Principles of Real Estate Financing · 2019-08-15 · LP-12 Required Reading Part One Page 1 of 46 Principles of Real Estate Financing Financing—lending and borrowing money—is

LP-12 Required Reading Part One

Page 1 of 46

Principles of Real Estate Financing

Financing— lending and borrowing money— is essential to the real estate

industry. I f f inancing weren’t available, buyers would have to pay cash for

their property, and very few people could afford to do so. Whether they’re

working with buyers or sellers, real estate agents need a thorough

understanding of the f inancing process. This chapter starts with background

information about real estate cycles, how the government inf luences real

estate f inance, and the secondary market. The chapter then goes on to

explain how mortgages and other f inancing instruments work, the foreclosure

process, and the various types of mortgage loans. The process of applying

for a mortgage loan is covered in Chapter 12.

The Economics of Real Estate Finance

Nearly every buyer needs to borrow money in order to purchase real

estate. Whether a part icular buyer wil l be able to obtain a loan depends in

part on his personal f inancial circumstances, and in part on national and

local economic condit ions. We’re going to discuss real estate cycles and the

government’s role in the economy, to help you understand the economic

factors that affect real estate lending.

From a lender ’s point of view, a loan is an investment. A lender loans

money in the expectat ion of a return on the investment. The borrower wil l

repay the money borrowed, plus interest; the interest is the lender’s return.

As a general rule, investors demand a higher return on risky investments

than they do on comparatively safe ones. That holds true for loan

transactions; the greater the risk that the borrower won’t repay the loan, the

higher the interest rate charged. But the interest rate a lender charges on a

part icular loan also depends on market forces and real estate cycles.


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Real Estate Cycles

The real estate market is cyclical: i t goes through active periods followed

by slumps. These periodic shif ts in the level of act ivity in the real estate

market are called real estate cycles . Residential real estate cycles can be

dramatic or moderate, and they can be local or regional. At any given t ime

and place, there may be a buyer’s market, where few people are buying and

homes sit on the market for a long t ime, or there may be a seller’s market,

where many people are buying and homes sell rapidly.

These cycles obey the law of supply and demand. When demand for a

product exceeds the supply (a seller’s market), the price charged for the

product tends to rise, and the price increase st imulates more production. As

production increases, more of the demand is sat isf ied, unti l eventually the

supply outstrips demand and a buyer’s market is created. At that point,

prices fall and production tapers off unti l demand catches up with supply,

and the cycle begins again.

Real estate cycles are caused by changes in the supply of and demand

for mortgage loan funds. The supply of mortgage funds depends on how

much money investors have available and choose to invest in real estate

loans. The demand for mortgage funds depends on how many people want to

purchase real estate and can afford to borrow enough money to do so.

Interest rates represent the price of mortgage funds. They affect supply

and demand, and they also f luctuate in response to changes in supply and

demand. Interest is sometimes called the cost of money.

Generally, when mortgage funds are plentiful, interest rates are low.

When funds are scarce, interest rates are high; this is called a tight money

market . While interest rates do not usually have an immediate impact on

property values, in a t ight market, sellers may have to resort to offering to

f inance part of the purchase price in order to close a sale.

In a healthy economy, supply and demand are more or less in balance.

This is the ideal; in reality, the forces affect ing supply and demand are


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constantly changing, and so is the balance between them. But as long as

supply and demand are reasonably close, the economy functions well. When

supply far exceeds demand, o r vice versa, the economy suffers.

Real estate cycles can be moderated, though not eliminated, by factors

that either help keep interest rates under control or direct ly affect the supply

of mortgage funds. Federal economic policy plays a key role in moderating

real estate cycles.

Interest Rates and Federal Policy

Economic stabil i ty is direct ly t ied to the supply of and demand for money.

If money is plentiful and can be borrowed cheaply (that is, interest rates are

low), increased economic act ivity is usually the result . On the other hand, if

funds are scarce and/or expensive to borrow, an economic slowdown

wil l result .

Thus, manipulat ion of the availabil i ty and cost of money can do much to

achieve economic balance. The federal government inf luences real estate

f inance, as well as the rest of the U.S. economy, through its fiscal policy

and its monetary policy .

Fiscal Policy. Fiscal policy refers to the way in which the federal

government manages its money. Congress and the President determine

f iscal policy through tax legislat ion and the federal budget. The U.S.

Treasury implements f iscal policy by managing tax revenues, expenditures,

and the national debt.

When the federal government spends more money than it takes in, a

shortfall called the federal defic it results . It is the Treasury’s responsibil i ty

to borrow enough money to cover the def icit . It does this by issuing interest -

bearing securit ies that are backed by the U.S. government and purchased by

private investors. The securit ies include Treasury bil ls, notes, and bonds.

Investors of ten prefer to invest in these government securit ies instead of

other investments, because they are comparatively low -risk.


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When the government borrows money, it competes with private industry

for available investment funds. Economists and polit icians debate what

impact this has on the economy. According to some, by draining the number

of dollars in circulat ion, heavy government borrowing may lead to an

economic slowdown. The greater the federal def icit , the more money the

government has to borrow, and the greater the effect on the economy. Other

economists argue that the federal def icit has l it t le effect on interest rates.

The government’s taxation policies also affect the supply of and demand

for money. As with the def icit , the effect of taxation on the economy is

controversial. Basically, when taxes are low, taxpayers have more money to

lend and invest. When taxes are high, taxpayers not only have less money to

lend or invest, they also may be more l ikely to invest what money they do

have in tax-exempt securit ies instead of taxable investments. Since real

estate and real estate mortgages are taxable investments, this may have a

signif icant impact on the real estate f inance industry.

Monetary Policy. Monetary policy refers to the direct control the federal

government exerts over the money supply and interest rates. The main goal

of monetary policy is to keep the U.S. economy healthy.

Monetary policy is determined by the Federal Reserve , commonly called

“the Fed.” The Federal Reserve System, established in 1913, is the nation’s

central banking system. It is governed by the Federal Reserve Board and the

board’s chairman. It has twelve districts nationwide, with a Federal Reserve

Bank in each district. Thousands of commercial banks across the country are

members of the Federal Reserve.

The Fed is responsible for regulat ing commercial banks, and it also

oversees implementation of the Truth in Lending Act (discussed in Chapter

12). But sett ing and implementing the government’s monetary policy is

perhaps the Fed’s most important function.


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The major object ives of the government’s monetary policy are high

employment, economic growth, price stabil i ty, interest rate stabil i ty, and

stabil i ty in f inancial and foreign exchange markets. Although these goals are

interrelated, we are most concerned with the Federal Reserve policies that

affect the availabil i ty and cost of borrowed money (interest rates), since

those have the most direct impact on the real estate industry.

One of the Fed’s main goals is to l imit inf lat ion . Inf lat ion is a general

rise in prices of goods and services over time, meaning that each dollar’s

purchasing power is reduced. Consumer price indexes, which track changes

in the price of certain commodit ies, can be used to track inf lat ion rates.

Inf lat ion tends to occur in periods of rapid economic growth. While

economic growth is ideal, too much growth too fast can push prices too high,

suddenly causing reduced demand and an economic contract ion. By raising

interest rates, the Fed can put a brake on inf lat ion.


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The Fed uses three tools to implement its monetary policy and

inf luence the economy:

key interest rates,

reserve requirements, and

open market operations.

Key Interest Rates . The Fed has control over two interest rates, the

federal funds rate and the discount rate. These are the interest rates

charged when a bank borrows money, either f rom another bank or f rom a

Federal Reserve Bank. When the Fed takes act ion to raise or lower the

interest rates that its member banks have to pay, the banks wil l typically

raise or lower the interest rates they charge their customers. Lower interest

rates tend to st imulate the economy, and higher rates tend to slow it down.

The Fed may increase rates if i t decides that a slower pace is desirable to

keep price inf lat ion in check.

Reserve Requirements. Commercial banks are required to keep certain

percentages of their customers’ funds on deposit at the Federal Reserve

Bank. These reserve requirements help prevent f inancial panics (a “run on

the bank”) by assuring depositors that their funds are safe and accessible;

their bank wil l always have enough money available to meet unusual

customer demand.

Reserve requirements also give the Fed some control over the growth of

credit . By increasing reserve requirements, the Fed can reduce the amount

of money banks have available to lend. On the other hand, a reduction in

reserve requirements f rees more money for investment or lending. So an

increase in reserve requirements tends to decrease available loan funds and

increase interest rates. Conversely, a decrease in reserve requirements

tends to increase available loan funds and decrease interest rates.

