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© 2012 Rockwell Publishing
Introduction
This lesson will cover:types of finance instrumentshow instruments workcommon provisions
© 2012 Rockwell Publishing
Promissory Notes
Promissory note: written promise to pay money.
Maker: the one who makes the promise.
Payee: the one to whom the promise is made.
Note: evidence of the debt and a promise to pay.
© 2012 Rockwell Publishing
Promissory Notes
Can be brief, simple document. Usually contains:
names of partiesamount of debtinterest ratehow/when money is to be repaid
Basic provisions
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Promissory Notes
Must be signed by maker.
If certain requirements are met, it’s a negotiable instrument: right to receive payment can be transferred by endorsement.
Basic provisions
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Promissory Notes
Negotiable instrument requirements: written, unconditional promiseto pay a certain sum of moneyon demand or on a certain datepayable to order or to bearersigned by maker
Negotiability
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Promissory Notes
“Without recourse” endorsement: issue of future payment strictly between maker and third party the instrument is endorsed to.
Original payee not liable if maker fails to pay.
Without recourse
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Promissory Notes
Holder in due course: someone who buys negotiable instrument:
for valuein good faithwithout notice of defenses
Even if maker has defense against original payee, maker still required to pay holder in due course.
Holder in due course
© 2012 Rockwell Publishing
Promissory Notes
Promissory notes classified as to how principal and interest are paid off.
Straight note: periodic payments are interest only, with principal due on maturity date.
Installment note: periodic payments include both principal and interest.
Types of notes
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SummaryPromissory Notes
• Maker
• Payee
• Negotiable instrument
• Without recourse
• Holder in due course
• Straight note
• Installment note
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Security Instruments
In real estate transactions, promissory note is accompanied by security instrument:
mortgagedeed of trust
Gives lender right to foreclose on property if borrower defaults.
Purpose
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Security Instruments
If no collateral, lender can still enforce promissory note.
Lender sues borrower, obtains judgment.But borrower may be “judgment-proof.”
Secured lender much more likely to collect payment.
Purpose
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Security Instruments
Personal property used as collateral for early forms of secured lending.
Borrower gave lender possession of collateral property until loan repaid.
Lender kept property if loan wasn’t repaid.
Historical background
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Security Instruments
Hypothecation: pledging property as collateral without giving up possession of it.
For real property loans, became standard arrangement for borrower to retain possession of land.
Lender held title until debt repaid.
Historical background
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Security Instruments
Legal title: title transferred only as collateral, without possessory rights.
Equitable title: property rights retained by borrower, without legal title.
Historical background
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Security Instruments
Eventually, transfer of legal title wasn’t necessary. More common to place lien against borrower’s property.
Lien: financial encumbrance on owner’s title, allowing lienholder to foreclose on property to collect debt.
Historical background
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Security Instruments
Two-party security instrument in which borrower mortgages his property to lender.
Mortgagor = borrowerMortgagee = lender
Mortgage
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Mortgages
Mortgage must include:names of partiesaccurate legal description of property
Also must identify promissory note it secures.
Basic provisions
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Mortgages
Mortgagor promises to:pay property taxes keep property insured against
fire and other hazardsmaintain structures in good repair
Mortgagee has right to inspect property.
Covenants
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Mortgages
Satisfaction of mortgage: document given to mortgagor by mortgagee after mortgage is paid off, releasing property from lien.
Mortgagor records document.
Satisfaction
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Security Instruments
Similar to mortgage, but involves three parties, rather than two.
Grantor/trustor = borrowerBeneficiary = lenderTrustee = neutral third party
Trustee arranges for release of property or foreclosure, as necessary.
Deed of trust
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Deeds of Trust
Deed of trust usually includes same basic provisions found in mortgage:
names of partiesproperty description identification of promissory note grantor’s promises to pay taxes and insure
propertybeneficiary’s right to inspect
property
Basic provisions
© 2012 Rockwell Publishing
Deeds of Trust
Deed of reconveyance: document releasing property from lien, executed by trustee when loan is paid off.
Recorded by grantor.
Reconveyance
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SummarySecurity Instruments
• Hypothecation
• Legal title
• Equitable title
• Lien
• Mortgage
• Satisfaction of mortgage
• Deed of trust
• Deed of reconveyance
© 2012 Rockwell Publishing
Security Instruments
Key difference between deeds of trust and mortgages: procedures used for foreclosure.
Foreclosure
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Foreclosure
At one time, judicial foreclosure was only option.
Lender filed lawsuit against borrower.Sheriff’s sale ordered by court if borrower
found to be in default.
Alternative to judicial foreclosure was eventually developed.
Methods
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Methods of Foreclosure
Nonjudicial foreclosure is generally associated with deeds of trust.
