important to note that the partial release clause is used to release each property from the blanket mortgage as it is sold It is also common before a lender will release that property from the blanket mortgage, some of the loan money has to be paid down.

Package Mortgage

A mortgage that uses both real and personal property as security. If personal property is used only, it's called a chattel mortgage.

Open End Mortgage

A mortgage that allows a borrower to borrow again and again on the same loan, like a home equity loan. It is a revolving line of credit.

Growing Equity Mortgage

Extra payments are made to the principal loan balance each month to be able to save money through an equity increasing mechanism.

Construction Loan

Dollars are released as needed as determined by the value of each aspect of building the asset. For example, the builder might take out a $30,000 draw against that loan for the foundation work right up front and then maybe after that out a $20,000 draw for the framing.Once the house is finished, the buyer will then take out a permanent loan, which is typically a thirty year fully amortized loan. This permanent loan actually pays off the construction loan.

Wraparound Mortgage

With a wraparound, the second lender assumes a note of the first lender, and then payment on the entire new mortgage is made to the second lender. It is mostly a financing mechanism.

Reverse Annuity Mortgage (RAM Loan)

A loan where the mortgagee (lender) pays the mortgagor (borrower) a fixed amount every month, typically for retirees.

Shared Appreciation Mortgage (SAM Loan)

A loan in which a lender participates or shares in the appreciation of the property.

Types of Loans: Conventional, FHA, VA

The three main types of loans will be discussed, along with their strengths and weaknesses.

Conventional Loan

A lender typically loans 80% of the property value, requiring 20% down. Loan to value ratio is the percent the loan is to the value of the property.

Federal Housing Administration (FHA) Loan

A lender loans a larger percentage, with a 95 to 97% loan to value ratio, requiring 3 to 5% down. FHA is an insurance company run by the government that insures the loan to the lender in case of default.

Department of Veterans Affairs (DVA) or GI Loan

A 100% loan to value ratio loan for veterans, meaning no down payment required. The government guarantees the loan.

Loan Comparisons

The three different types of loans have vastly different requirements.

• Eligibility: Conventional and FHA loans are available to any person, while VA loans are for eligible veterans and unmarried widows.
• Government Support: Conventional loans have none, FHA is under HUD and insures loans, and VA guarantees loans.
• Property Type: Conventional loans work for any property type, while FHA and VA require a one to four plex that is owner-occupied.
• Dollar Amounts: Conventional loans have no limits, while FHA insures up to certain dollar amounts. Veterans can reuse VA eligibility after their previous VA loan is paid off.
• Interest Rates and Payments: These are fully negotiable on all three loan types.
• Down Payment: Conventional loans typically require 20%, FHA usually requires 3 to 5%, and VA requires nothing down, with the loan based on the lower of the sale price or appraisal.
• PMI: Private mortgage insurance is required on conventional loans with less than 20% down.
• Prepayment Penalty: Allowed on conventional loans, not allowed on FHA and VA loans.
• Alienation (Due on Sale) Clause: Allowed on conventional loans, not allowed on FHA and VA loans, meaning FHA and VA loans are assumable, with the buyer qualifying financially on loan assumption. Anyone, veteran or not, can assume a VA loan.

Points

Know that points equal percentage. For example, one point equals 1%.

Discount Points

Discount points. mathematically are 1/8%. The discount points are a charge to give the borrower a lower interest rate in order to make more money by charging discount points and collecting them for making that particular loan. It is always based on the loan amount, not the sales price

Buy Down

Helps buyer qualify financially because the interest rate is brought down for the first several years. It is similar to discount points in that one pays extra money upfront to lower the rate. Note that anyone can pay for the buy down.

Loan Origination Fee

What the cost charge is used for originating the process (all the costs) and initiating loan.

Lock-in Commitment

The fixed interest rate guaranteed by the lender. During a specific time period. The lender locks a buyer in on an interest rate and discount points.

Alternative Financing

When it comes to alternative financing there is usually no lender, so no qualification is possible.

Contract For Deed, Installment Contract, Land Contract

Here financing without a lender. Note any of the three terms will apply.

Vendor: Here the seller attains legal title, the seller retains legal title to the property during the entire contract for deed.
Vendee: Buyer who retains equitable title - buyer receives the legal title after the final payment is made
Advantages: no qualifying for the buyer, fewer closing cost, little or no down payment
Disadvantages: the riskier option of the two of losing for the buyer for the seller may still borrow against a property

Sale Leaseback

Here is where the property business or personal assets are sold to investors then they can have the property used again in their name. Business assets must be sold to a buyer then there will be a lease on the asset when sold meaning no debt.
Advantages for the seller are that they can lease out assets without taking money with tax right off advantages
Advantages for the buyer or ownership of real estate (mortgage rate, business rate and tax rate reduction).

Activities of the Federal Reserve

The Federal Reserve has three ways to control the money supply.

Reserve Controls

That is the percentage of bank funds that the banks must keep on hand. If the reserve requirement is ten, that means the banks can loan out 90% of their available deposits. That would tend to lower interest rates and stimulate the economy.

Discount Rate

The interest rate the banks pay to borrow money. For example, if a local bank has to borrow money from the district bank at 7% interest, that is a discount rate, then the actual rate to local borrowers would have to be a little bit higher, in this case, 10%.

Open Market Operations

That is through buying and selling securities, things like t bills, etcetera. So what happens is as follows is if the Fed decides to sell securities, treasury bills, the like, people will be buying those treasury bills, thereby taking money out of circulation among the general public.

Primary Mortgage Market

The location where borrowers go to obtain money to purchase real estate.

• Savings and Loans: They primarily make residential home loans where Their largest investment is in residential home loans.
• Commercial Banks: They make business loans but can make all types of other loans as well.
• Insurance Companies: They make high dollar loans for shopping centers, apartments, things like that.
• Mortgage Banker: This is a place where borrowers can obtain a loan, typically to buy a house. The mortgage Banker does not loan their own money like banks do out of deposits, but rather they acquired the money from other lenders investors and then the mortgage banker makes the home loan to the borrower and gets paid service fees and discount points things like that. So the mortgage banker actually does make a loan, but they typically loan other people's money.
• Mortgage Broker: A mortgage broker does not make loans. A mortgage broker is a true broker by definition, which means the mortgage broker simply brings together a borrower and a lender and gets paid. for the service of bringing the two parties together. So mortgage bankers actually make loans, mortgage brokers do not make loans, rather they bring lenders and borrowers together.
• Participation Loan: Where a lender will participate in maybe the ownership of an entity or maybe the profits and or equity growth. Note it could be any or all three. So once again, participation loans are where the lender makes a loan to a borrower, and then maybe get stock ownership in the company, maybe participates in profits, equity growth, things like that.
• Warehousing: Where a lender will assemble several loans into one package for resale, which we will talk more about in the very next section.

Secondary Mortgage Market