Open Market Operations. The Fed also buys and sells government

securit ies; these transactions are called open market operations. They are

the Fed’s chief method of controll ing the money supply, and with the money


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supply, inf lat ion and interest rates. Only money in circulat ion is considered

part of the money supply, so act ions by the Fed that put money into

circulat ion increase the money supply, and act ions that take money out of

circulat ion decrease it .

When the Fed buys government securit ies f rom an investor, it increases

the money supply, because the money that the Fed uses to pay for the

securit ies goes into circulat ion. When the Fed sells government securit ies,

the money the buyer uses to pay for the securit ies is taken out of circulat ion,

decreasing the money supply. Interest rates tend to fall with increases in

the money supply, and to rise with decreases in the money supply.

Other Federal Influences on Finance . Aside f rom the Federal Reserve,

there are a number of other federal agencies, programs, and regulatory

systems that have an impact on real estate f inance.

Federal Home Loan Bank System. The Federal Home Loan Bank System

(FHLB) is made up of twelve regional, privately owned wholesale banks.

The banks loan funds to FHLB members— local community lenders—and

accept their mortgages and other loans as collateral. The FHLB, which is

overseen by the Federal Housing Finance Board, is act ive in promoting

affordable housing.

Federal Deposit Insurance Corporation . The FDIC was created in 1933 to

insure bank deposits against bank insolvency. If a bank or savings and loan

fails, the FDIC will step in to protect the inst itut ion’s customers against the

loss of their deposited funds, up to specif ied l imits.

HUD. The Department of Housing and Urban Development (HUD) is a federal

cabinet department. Among many other things, HUD’s responsibil i t ies

include urban renewal projects, public housing, FHA -insured loan programs,

and enforcement of the Federal Fair Housing Act (see Chapter 16). Ginnie

Mae (discussed later in this chapter) and the Federal Housing Administrat ion

(discussed in Chapter 12) are both part of HUD.


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Rural Housing Service. Formerly known as the Farmers Home

Administrat ion or FmHA, the Rural Housing Service is an agency within the

Department of Agriculture. To help people l iving in rural areas purchase and

improve the ir homes, the Rural Housing Service makes loans and grants and

also guarantees loans made by lending inst itut ions. In addit ion, it f inances

the construct ion of affordable housing in rural areas. (These loan programs

are discussed in Chapter 12.)

Farm Credit System. Originally developed by the federal government, the

Farm Credit System is now a privately owned cooperative. It provides

f inancial assistance to farmers, ranchers, and others in rural areas.

Community Reinvestment Act . Congress passed the Communi ty

Reinvestment Act (CRA) in 1977 to help ensure that federally supervised

f inancial inst itut ions meet the credit needs of their local communit ies,

including the need for affordable home loans. The federal agencies that

oversee f inancial inst itut ions (the Federal Reserve, the FDIC, the Off ice of

the Comptroller of the Currency, and the Off ice of Thrif t Supervision)

periodically evaluate their community lending act ivit ies.

Real Estate Finance Markets

There are two “markets” that supply the funds available for real estate

loans: the primary market and the secondary market. In addit ion to using

monetary policy to control the money supply and interest rates, another way

in which the federal government has helped moderate the severity and

durat ion of real estate cycles is by establishing a strong, nationwide

secondary market. The secondary market l imits the adverse effects of local

economic circumstances on real estate lending. We’l l look f irst at the

primary market, then at the secondary market.

Primary Market

The primary market is the market in which mortgage lenders make loans

to home buyers. When buyers apply for a loan to f inance their purchase,

they’re seeking a loan in the primary market. Originally, the primary market


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was entirely local. It was made up of the various lending inst itut ions in a

community— the local banks and savings and loan associat ions. (Today the

primary market is considerably more complicated, since there are interstate

lenders, online lenders, nationwide mortgage companies, and so on .) The

tradit ional source of funds for the primary market was the savings of

individuals and businesses in the local area. A bank or savings and loan

would use the savings deposits of members of the local community to make

mortgage loans to members of that same community.

The local economy has a signif icant effect on the amount of deposited

funds available to a lender, and on the local demand for them. When

employment is high, consumers are more l ikely to borrow money for cars,

vacations, or homes. Bus inesses expand and borrow to f inance their growth.

At the same t ime, fewer people are saving. This decrease in deposits

means that less local money is available for lending, making it dif f icult to

meet the increased demand for loans. On the other hand, when an area is in

an economic slump, consumers are more inclined to save than to borrow.

Businesses suspend plans for growth. The result is a drop in the demand for

money, and the local lending inst itut ions’ deposits grow.

Disintermediation is another phenomenon that affects the amount of

deposited funds available to lenders. It occurs when depositors withdraw

funds f rom savings accounts and put them into competing investments that

offer higher returns, such as stocks and bonds. Changes in interest rates

and investment yields can lead to disintermediat ion.

From a lender’s point of view, either too l it t le or too much money on

deposit is cause for concern. In the f irst case, with l i t t le money to lend, a

lender’s primary source of income is affected. In the second case, the lender

is paying interest to its depositors, and if i t is unable to reinvest the

deposited funds quickly, it wil l lose money.

The solut ion to these problems has been for lenders to look beyond their

local area. When local savings deposits are low, a lender needs to get funds

f rom other parts of the country to lend locally. When local demand for loans


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is low, a lender needs to send funds to other parts of the country where

demand is higher. This is where the secondary market comes in. The

secondary market makes it easy for lenders to obtain funds f rom around

the country.

Secondary Market

The secondary market is a national market. In t he secondary market,

private investors, government agencies, and government -sponsored

enterprises buy and sell mortgages secured by real estate in all parts of the

United States.

Buying and Selling Loans. Mortgage loans can be bought and sold just l ike

other investments—stocks or bonds, for example. The value of a loan is

inf luenced by the rate of return on the loan compared to the market rate of

return, as well as the degree of risk associated with the loan (the l ikelihood

of default). For instance, a seasoned loan—one with a history of several

years of t imely payments by the borrower— is less risky than a new, untested

loan. As a result , a seasoned loan is worth more to an investor than a new

loan for the same amount.


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Investors generally buy mortgage loans at a discount, for less than their

face value. However, if a borrower defaults on a loan purchased at a

discount, the investor can st i l l foreclose (force the sale of the property to

recoup the amount of the debt) for the full face amount of the mortgage. For

example, if an investor bought a $100,000 mortgage for $80,000 and the

borrower immediately defaulted on the loan, the investor could foreclose for

the full $100,000.

The availabil i ty of funds in the primary market now depends a great deal

on the existence of the national secondary market. As explained above, a

part icular lender may have either too much or too l it t le money to lend,

depending on condit ions in the local economy. It is the secondary market

that provides balance by transferring funds f rom areas where there is an

excess to areas where there is a shortage. When local demand for loan

funds is high, lenders can sell loans they’ve already made on the secondary

market and use the proceeds of those sales to make more loans. When local

demand for loan funds is low, lenders can use their excess funds to

purchase loans on the secondary market.

The secondary market has a stabil izing effect on local mortgage markets.

Lenders are wil l ing to commit themselves to long -term real estate loans even

when local funds are scarce, because they can raise more funds by

l iquidating their loans on the secondary market.

Secondary Market Entit ies. The federal government has played a central

role in developing the secondary market for mortgage loans. It ’s done this by

establishing four secondary market entit ies: Fannie Mae, Freddie Mac,

Ginnie Mae, and Farmer Mac. We’ll describe each of these entit ies short ly,

after a general descript ion of what they do.

A secondary market entity buys large numbers of mortgage loans f rom

primary market lenders, and then issues securit ies using the loans as

collateral (“securit izes” the loans). The entity sells these mortgage-backed

securit ies to private investors. As the underlying loans are repaid by the

borrowers, the secondary market entity passes the payments through to the


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investors; that’s the return on their investment. The securit ies are

guaranteed by the secondary market entity, so the investors wil l receive

their payments f rom the entity even if borrowers default on some of the

under lying loans.