Lender doesn’t have to file lawsuit.Trustee arranges for property to be
sold at trustee’s sale.Property sold to highest bidder.
Judicial vs. nonjudicial
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Methods of Foreclosure
Nonjudicial foreclosure requires power of sale clause in security instrument.
Power of sale clause: authorizes trustee to sell property in event of default.
All deeds of trust contain one.May be included in mortgage, but usually
not.
Power of sale
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Methods of Foreclosure
Judicial foreclosure used when:state law doesn’t allow nonjudicial
foreclosurethere’s no power of sale clause in
security instrumentcircumstances make it better choice for
lender
Judicial foreclosure
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Judicial Foreclosure
1. Acceleration of debt
2. Foreclosure lawsuit
3. Equitable redemption or cure and reinstatement
4. Writ of execution
5. Sheriff’s sale
6. Statutory redemption
7. Sheriff’s deed
Steps in judicial foreclosure
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Judicial Foreclosure Steps
1. Acceleration of debt: if mortgagor defaults, mortgagee notifies mortgagor that entire outstanding loan balance is due.
2. Foreclosure lawsuit: unless mortgagor pays off accelerated debt, mortgagee files foreclosure action.
Acceleration & Lawsuit
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Judicial Foreclosure Steps
3. Equitable redemption or cure & reinstatement: while lawsuit is pending, mortgagor has right to stop proceedings by paying mortgagee.
Depending on state law, may be:equitable right of redemption, orright to cure and reinstate.
Stopping a pending foreclosure
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Judicial Foreclosure Steps
Equitable right of redemption: mortgagor’s right to stop proceedings by paying entire amount owed, plus costs.
Loan is paid off and property is redeemed.
Stopping a pending foreclosure
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Judicial Foreclosure Steps
Cure and reinstatement: mortgagor may “cure” default by paying just delinquent amount plus costs.
Foreclosure proceedings terminate, loan is reinstated.
Stopping a pending foreclosure
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Judicial Foreclosure Steps
4. Writ of execution: if loan not cured or redeemed, judge schedules hearing to determine if default exists.
If so, judge issues writ of execution.Directs sheriff to seize and sell
property.
Court order
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Judicial Foreclosure Steps
5. Sheriff’s sale: public auction where property is sold to highest bidder.
Purchaser given certificate of sale. Proceeds of sale pay costs and debt.
Sale of property
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Judicial Foreclosure Steps
If proceeds aren’t enough to pay off foreclosed mortgage, court may award deficiency judgment against debtor for amount of deficiency.
Sale of property
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Judicial Foreclosure Steps
6. Statutory right of redemption: additional period after sheriff’s sale to redeem property.
Must pay purchaser amount paid at auction, plus interest.
Depending on state law, period can be 6 months to 2 years.
After sheriff’s sale
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Judicial Foreclosure Steps
7. Sheriff’s deed given to purchaser at end of redemption period.
State law may allow purchaser to:take possession of property
immediately, orcollect rent from debtor during
redemption period.
Rights of sheriff’s sale purchaser
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Nonjudicial Foreclosure
1. Notice of default
2. Notice of sale
3. Cure and reinstatement
4. Trustee’s sale
5. Trustee’s deed
Steps
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Nonjudicial Foreclosure Steps
1. Notice of default: to begin, trustee must give notice of default to grantor.
2. Notice of sale: trustee must wait certain time after notice of default before issuing notice of sale. Usually 3 to 6 months.
Notice to borrower
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Nonjudicial Foreclosure Steps
3. Cure and reinstatement: grantor allowed to cure default and reinstate loan by paying delinquent amounts plus costs.
Right ends shortly before trustee’s sale.No right of redemption after trustee’s
sale.
Stopping the foreclosure
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Nonjudicial Foreclosure Steps
4. Trustee’s sale: like sheriff’s sale, trustee’s sale is public auction.
Proceeds first applied to costs, then to debt, then junior liens.
Sale of property
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Nonjudicial Foreclosure Steps
5. Trustee’s deed: highest bidder receives trustee’s deed immediately after sale.
Debtor’s title terminates immediately.Must vacate property within short period
(such as 30 days).