Of course, the secondary market entit ies don’t want to buy loans that

carry a high risk of default . To prevent that, the entit ies have established

their own underwriting standards . Underwrit ing standards are the criteria

used to evaluate a loan applicant and the property offered as security, to

determine if the loan would be a good investment or would involve too much

risk. Lenders may apply their own underwrit ing standards when they make

loans, but they generally cannot sell the loans to a secondary market entity

unless the loans conform to the entity’s underwrit ing standards. Because

most lenders want to have the option of sell ing their loans on the secondary

market, the majority of conventional mortgage loans in the U.S. are now

made in accordance with entit ies’ standards. (Underwrit ing standards are

discussed in more detail in Chapter 12.)

Fannie Mae. The most prominent of the secondary market entit ies is the

Federal National Mortgage Associat ion (FNMA), of ten referred to as “Fannie

Mae.” Fannie Mae started out as a federal agency in 1938. Its original

purpose was to provide a secondary market for FHA-insured loans. Fannie

Mae was eventually reorganized as a private corporation, but it is st i l l

chartered by the federal government. It is sometimes referred to as a

government sponsored enterprise , or GSE. Fannie Mae purchases

conventional, FHA, and VA loans to use as the collateral for its mortgage -

backed securit ies. (These dif ferent types of loans are discussed in

Chapter 12.)

Freddie Mac. Congress created the Federal Home Loan Mortgage

Corporation (FHLMC), nicknamed “Freddie Mac,” in 1970. Its original

purpose was to assist savings and loan associat ions (which had been hit

part icularly hard by a recession) by buying their conventional loans. Freddie

Mac is now authorized to purchase and securit ize conventional, FHA, and


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VA loans f rom any type of lender. Like Fannie Mae, Freddie Mac is a

government-sponsored enterprise.

Ginnie Mae. The Government National Mortgage Associat ion (GNMA) is

one of the federal agencies that make up HUD. Among many other things,

Ginnie Mae guarantees securit ies backed by loans made through the FHA

and VA loan programs. It also provides assistance to urban renewal and

housing programs. Note that unlike the other secondary market entit ies,

Ginnie Mae is a government agency, not a government

sponsored enterprise.

Farmer Mac. Like Fannie Mae and Freddie Mac, Farmer Mac (the Federal

Agricultural Mortgage Corporation, or FAMC) is a government-sponsored

enterprise. It was created by Congress in 1988 to establish a secondary

market for agricultural real estate loans and rural housing mortgage loans.

Farmer Mac is regulated and supervised by the Farm Credit Administrat ion.

Current Status of Secondary Market Entities . Because of severe

f inancial problems brought on by the recession that began in 2007, the

federal government was forced to place both Fannie Mae and Freddie Mac

into conservatorship in late 2008. This was essentially a government

takeover of both entit ies, and it wil l continue unti l their solvency is restored.

As part of the takeover, Congress also created a new government

regulator for the two entit ies, the Federal Housing Finance Agency (FHFA).

Previously, Fannie Mae and Freddie Mac had been supervised by HUD; now

Ginnie Mae is the only secondary market entity that HUD has authority over.

Real Estate Finance Documents

Now let ’s turn to the legal aspects of a real estate f inance transaction.

Once a buyer has found a lender wil l ing to f inance his purchase on

acceptable terms, the buyer is required to sign the f inance documents. The

legal documents used in conjunction with most real estate loans are the

promissory note and a security instrument, which is either a mortgage or a

deed of trust.


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We’ll look f irst at promissory notes, and then at security instruments and

foreclosure procedures.

Promissory Notes

A promissory note is a writ ten promise to repay a debt. One person loans

another money, and the other signs a promissory note, promisin g to repay

the loan (plus interest, in most cases). The borrower who signs the note is

called the maker, and the lender is called the payee . In some states, a bond

is used in the place of a promissory note. The basic provisions and rules we

wil l discuss below apply to both notes and bonds.

Basic Provisions. A promissory note states the loan amount (the

principal), the amount of the payments, when and how the payments are to

be made, and the maturity date—when the loan is to be repaid in full.


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The note also specif ies the interest rate, and whether it is f ixed or

variable. In many states, the interest rate must not violate the usury law.

Usury refers to charging an unfairly high interest rate on a loan. To protect

consumers, a usury law places a l imit on the interest rate lenders may

charge on certain types of loans. The maximum rate may be a f ixed

percentage, or it may be a f loat ing rate, adjusted in response to changes in

an economic index.

Naturally, the names of the borrowers wil l be l isted on the promissory

note. If each of the borrowers is to be individually l iable for the entire loan

amount, then the note wil l state that the borrowers are “joint ly and severally”

l iable for the debt.

A promissory note in a real estate loan transaction does not need to

contain a legal descript ion of the property, because the note concerns only

the debt, not the property. The legal descript ion is instead included in the

security instrument. Because the promissory note does not concern the

property, it is ordinarily not recorded.

The note usually explains the consequences of a failure to repay the loan

as agreed. Real estate lenders often protect themselves with late charges,

accelerat ion clauses, and similar provisions; these wil l be discussed later in

this chapter.

Types of Notes. There are various types of promissory notes, classif ied

according to the way the principal and interest are paid off . With a straight

note (also called a term note ), the periodic payments are interest only

payments: they cover the interest that ’s accruing, but pay back none of the

principal. The full amount of the pincipal is due in a lump sum (called a

balloon payment) when the loan term ends. With an insta llment note , the

periodic payments include part of the principal as well as interest. If the

installment note is fully amortized , the periodic payments are enough to

pay off the entire loan, both principal and interest, by the end of the term.

(Amort izat ion is discussed in Chapter 12.)


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Whether the payments are interest -only or amort ized, the interest paid on

a real estate loan is simple interest . That means it is computed annually on

the remaining principal balance. (This is in contrast to compound interest,

which is computed on the principal amount plus the accrued interest.) Since

each installment payment on an amort ized loan reduces the principal

balance, the borrower pays less and less interest over the course of the

loan term.

Signing and Endorsing the Note . Though many copies of the note may be

prepared, the maker (the borrower) signs only one copy. This is for the

maker’s protect ion. A promissory note is usually a negotiable instrument,

which means the payee (the lender) has the option of assigning the debt to

someone else by endorsing the note. (A note is endorsed to transfer the

right to payment to another party in the same way that a check is endorsed.

A check is another example of a negotiable instrument.) Having only one

copy of the note signed by the maker ensures that the payee can assign the

note to only one other party. If there were two or three signed copies, it

would be possible to assign the note to two or three dif feren t part ies, so that

more than one could demand payment of the same debt f rom the maker.

When the debt is paid off , the signed copy is returned to the maker

marked “Paid.”

To be negotiable, the note must state that it is payable either “to the

order of ” someone or “to bearer.” To sell the note (at the secondary market

level), the payee endorses it to a third party purchaser. If the purchaser

buys the note for value, in good faith, and without notice of defenses against

it , the purchaser is called a holder in due course . If the holder in due

course later sues the maker for nonpayment, certain defenses that the

maker might have been able to raise against the payee can’t be raised

against the holder in due course.

If a note is endorsed to a specif ied person, it is called a special

endorsement. Otherwise , the endorsement is said to be “in blank.” The

payee may also state that the endorsement is without recourse (or without

warranty). This means that the matter of future payments is strict ly between


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the maker and the third party purchaser; the original payee wil l not be l iable

to the holder in due course if the maker fails to pay as agreed. An

endorsement without recourse is sometimes called a qualif ied endorsement.

Security Instruments

When someone borrows money to buy real estate, in addit ion to signing a

promissory note in favor of the lender, he is also required to sign a security

instrument. As we said earlier, the security instrument is either a mortgage

or a deed of trust.

Relationship between Note and Security Instrument. It ’s important to

understand the relat ionship between the promissory note and the security

instrument. The promissory note is the borrower’s binding promise to repay

the loan. The security instrument is a contract that makes the real property

collateral for the loan; it secures the loan by creating a l ien on the property.

If the borrower doesn’t repay the loan as agreed, the security instrument

gives the lender the right to foreclose on the property.

A promissory note can be enforced even if i t is not accompanied by a

security instrument. If the borrower does not repay as agreed, then the

lender can f i le a lawsuit and obtain a judgment against the default ing

borrower. But without a security instrument, the lender might have no way

of collect ing the judgment. For example, the borrower may have already sold

all of her property, leaving nothing for the lender (now the judgment creditor)

to obtain a l ien against.

Title Theory vs. Lien Theory. To understand how security instruments

work, i t ’s useful to know how they developed. Historically, to protect the

lender against default , a real estate borrower was required to transfer t it le to

the property to the lender for the term of the loan. The borrower remained in

possession of the property and had the full use of it , but the lender held t it le

until the loan was paid off . If i t wasn’t paid off as agreed, the lender could

take possession of the property.


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This arrangement— in which t it le to

property is given as collateral, but

the borrower retains possession— is

called hypothecation . W hen t it le is

transferred only as collateral,

unaccompanied by possessory

rights, it is called legal t i t le, bare

t it le, or naked t it le. The property

rights the borrower retains (without

legal t i t le) are referred to as

equitable rights or equitable t it le.

In the United States today, a handful of states st i l l regard the execution

of a mortgage or a deed of trust as a transfer of legal t i t le. Those states are

called “t it le theory” states. However, most states now follow “l ien theory.”

According to l ien theory, execution of a mortgage or a deed of trust only

creates a l ien against the property; it does not transfer t it le. The borrower

retains full t i t le to the property throughout the term of the loan, and the

lender simply has the right to foreclose the l ien if the borrower defaults.

Some states follow “intermediate theory,” which mixes t it le theory and

l ien theory together. In these states, a mortgage or deed of trust is simply a

l ien unti l the borrower defaults. Upon default , the mortgage or deed of trust

is governed by t it le theory. Today it doesn’t make much dif ference whether

a state follows t it le theory, l ien theory, or intermediate theory, in terms of

lending and foreclosure procedures; the dist inct ion is more theoretical than

pract ical. Under any of the theories, the borrower wil l lose the property if the

loan is not repaid.

Mortgage vs. Deed of Trust . Now let ’s consider the two types of real

property security instruments: mortgages and deeds of trust. Both are

contracts in which a real property owner gives someone else a security

interest in the property, usually as collateral for a loan. The most important

dif ference between a mortgage and a deed of trust concerns the procedures


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for foreclosure if the borrower defaults. We wil l discuss the foreclosure

process later in this chapter.

There are two part ies to a mortgage: the mortgagor and the mortgagee .

The mortgagor is the property owner and borrower. The mortgagee is the

lender.

A deed of trust (sometimes called a trust deed) has three part ies: the

trustor or grantor (the borrower), the benefic iary (the lender), and the

trustee . The trustee is a neutral third party who wil l handle the foreclosure

process, if that proves necessary.

The terminology used in a deed of trust has its roots in t it le theory. The

document i tself is called a “deed,” and it purports to convey legal t i t le to the

trustee. The trustee holds the deed “in trust” pending repayment of the debt.

When the loan has been repaid, the trustee “reconveys” legal t i t le to the

trustor. Even so, deeds of trust are used in l ien theory and intermediate

theory states as well as t it le theory states.

Note that the terms “mortgage” and “mortgage loan” are of ten used to

refer to any type of loan secured by real property, whether the security

instrument actually used in the transaction is a mortgage or deed of trust.

Recording. W hether it ’s a mortgage or a deed of trust, the lender should

always record the security instrument immediately af ter the loan is made.

The security instrument does not have to be recorded to create a valid l ien

on the property, but without recording only the lender and borrower would

know the l ien exists. Other part ies who acquired an interest in the property

w i thout notice of the lender’s security interest would not be subject to it , and

subsequent l iens would have priority over the lender’s.

Instruments as Personal Property. Note that even though it creates a l ien

against real property, a mortgage or deed of t rust is itself classif ied as

personal property. A promissory note is also personal property.


Page 20 of 46

Assignment. W hen a lender sells a loan secured by a mortgage or deed of

trust to an investor, in addit ion to endorsing the promissory n ote, the lender

executes a document called an assignment of mortgage (or deed of trust).

The investor may request an offset statement f rom the borrower. In an

offset statement, the borrower conf irms the status of the loan (the interest

rate, principal balance, etc.) and describes any claims that could affect the

investor’s interest. The investor may also obtain a similar statement

concerning the loan’s status f rom the lender; this is called a beneficiary’s

statement . In some states, either an offset statement or a benef iciary’s

statement may be referred to as an estoppel certif icate .

Personal Property as Collateral . Of course, personal property as well as

real property may be used as collateral for a loan. When a borrower

transfers possession of an item of personal property to a lender pending

repayment of the loan, it is called a pledge . Alternatively, the borrower may

retain possession of the personal property and give the lender a security

interest in it . In that case, the borrower signs a document called a security

agreement . A security agreement is the equivalent of a mortgage or deed of

trust for personal property.

Finance Document Provisions

Next, let ’s look at key provisions in the legal documents for a real estate

loan. Some of these are essential, while others are optional, or used only in

certain situations. Some of them may appear in the promissory note as well

as, or instead of , the security instrument. And in a few cases (noted below),

there’s a dist inct ion between the type of provision found in a mortgage and

the type found in a deed of trust.

Mortgaging or Granting Clause . Every security instrument is required to

include a statement expressing what the instrument is designed to do,

indicating that the property is being promised as security for the loan. This

is called the mortgaging clause or (in a deed of trust) the granting clause.


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Property Description. Like a deed or any other document that transfers an

interest in real estate, the security instrument must contain a complete and

unambiguous descript ion of the collateral property.

Acceleration Clause. An accelerat ion clause states that if the borrower

defaults, the lender has the option of declaring the entire loan balance (all

the principal st i l l owed) due and payable immediately. Sometimes this is

referred to as “call ing the note.” If the borrower fails to pay the balance as

demanded, the lender can sue on the note or foreclose the l ien.

An accelerat ion clause is l ikely to appear in both the promissory note and

in the security instrument. Accelerat ion can be t riggered by failure to make

loan payments as agreed in the note, or by breach of a provision in the

security instrument, such as failure to keep the property insured

(see below).

Covenants. A security instrument typically contains a number of covenants

(promises) made by the borrower to the lender. W ith the covenant to pay

taxes, the borrower promises to pay the general real estate taxes and any

special assessments when due. With the covenant of insurance , the

borrower promises to keep the property insured against damage or

destruct ion. If the borrower were to allow the taxes to become delinquent or

the hazard insurance to lapse, the value of the lender’s security interest

could be severely diminished—by tax l ien foreclosure or a f ire, for example.

With the covenant against removal , the borrower promises not to

remove or demolish buildings or other improvements. The covenant of good

repair requires the borrower to keep the property in good condit ion, and

also authorizes the lender to inspect the property to make sure that it is

being properly maintained.

Alienation Clause. An alienation clause is also called a due-on-sale

clause . This provision gives the lender the right to accelerate the loan —

demanding immediate payment of the entire loan balance, as described

above— if the borrower sells the property or otherwise alienates an interest

in it . (Alienation refers to any transfer of an interest in real estate. See


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Chapter 4.) An alienation clause does not prohibit the sale of the property,

but it allows the lender to force the borrower to pay off the loan if the

property is sold without the lender’s approval.

Whether or not there is an alienation clause in the mortgage or deed of

trust, sale of the property doesn’t ext inguish the lender’s l ien. If the loa n

isn’t paid off at closing, the buyer wil l take t it le subject to the l ien. The buyer

may also arrange to assume the loan.

In an assumption , the borrower sells the security property to a buyer

who agrees to accept legal responsibil i ty for the loan and pay it off

according to its terms. The buyer takes on primary l iabil i ty to the lender for

repayment of the loan, but the seller (the original borrower) retains

secondary l iabil i ty in case the buyer defaults.

By contrast, when a buyer takes t it le subject to an exist ing mortgage or

deed of trust without assuming it , the seller remains fully l iable for the debt.

The buyer isn’t personally l iable to the lender, although in case of default

the lender can st i l l foreclose on the property.

Even though the sale of the property doesn’t ext inguish the mortgage or

deed of trust l ien, lenders prefer to have the opportunity to approve or reject

a prospective purchaser. Thus, most mortgages and deeds of trust include

an alienation clause. When a lender evaluates a purchaser and concludes

that she is creditworthy, the lender may agree to an assumption of the loan.

The lender wil l usually charge an assumption fee, and may also raise the

interest rate on the loan. In most cases, the lender wil l release the original

borrower f rom any further l iabil i ty; this is called a novation .

Late Payment Penalty. If a lender wants to impose a penalty for late

payment, the penalty must be clearly def ined in the f inance documents. Most

states place some limitat ions on late payment penalt ies; federal law also

l imits late payment penalt ies in certain types of loans. For example, a

penalty might not be allowed to exceed a certain percentage of the loan’s

principal balance, and the lender might not be allowed to charge the penalty

unti l the borrower’s payment is a certain number of days overdue.