No redemption period
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Nonjudicial Foreclosure
State law may place restrictions on nonjudicial foreclosures, such as:
requiring post-sale redemption period for agricultural property
prohibiting beneficiary from obtaining deficiency judgment after sale
Restrictions
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Judicial vs. Nonjudicial
Judicial foreclosure advantages:borrower can’t reinstate loanright to deficiency judgment
Nonjudicial foreclosure advantages:quick and inexpensive
Lender’s point of view
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Judicial vs. Nonjudicial
Judicial foreclosure advantages:slow processpost-sale redemption
Nonjudicial foreclosure advantages:right to cure and reinstate
Borrower’s point of view
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SummaryForeclosure
• Judicial foreclosure• Equitable right of redemption• Sheriff’s sale• Deficiency judgment• Statutory right of redemption• Nonjudicial foreclosure• Power of sale• Cure and reinstatement• Trustee’s sale
© 2012 Rockwell Publishing
Alternatives to Foreclosure
Three alternatives allow borrowers who can no longer make payments to avoid foreclosure:
loan workoutdeed in lieushort sale
© 2012 Rockwell Publishing
Alternatives to Foreclosure
All three alternatives require lender’s consent.
Lender’s incentives to cooperate:avoiding foreclosure costsending money-losing situation
more quickly
Lender’s consent needed
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Alternatives to Foreclosure
First step for borrower hoping to avoid foreclosure: asking lender for loan workout.
Two types of workouts:repayment planloan modification
Workouts
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Workouts
With repayment plan, lender allows borrower to change timing of limited number of payments.
Borrower in more dire situation may need loan modification: permanent change in terms of repayment (like reduced principal or interest rate).
Repayment plans / loan modifications
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Alternatives to Foreclosure
If borrower can’t negotiate workout and will lose property anyway, can offer lender deed in lieu.
If lender accepts deed in lieu:borrower deeds property to lenderdebt satisfied
Deed in lieu of foreclosure
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Deed in Lieu of Foreclosure
Lender agrees to release borrower even though property is usually worth less than amount owed.
Lender could require borrower to sign promissory note for shortfall, but that isn’t typical.
Settlement of debt
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Deed in Lieu of Foreclosure
Compared to foreclosure, deed in lieu is:simplerless public
Borrower’s credit rating suffers almost as much as from foreclosure.
Impact on borrower
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Deed in Lieu of Foreclosure
Lender takes title subject to other liens.Not like foreclosure, which extinguishes
junior liens.
Junior liens
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Alternatives to Foreclosure
Short sale: when borrower sells property to third party for less than amount owed.
Borrower facing foreclosure may ask lender to approve short sale.
If lender approves buyer, lender receives sale proceeds and releases lien.
Short sales
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Short Sales
Like ordinary sale, short sale doesn’t extinguish junior liens.
If there are junior liens, short sale must be approved by all lienholders.
Junior lienholders unlikely to consent.
Junior liens
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Alternatives to Foreclosure
To arrange workout, deed in lieu, or short sale, borrower contacts loan servicer.
May need approval from more than onedepartment or entity.
Obtaining lender’s consent
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Obtaining Lender’s Consent
Borrower wanting help with process should contact nonprofit HUD-approved housing counseling service.
Problems with predatory for-profit loan modification companies.
Many states now have “distressed property laws” regulating them.
Assistance for borrowers
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Obtaining Lender’s Consent
If loan has been securitized, it’s difficult to obtain consent.
Under some MBS contracts, any purchaser (investor) can object and prevent loan modification or settlement.
Impractical to obtain consent of all investors.
Securitized loans
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Alternatives to Foreclosure
Generally, IRS views debt relief (reduction in amount owed) as income.
Borrower who enters arrangement reducing amount owed may have to pay income tax on debt relief.
Income tax implications
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Alternatives to Foreclosure
Exceptions: debt relief not taxed if:debt was secured by principal residence
and forgiven between 2007-2012debtor was insolvent when debt forgiven
Income tax implications
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SummaryAlternatives to Foreclosure
• Loan workout
• Repayment plan
• Loan modification
• Deed in lieu
• Short sale
• Housing counseling service
• Distressed property laws
• Debt relief
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Finance Instrument Provisions
Rights and responsibilities of borrower and lender may be affected by:
subordination clauselate charge provisionprepayment provisionpartial release clauseacceleration clausealienation clause
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Finance Instrument Provisions
Subordination clause: gives a mortgage lower priority than another mortgage that will be recorded later on.
Common in construction financing.
Subordination clauses
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Finance Instrument Provisions
Promissory notes usually provide for late charges if borrower doesn’t make payments on time.
State laws may override late charge provision, to protect borrowers from excessive charges.
Late charge provisions
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Finance Instrument Provisions
Prepayment provision: imposes penalty on borrower who repays some or all of principal before due.
Prepayment deprives lender of some of interest it expected to receive over loan term.
Prepayment provisions
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Finance Instrument Provisions
Not standard in residential loan agreements.Fannie Mae/Freddie Mac promissory
note gives borrower right to prepay.Prepayment penalties prohibited with
FHA and VA loans.Dodd-Frank Act places new restrictions
on prepayment penalties.