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Note that late payment penalt ies are not considered interest on the loan,

so they are not deductible on the borrower’s income tax return.

Lock-in Clause. A lock-in clause prohibits the borrower f rom prepaying the

loan—paying it off early, before payment is due. The borrower is “locked in”

to the loan for the full term or for a specif ied number of years, so that the

lender wil l not be deprived of interest it expects to collect. Some states do

not allow lock-in clauses in loans secured by residential property.

Prepayment Penalty. Under the terms of some loans, the lender may

impose a penalty if the borrower prepays all or part of the loan balance. For

example, a promissory note might state, “The borrower may prepay up to

15% of the original loan amount during any twelve-month period without

penalty. If the borrower prepays more than 15%, a prepayment fee equal to

six months’ interest on the excess wil l be charged.”

A prepayment penalty is intended to co mpensate the lender for interest

that it expected to collect, but won’t be collect ing because the borrower is

paying the loan off early. The prepayment of a loan without a penalty does

not in itself cause a direct loss to the lender, but the lender’s prof it on the

loan wil l be less than expected.

A lender may be wil l ing to waive a prepayment penalty if market interest

rates are high. Under those circumstances, when borrowers prepay their

loans, the lender can turn around and lend the same money at a highe r rate.

Some states impose specif ic restrict ions on prepayment penalt ies for

certain types of loans. For example, for a home purchase mortgage, a

prepayment penalty might not be allowed after the f irst f ive years of the loan

term. Or a penalty might be allowed only if the loan is paid off with borrowed

funds (ref inanced).

Loans that wil l be insured or guaranteed by the federal government (FHA

or VA loans, for example) cannot include a prepayment penalty provision,

and loans that are going to be sold to Fannie Mae or Freddie Mac also do

not ordinarily include one. They are also prohibited in certain high -cost


Page 24 of 46

loans. As a result , prepayment penalt ies are not charged on many home

loans made by inst itut ional lenders.

A mortgage loan without a prepayment penalty is sometimes referred to

as an open mortgage . When prepayment is allowed without penalty, the

promissory note usually contains a provision that states that the borrower

can make the required payment “or more” on the specif ied payment date.

Subordination Clause. Occasionally a security instrument includes a

subordination clause, which states that the instrument wil l have lower l ien

priority than another mortgage or deed of trust to be executed in the future.

The clause makes it possible for a later security instrument to assume a

higher priority posit ion—usually f irst l ien posit ion—even though this earlier

security instrument was executed and recorded f irst.

Subordination clauses are common in mortgages and deeds of trust that

secure purchase loans for unimproved land, when the borrower is planning

to get a construct ion loan later on. The construct ion lender wil l demand f irst

l ien posit ion for its loan. Lien priority is ordinarily determined by recording

date (“f irst in t ime is f irst in right”), but the subordination clause in the

earlier land loan allows the later construct ion loan to have f irst l ien posit ion.

Condemnation Clause. Sometimes a security instrument includes a

condemnation clause. If the property is taken in an eminent domain act ion

(see Chapter 6), the condemnation clause gives the lender the right to use

all or part of the condemnation award to satisfy the loan.

Assignment of Rents Clause . In mortgages on income-producing property,

lenders of ten enhance their security with an assignment of rents clause.

Under this provision, the borrower assigns the rental income generated by

the property to the lender in the event of default . If the borrower defaults on

the loan, the lender wil l apply the rents to the loan’s principal balance. In

some states, the lender must ask a court to appoint a receiver before the

lender can begin collect ing rents.


Page 25 of 46

Defeasance Clause. A defeasance clause states that when the debt has

been paid, the security instrument wil l be canceled, releasing the property

f rom the lender’s claim.

If the security instrument is a deed of trust, the benef iciary (lender) wil l

submit a “request for reconveyance” to the trustee. The trustee wil l execute

and record a deed of reconveyance , or reconveyance deed.

If the security instrument is a mortgage, the document that is recorded to

remove the mortgage l ien is called a certificate of discharge or

satisfaction of mortgage . Either this document or a deed of reconveyance

may be referred to as a lien re lease . The document should be recorded to

clear the t it le.

Foreclosure Procedures

If the borrower doesn’t repay a secured loan as agreed, the lender may

foreclose and collect the debt f rom the proceeds of a forced sale.

Establishing the lender’s right to foreclose is the basic purpose of a

security instrument.

The forms of foreclosure available to a lender vary f rom state to state, as

do the procedures and rules governing the process. The two main forms of

foreclosure are judicial foreclosure and nonjudicial foreclosure. In many

states, mortgages are usually foreclosed judicially and deeds of trust are

usually foreclosed nonjudicially.

Judicia l Foreclosure. As the term suggests, a judicial foreclosure is carried

out through the court system. Upon default , the lender f i les a lawsuit against

the borrower in a court in the county where the collateral property is located.

If there are any junior l ienholders (l ienholders whose l iens have lower

priority than the mortgage being foreclosed on), they are also included in the

foreclosure act ion, so that they can take steps to protect their interests. (A

junior l ienholder may be adversely affected by foreclosure of a senior l ien if

the sale proceeds aren’t suff icient to pay off all of the l iens against

the property.)


Page 26 of 46

The lender records a lis pendens , which is a notice of a pending legal

act ion (in this case, the foreclosure act ion) that could affect specif ied real

property. A l is pendens makes the f inal court judgment binding on anyone

who might acquire an interest in the property while the foreclosure act ion

is pending.

When the complaint is heard in court, in the absence of unusual

circumstances, the judge wil l issue a decree of foreclosure , ordering the

property to be sold to satisfy the debt. The judge appoints a receiver to

conduct the sale. The sale, which takes the form of a public auction, is of ten

referred to as a sheriff’s sale .

Reinstatement . In some states, while the foreclosure act ion is pending,

the borrower must be allowed to “cure” the loan default by paying all past

due amounts, plus the costs and fees of the lawsuit. In that case, the loan is

reinstated ; the foreclosure proceedings are terminated, and the mortgage

continues in full force and effect. Once the decree of foreclosure is issued,

this right of reinstatement no longer exists.

Equitable Redemption. Some states do not give the borrower the right to

cure the default and have the loan reinstated once the foreclosure act ion

has begun. However, the borrower generally does have the right to stop the

foreclosure and redeem the property by paying off the entire loan balance,

plus interest, costs, and fees. This is called the borrower’s equitable right

of redemption .

Statutory Redemption . In some states, af ter the sherif f ’s sale the

borrower has a f inal chance to redeem the property by paying off the entire

debt (the unpaid loan balance, interest, costs, and fees). This is called the

statutory right of redemption . How long the statutory right of redemption

exists depends on state law; it might last only one month, or it could last as

long as one year. However, if the lender waives the right to a def iciency

judgment (discussed below) or is prohibited f rom obtaining a def iciency

judgment, the borrower usually has no right of redemption af ter the

sherif f ’s sale.


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When the property is sold subject to the statuto ry right of redemption, the

successful bidder at the sherif f ’s sale receives a certificate of sale instead

of a deed. Depending on state law, the borrower may be entit led to keep

possession of the property during the redemption period (provided he pays

reasonable rent to the holder of the cert if icate of sale), or the property may

be managed by a receiver. At the end of the redemption period the

cert if icate holder is given a sheriff’s deed , which transfers t it le and the

right of possession of the property to the new owner.

Credit Bidding. A long redemption period makes bidding at a sherif f ’s

sale unappealing to many investors; understandably, they don’t want to wait

to gain t it le to the property. For this reason, a judicial foreclosure sale that

wil l be followed by a long redemption period of ten attracts no outside

bidders, and the lender acquires the property by bidding the amount the

borrower owes. This is called credit bidding , since the lender doesn’t have

to pay any cash.

Surplus or Deficiency. If there are outside bidders at the auction and

the proceeds f rom the sale exceed the amount necessary to satisfy all valid

l iens against the property, the surplus belongs to the borrower.

However, the proceeds of a foreclosure sale are of ten insuff icient to

satisfy even the debt owed to the foreclosing lender. In that situation, some

states allow the lender to sue the borrower for a deficiency judgment . A

def iciency judgment is a personal judgment for the dif ference between the

amount owing on the debt and the net proceeds f rom the foreclosure sale. A

court may award a lender a def iciency judgment at the same t ime the decree

of foreclosure is entered, or the lender may have to f i le a separate act ion for

a def iciency judgment af ter the foreclosure sale.

Anti-def iciency rules in some states prohibit def iciency judgments in

certain circumstances and in connection with certain types of mortgages.


Page 28 of 46

Nonjudicia l Foreclosure . A deed of trust includes a special provision call ed

a power of sale clause . If the borrower defaults, this provision authorizes

the trustee to sell the property through nonjudicial foreclosure, if permitted

by state law. To foreclose nonjudicially, it ’s not necessary to f i le a

foreclosure lawsuit or get a decree of foreclosure f rom a judge. Instead, the

trustee can sell the property at an auction called a trustee’s sa le , then use

the sale proceeds to pay off the debt owed to the lender (benef iciary). If the

sale results in a surplus, the excess amount be longs to the borrower. The

lender may be allowed to credit bid. The successful bidder at a trustee’s

sale receives a trustee’s deed .

In some states, a power of sale clause may be included in a mortgage. A

mortgage with a power of sale clause can be forec losed nonjudicially, l ike a

deed of trust.

Notices of Default and Sale . A nonjudicial foreclosure must be

conducted in accordance with procedures prescribed by state statute. These

procedures require notif icat ion of the affected part ies (including the

borrower and any junior l ienholders) that a foreclosure is pending.


Page 29 of 46

In many states, the trustee begins by recording a notice of default . Af ter a

certain period (for example, three months) the trustee records a notice of

sale and mails copies of the notice to the affected part ies. The trustee

usually must also publish the notice in a newspaper of general circulat ion.

Af ter the notice has appeared in the paper for a certain number of weeks,

the foreclosure sale can take place.

Reinstatement or Redemption . In a nonjudicial foreclosure, the

borrower generally has the right to reinstate the loan by paying all past due

amounts, plus costs and fees. This right usually lasts unti l short ly before

the scheduled date of the trustee’s sale. If the loan is reinstated, the

foreclosure proceedings terminate.

Alternatively, the borrower can redeem the property by paying off the

entire loan balance, plus costs and fees, at any t ime prior to the actual sale.

Af ter the sale, however, redemption is generally no longer allowed. This is

an important dist inct ion between nonjudicial and judicial foreclosure in

many states.

Deficiency Judgments . In most states, a lender loses the right to a

def iciency judgment by foreclosing nonjudicially; the lender’s recovery is

l imited to the proceeds of the trustee’s sale. In states that do permit a

def iciency judgment af ter a trustee’s sale, the lender generally must obtain a

court order to collect such a judgment.

Comparison of Judic ial and Nonjudicia l Foreclosure. From a lender’s

point of view, nonjudicial foreclosure has two main advantages over judicial

foreclosure. First, i t ’s of ten much faster, since court proceedings can be

very slow. Second, as we just discussed, there usually isn’t a statutory

redemption period af ter the trustee’s sale. On the other hand, there’s

generally no right to a def iciency judgment af ter a trustee’s sale, and that

can be very important to a lender. If the sale proceeds are l ikely to be less

than the debt, a lender might choose judicial foreclosure, even if nonjudicial

foreclosure would be allowed.


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Junior Lienholders. Junior l ienholders are generally entit led to notice of a

foreclosure, whether it ’s judicial or nonjudicial. A l ienholder who didn’t

receive proper notice may st i l l have a valid l ien against the property af ter

the foreclosure sale.

The l ien of a junior l ienholder who did receive notice is usually

terminated by the foreclosure sale. The junior l ienholder may get a share of

the sale proceeds, but only if there’s money left over after l iens with higher

priority have been paid off .

Upon receiving notice of a pending foreclosure, a junior l ienholder may

be able to protect her interest by paying the delinquencies on the senior l ien

(curing the default) and adding the amount of these payments to the balance

due under the junior l ien. The junior l ienholder may then foreclose on her

own lien. A purchaser at a junior l ienholder’s sale takes t it le to the property

subject to all senior l iens.

Strict Foreclosure. Some states permit a form of foreclosure called strict

foreclosure. In strict foreclosure, a lender is allowed to acquire t it le to

mortgaged property without a public sale. When the borrower defaults, the

lender f i les a lawsuit and the court establishes a deadline for redemption of

the property. If the borrower does not pay off the loan by the deadline, the

lender is awarded t it le to the property. Strict foreclosure is widely used in

very few states.

Alternatives to Foreclosure . There are three alternatives to foreclosure for

a default ing homeowner: loan workouts, deeds in l ieu of foreclosure, and

short sales. A lender might agree to one of these alternatives to save t ime,

money, and aggravation.

Loan Workouts. A loan workout f rom the lender can sometimes be the

simplest way to avoid a foreclosure. Some workouts involve a repayment

plan—an adjustment in the repayment schedule, of ten referred to as a

forbearance. The borrower gets extra t ime to make up a missed payment or

is allowed to skip a few payments. (The skipped payments are added on to

the repayment period.) If a forbearance wouldn’t solve the problem (for


Page 31 of 46

instance, if the payment amount is about to increase dramatically, far

beyond the borrower’s means), the lender may agree to modify the terms of

the loan. A loan modif ication might involve changing an ARM to a f ixed-rate

mortgage (to prevent it f rom resett ing to a higher rate), reducing the interest

rate, or reducing the amount of principal owed.

Deed in Lieu of Foreclosure. A default ing borrower who can’t negotiate

a loan workout may opt to give the lender a deed in l ieu of foreclosure,

sometimes called a deed in lieu . The deed in l ieu transfers t it le f rom the

borrower to the lender; this sat isf ies the debt and stops fo reclosure

proceedings. The borrower wil l want to make sure that the lender doesn’t

have the right to sue for a def iciency following the sale.

The lender takes t it le subject to any other l iens that encumber the

property. Thus, before accepting a deed in l ieu, the lender wil l determine

what other l iens have attached to the property since the original loan

was made.

Short Sales. Another alternative to foreclosure is a short sale. In a short

sale, the owner sells the house for whatever it wil l bring (somet hing “short”

of the amount owed because the home’s market value has decreased). The

lender receives the sale proceeds and, in return, releases the borrower f rom

the debt. As when arranging a deed in l ieu, the borrower wil l want to avoid

the possibil i ty of a def iciency judgment.

The existence of secondary l iens won’t necessarily prevent a lender f rom

approving a short sale. This is because—unlike with a deed in l ieu— the

lender isn’t taking responsibil i ty for the property or its l iens. However, the

presence of mult iple l iens wil l complicate matters, since all of the

l ienholders must consent to the sale. The junior l ienholders (or creditors)

aren’t l ikely to get much if anything f rom a short sale and may not be

wil l ing to approve the transaction. In this situ ation, a foreclosure may

be inevitable.


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Foreclosure vs. Bankruptcy. Although they can both happen to a person at

the same t ime, foreclosure and bankruptcy are entirely separate legal

procedures. A real property owner who is facing foreclosure is not

necessarily also facing bankruptcy. And a property owner can declare

bankruptcy without necessarily having his property foreclosed on.

Bankruptcy is a federal court procedure that enables a debtor to reduce,

modify, or eliminate debts that have become un manageable. If a mortgage or

deed of trust borrower who is facing foreclosure f i les for bankruptcy, the

foreclosure proceedings are temporarily stayed (put on hold). Any other

act ions by creditors are also stayed.

There are two types of consumer bankruptcy: Chapter 7 and Chapter 13.

(A third type of bankruptcy, Chapter 11, applies only to businesses.) In

Chapter 13 bankruptcy, the debtor enters into a repayment plan to part ially

repay the creditors over f ive years. The debtor is ordinarily allowed to keep

her property.

In Chapter 7 bankruptcy, most of the debtor’s obligat ions are completely

discharged. (Certain types of debts, such as child or spousal support and

student loans, are non-dischargeable.) In exchange for the discharge, the

Chapter 7 debtor is required to surrender all non-exempt property.

Household goods and cars are exempt (with certain l imits); l i fe insurance,

pensions, and public benef its are also exempt.

If the debtor owns a home, the homestead exemption wil l generally

protect at least some of the debtor’s equity (see Chapter 5). The exemption

amount varies f rom state to state. If the debtor’s equity is less than the

applicable exemption amount and the mortgage payments are current, the

debtor may be allowed to keep the home. If the debtor’s equity is greater

than the exemption amount, the home wil l most l ikely be sold.