Prepayment provisions
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Finance Instrument Provisions
Partial release clause: obligates lender to release part of property from lien when part of debt is paid.
Typically found in deed of trust or mortgage that covers subdivision, allowing release of individual lot from lien when lot is sold.
Partial release clauses
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Finance Instrument Provisions
Acceleration clause: allows lender to declare outstanding loan balance due immediately in event of default.
Most lenders wait 90 days before accelerating.
Some states now have laws requiring specific waiting period.
Acceleration clauses
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Finance Instrument Provisions
Alienation clause: prevents borrower from selling security property without lender’s permission unless loan paid off at closing.
If title transferred without permission, lender can accelerate loan.
Also called due-on-sale clause.
Alienation clauses
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Alienation Clauses
Most alienation clauses triggered by transfer of any significant interest in property.
Includes long-term leases, or leases with options to purchase.
Lender can’t forbid transfer, but can demand payment of loan.
Triggered by transfer of any interest
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Alienation Clauses
To understand purpose of alienation clause, consider what happens when borrower sells property without paying off loan.
Transfer of title without loan payoff
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Alienation Clauses
Three possibilities:
1. New owner takes title subject to loan but
does not assume it.
2. New owner assumes loan but original borrower is not released.
3. New owner assumes loan and lender agrees to release original borrower.
Transfer of title without loan payoff
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SummaryFinance Instrument Provisions
• Subordination clause
• Late charge provision
• Prepayment provision
• Partial release clause
• Acceleration clause
• Alienation clause
• Assumption
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Types of Real Estate Loans
Junior mortgage: mortgage with lower lien priority than another against same property.
Senior mortgage: mortgage with higher lien priority than another on same property.
At foreclosure, junior mortgage paid only after senior has been paid in full.
Junior or senior mortgage
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Types of Real Estate Loans
Lien having most senior (first) position is called first mortgage.
Junior mortgages may be referred to as second mortgage, third mortgage, etc.
First mortgage
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Types of Real Estate Loans
Purchase money mortgage: any mortgage loan used to finance purchase of property that is collateral for loan.
A mortgage that buyer gives to seller in seller-financed transaction.
Purchase money mortgage
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Types of Real Estate Loans
Home equity loan: loan secured by mortgage against borrower’s equity in home she already owns. (Interest rates higher than on purchase loans.)
Equity: difference between property’s market value and total liens against it.
Home equity loan
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Types of Real Estate Loans
Home equity line of credit (HELOC): line of credit with limit and minimum monthly payments; homeowner can draw upon as needed.
Automatically secured by borrower’s home.
Home equity loan
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Types of Real Estate Loans
Refinancing: new loan used to pay off existing mortgage against same property.
Often used:to take advantage of market interest rate
decreasewhen balloon payment due on existing
loan
Refinance mortgage
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Types of Real Estate Loans
Bridge loan: provides cash for purchase of new home pending sale of old home.
Secured by equity in old home.Usually has interest-only payments.Also called swing loan or gap loan.
Bridge loan
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Types of Real Estate Loans
Budget mortgage: loan with monthly payments that include property taxes and hazard insurance.
Lender holds tax and insurance portions of borrower’s payments in impound account until payments due.
Budget mortgage
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Types of Real Estate Loans
Package mortgage: loan secured by personal property as well as real property.
Alternatively, personal property may be financed separately, using separate security agreement.
Lender must file financing statement with Secretary of State.
Package mortgage
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Types of Real Estate Loans
Blanket mortgage: loan secured by more than one parcel of land; contains partial release clause.
Partial release clause: requires lender to release some of security property from lien when portion of debt is paid off.
Blanket mortgage
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Types of Real Estate Loans
Construction loan: short-term loan used to finance construction on land already owned by borrower.
Once construction completed, construction loan replaced by take-out loan.
Borrower repays amount over specified term.
Construction loan
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Types of Real Estate Loans
Nonrecourse mortgage: loan that gives lender no recourse against borrower.
Lender’s only remedy in event of default is foreclosure on collateral property.
Borrower not personally liable for loan repayment.
Nonrecourse mortgage
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Types of Real Estate Loans
Participation mortgage: allows lender to participate in earnings generated by mortgaged property, in addition to collecting interest payments.
Shared appreciation mortgage: entitles lender to share of increase in property’s value.
Participation / shared appreciation
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Types of Real Estate Loans
Wraparound mortgage: new mortgage that includes existing first mortgage on property.
Used almost exclusively in seller-financed transactions.
Wraparound mortgage
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Types of Real Estate Loans
Reverse mortgage: provides elderly homeowners source of income, without requiring sale of home.
Homeowner borrows against equity.Monthly check from lender.Borrower required to be over certain age.Home sold after death to repay loan.
Reverse mortgage