Before a debtor can f i le for Chapter 7 bankruptcy, a “means test” is

applied to determine whether the debtor can afford to pay back a certain

amount of the debt. If so, the debtor wil l be required to f i le Chapter 13

bankruptcy instead of Chapter 7.


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Seller Financing

Most real estate buyers f inance their purchases with loans f rom an

inst itut ional lender. But some transactions are f inanced by the seller; the

seller extends credit to the buyer, accepting a downpayment and arranging

to be paid over t ime, instead of requiring full payment at closing. In certain

cases, a seller offers more favorable terms than inst itut ional lenders (such

as an exceptionally low interest rate), in order to attract a wider range of

potential buyers and obtain a higher price for the property.

In a seller-f inanced transaction, the seller may ask the buyer to execute a

mortgage or a deed of trust, just l ike an inst itut ional lender. This may be

called a purchase money loan . (W e’l l discuss that term in the following

section of the chapter.)

Sellers also have the option of using a third type of security instrument:

the land contract , also called a real estate contract, installment sales

contract, or contract for deed. The part ies to a land contract are the vendor

(the seller) and the vendee (the buyer). The vendee agrees to pay the

purchase price (plus interest) in installments over a specif ied number of

years. The vendee takes possession of the property right away, but the

vendor retains legal t i t le unti l the full price has been paid. In the meantime,

the vendee has equitable t it le to the property. When the contract is f inally

paid off , the vendor delivers the deed to the vendee.

The rights and responsibil i t ies of the buyer and seller under a land

contract are discussed in Chapter 8.

Types of Mortgage Loans

There are many types of mortgage loans, loans secured by real property

that are used in various circumstances or designed to serve part icular

functions. In this section, we’ll explain some of the types you’re most l ikely

to encounter or hear mentioned. Even though we’l l generally be referring to


Page 34 of 46

these as mortgages or mortgage loans, remember that a deed of trust could

be (and in some states usually would be) used instead of a mortgage.

First Mortgage. A f irst mortgage is simply any security instrument that holds

f irst l ien posit ion; it has the highest l ien priority. A second mortgage is one

that holds second l ien posit ion, and so on.

Senior and Junior Mortgages. Any mortgage that has higher l ien priority

than another is called a senior mortgage in relat ion to that other one, which

is called a junior mortgage. A f irst mortgage is senior to a second mortgage;

a second mortgage is junior to a f irst mortgage, but senior to a third.

As explained in Chapter 5, l ien priority matters in the event of a

foreclosure, since the sale proceeds are used to pay off the f irst l ien f irst . If

any money remains, the second l ien is paid, then the third, and so on, unti l

the money is exhausted. Obviously, it is much better to be in f irst l ien

posit ion than in third.

Purchase Money Mortgage. This term is used in two ways. Sometimes it

means any mortgage loan used to f inance the purchase of the property that

is the collateral for the loan: a buyer borrows money to buy property and

gives the lender a mortgage on that same property to secure the loan.

In other cases, “purchase money mortgage” is used more narrowly, to

mean a mortgage that a buyer gives to a seller in a seller -f inanced

transaction. Instead of paying the full price in cash at closing, the buyer

gives the seller a mortgage on the property and pays the price off in

installments. In this si tuation, the seller is said to “take back” or “carry back”

the mortgage.

Example: The sales price is $240,000. The buyer makes a $24,000

downpayment and signs a promissory note and purchase money

mortgage in favor of the seller for $216,000. The buyer wil l pay the

seller in monthly installments at 7% interest over 15 years.


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In this narrower sense, a purchase money mortgage is sometimes called

a soft money mortgage , because the borrower receives credit instead of

actual cash. If a borrower gives a lender a mortgage and receives cash in

return (as with a bank loan), it is called a hard money mortgage .

Swing Loan. It of ten happens that buyers are ready to purchase a new

home before they’ve succeeded in sell ing their current home. They need

funds for their downpayment and closing costs right away, without wait ing

for the proceeds f rom the eventual sale of the current home. In this

situation, the buyers may be able to obtain a swing loan. A swing loan is

usually secured by the property that is for sale, and it wil l be paid off when

that sale closes. A swing loan may also be called a gap loan or a

bridge loan .

Budget Mortgage. The monthly payment on a budget mortgage includes not

just principal and interest on the loan, but one -twelf th of the year’s property

taxes and hazard insurance premiums as well. The lender holds the money

in trust and pays the taxes and insurance premiums when due. Many

residential loans are secured by budget mortgages. This is the most

pract ical way for lenders to make sure the property taxes and insurance

premiums are paid on t ime.

Package Mortgage. When personal property is sold together with real

estate, both the personal property and the real estate may be f inanced with

one loan. This is called a package mortgage. For example, if a bu yer bought

ovens, f reezers, and other equipment along with a restaurant building, the

purchase might be f inanced with a package mortgage.

Construction Loan. A construct ion loan (sometimes called an interim loan)

is a temporary loan used to f inance the cons truct ion of improvements on the

land. When the construct ion is completed, the construct ion loan is replaced

by permanent f inanc ing, which is called a take-out loan . A lender’s promise

to make a take-out loan at a later t ime when the borrower needs it is called

a standby loan commitment .


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Construct ion loans can be prof itable, but they are considered quite risky.

Accordingly, lenders charge high interest rates and loan fees on construct ion

loans, and then supervise the progress of the construct ion. There is always

a danger that the borrower wil l overspend on a construct ion project and

exhaust the loan proceeds before construct ion is completed. If the borrower

cannot afford to f inish, the lender is lef t with a security interest in a part ially

completed project .

Lenders have devised a variety of plans for disbursement of construct ion

loan proceeds that guard against overspending by the borrower. Perhaps

the most common is the fixed disbursement plan . This calls for a series of

predetermined disbursements, called obligatory advances , at various

stages of construct ion. Interest begins to accrue with the f irst disbursement.

Example: A construct ion loan agreement st ipulates that the lender

wil l release 10% of the proceeds when the project is 20% complete,

and thereaf ter 20% draws wil l be available whenever construct ion

has progressed another 20% toward complet ion.

The lender wil l of ten hold back 10% or more of the loan proceeds unti l

the period for claiming mechanic’s l iens has expired, to protect against

unpaid l iens that could affect the marketabil i ty of the property. The

construct ion loan agreement usually states that if a valid mechanic’s

l ien is recorded; the lender may use the undisbursed port ion of the loan to

pay it off .

Blanket Mortgage. When a borrower mortgages more than one piece of real

property as security for a single loan, it is called a blanket mortgage. For

example, if one property does not provide suff icient collateral for a loan,

another property that the borrower owns may be offered as addit ional

collateral. The borrower wil l give the lender a blanket mortgage covering

both propert ies.

Blanket mortgages are also used in subdivision development. For

instance, a ten-acre parcel subdivided into twenty lots might be used to

secure one loan made to the subdivider. Blanket mortgages usually have a


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partia l release clause (also called a partial sat isfact ion clause, or in a

blanket deed of trust, a part ial reconveyance clause). This provision requires

the lender to release some of the security p roperty f rom the blanket l ien

when specif ied port ions of the overall debt have been paid off .

Example: A ten-acre parcel subdivided into twenty lots secures a

$1,500,000 loan. After sell ing one lot for $175,000, the subdivider

pays the lender $150,000 and receives a release for the lot that is

being sold. The blanket mortgage is no longer a l ien against that

lot, so the subdivider can convey clear t it le to the lot buyer.

A release schedule determines how much of the loan must be paid off in

order to have a lot released f rom the blanket l ien. The borrower typically has

to pay off a larger share of the loan to release the f irst lots sold than to

release the last lots sold. This arrangement helps protect the lender’s

security interest, since the best lots in a development of ten sell f irst.

Note that a mortgage is not the only type of l ien that can be a blanket

encumbrance. A contractor who provides labor or materials on more

than one property owned by the same person can obtain a blanket

mechanic’s l ien.

Participation Mortgage. A part icipation mortgage allows the lender to

part icipate in the earnings generated by the mortgaged property, usually in

addit ion to collect ing interest payments on the principal. In some cases, the

lender part icipates by becoming a part-owner of the property. Part icipation

loans are most common on large commercial projects where the lender is an

insurance company or other large investor.

Shared Appreciation Mortgage . Real property ordinarily appreciates

(increases in value) over t ime. Appreciat ion usually benef its only the

property owner, by adding to his equity. With a shared appreciat ion

mortgage, however, the lender is entit led to a specif ied share of the

increase in the property’s value. This is sometimes called an equity shar ing

arrangement. (The equity is the dif ference between the market value of the

property and the l iens against it .)


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Graduated Payment Mortgage . A graduated payment mortgage allows the

borrower to make smaller payments at f irst and gradually step up to large r

payments. For example, the payments might increase annually for the f irst

three to f ive years of the loan, and then remain level for the rest of the loan

term. This arrangement can benef it borrowers who expect their earnings to

increase during the next f ew years.

Growing Equity Mortgage. A growing equity mortgage, sometimes called a

rapid payoff mortgage, is also benef icial to borrowers whose income is

expected to increase. This type of mortgage uses a f ixed interest rate

throughout its term, but payments wil l increase according to an index or

preset schedule. The amount of the increase is applied direct ly to the

principal balance, thus allowing the borrower to pay off the loan

more quickly.

Subprime Mortgage. A subprime mortgage is a loan made to a borrower

who wouldn’t qualify for an ordinary mortgage loan, perhaps because her

credit history or debt-to- income rat io doesn’t meet the usual standards, or

because she’s unable or unwil l ing to provide the documenta tion usually

required. A subprime lender typically charges higher interest rates and fees

to offset the extra risk the loan entails. Subprime lending is discussed in

more detail in Chapter 12.

Adjustable-rate Mortgage. The interest rate of an adjustable -rate mortgage,

or ARM, may be increased or decreased periodically during the loan term to

ref lect changes in market interest rates. ARMs are discussed in detail in

Chapter 12.

Wraparound Mortgage. A wraparound mortgage is a new mortgage that

includes or “wraps around” an exist ing f irst mortgage on the property.

Wraparounds are generally used only in seller-f inanced transactions.

Example: A home is being sold for $200,000; there is an exist ing

$80,000 mortgage on the property. Instead of assuming that

mortgage, the buyer merely takes t it le subject to it . The buyer

gives the seller a $40,000 downpayment and a second mortgage


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for the remaining $160,000 of the purchase price. The $160,000

second mortgage is a wraparound mortgage. Each month, the buyer

makes a payment on the wraparound to the seller, and the seller

uses part of that payment to make the monthly payment on the

underlying $80,000 mortgage.

Wraparound f inancing works only if the underlying loan does not contain

an alienation clause (see the discuss ion earlier in this chapter). Otherwise

the lender would require the seller to pay off the underlying loan at the t ime

of sale. A wraparound arrangement should always be designed so that the

underlying loan wil l be paid off before the wraparound, to ensure that the

buyer’s t i t le wil l not st i l l be encumbered with the seller’s debt af ter the buyer

has paid the full purchase price.

If the security instrument used for this type of f inancing arrangement is a

deed of trust rather than a mortgage, it is called an all- inclusive

trust deed .

Open-end Mortgage. An open-end mortgage sets a borrowing l imit, but

allows the borrower to reborrow, when needed, any part of the debt that has

been repaid, without having to negotiate a new mortgage. The interest rate

on the loan is usually a variable rate that rises and falls with market

interest rates.

Home Equity Loan. A borrower can obtain a mortgage loan using the equity

in property that she already owns as collateral. This is called an equity

loan ; when the property is the borrower’s residence, it ’s called a home

equity loan .

Equity, as we said earlier, is the dif ference between a property’s market

value and the l iens against it . In other words, it ’s the port ion of the

property’s current value that the owner owns f ree and clear, which is

therefore available to serve as collateral for another loan. A home equity

loan is typically a second mortgage; the exist ing f irst mortgage is the loan

the owner used to purchase the property.


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Sometimes a home equity loan is used to f i nance remodeling or other

improvements to the property. In other cases, it ’s used for expenses

unrelated to the property, such as a major purchase, college tuit ion, medical

bil ls, or to pay off credit cards. The interest rate on the home equity loan is

often much lower than the rate on the credit cards, and the interest on the

loan is usually tax-deductible, whereas the credit card interest is not.

(Mortgage interest is currently the only type of interest on consumer debt

that is deductible. See Chapter 15. )

Instead of having to apply for a home equity loan when they need money

for a part icular purpose, some homeowners have a home equity l ine of

credit (or HELOC ) that they can draw on when the need arises. This works

in much the same way as a credit card—with a credit l imit and minimum

monthly payments—except that the debt is automatically secured by the

borrower’s home. A HELOC is a revolving credit account, in contrast to a

home equity loan, which is an installment loan with regular payments made

over a certain term.

Reverse Mortgage. A reverse mortgage, sometimes called a reverse annuity

mortgage or reverse equity mortgage, is designed to provide income to older

homeowners. The owner borrows against the home’s equity but wil l receive

a monthly check f rom the lender, rather than making monthly payments.

Typically, a reverse mortgage borrower must be over a certain age (for

example, 62 or 65) and must own the home with l i t t le or no outstanding

mortgage balance. The home usually must be sold when the owner dies in

order to pay back the mortgage.

Refinancing. Borrowers who ref inance their mortgage are actually obtaining

an entirely new mortgage loan to replace the exist ing one. The funds f rom

the ref inance loan are used to pay off the exist ing loan.

Ref inancing may be obtained f rom the same lender that made the exist ing

loan, or f rom a dif ferent lender. Borrowers often choose to ref inance when

market interest rates drop; ref inancing at a lower interest rate can result in

substantial savings over the long run. Another situation in which borrowers


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are l ikely to ref inance is when the payoff date of the exist ing mortgage is

approaching and a large balloon payment wil l be required.

In some cases, borrowers get a ref inance loan for more than the amount

needed to pay off their exist ing loan, so that they also receive cash f rom the

transaction. This is called cash-out refinancing . Depending on the terms of

the ref inance loan, the addit ional funds might be used for property

improvements, debt consolidation, or other purposes. (Rockwell, 264-289)

Loan Problems

Loan problems include interest problems and principal balance

problems. These can be solved using the general percentage formula:

Part = Whole × Percentage. Here, the part is the amount of the interest, the

whole is the loan amount or principal balance, and the percentage is the

interest rate.

Example: Henry borrows $5,000 for one year and agrees to pay 7%

interest. How much interest wil l he be required to pay?

1. Write down the formula . P = W × %

2. Substitute . P = $5,000 × .07

3. Calculate .

$5,000 Loan amount

× .07 Interest rate

$350 Interest

Henry wil l pay $350 in interest.

Interest Rates. Interest rates are expressed as annual rates —a certain

percentage per year. Some problems present you with monthly, quarterly, or


Page 42 of 46

semi-annual interest payments instead of the annual amount. In that

case, you’l l need to mult iply the payment amount stated in the problem to

determine the annual amount before you substitute the numbers into

the formula.

Example: If $450 in interest accrues on a $7,200 interest -only loan

in six months, what is the annual interest rate?

1. Read the question . You’re asked to f ind the annual interest

rate, but the interest amount given in the problem ($450)

accrued in only six months. The annual interest amount would

be double that, or $900.

2. Write down the formula . P = W × %

3. Substitute . For the part (the interest amount), be sure to use

the annual f igure ($900): $900 = $7,200 × Percentage.

4. Calculate . Rearrange the formula to isolate the unknown (in this

case, the percentage). The part is divided by the whole to

determine the percentage: $900 ÷ $7,200 = .125.

Convert the decimal number back into a percentage: .125 becomes

12.5%. Thus, the annual interest rate is 12½%.

Principal Balance. Some loan problems ask you to determine a loan’s

current principal balance at a certain point in the loan term.

Example: A home loan has monthly payments of $625, which

include principal and 9% interest and $47.50 per month for tax and

insurance reserves. If $27.75 of the June 1 payment was applied to

the principal, what was the outstanding principal balance during the

month of May? (Mortgage interest is paid in arrears, so the June

payment includes the interest that accrued during May.)

1. Write down the formula . P = W × %. Once again, in this

context the part is the amount of interest, the whole is the loan

balance, and the percentage is the interest rate.


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2. Substitute . First, f ind the interest port ion of the payment by

subtract ing the reserves and the principal port ion.

$625.00 Total June payment

47.50 Reserves

– 27.75 Principal

$549.75 Interest port ion of payment

Next, mult iply the interest port ion by 12 to determine the annual

interest amount: $549.75 × 12 = $6,597.

Now substitute the annual interest amount and rate into the

formula: $6,597 = W × .09.

3. Calculate . Rearrange the formula to isolate the unknown, W .

This is a division problem. $6,597 ÷ .09 = $73,300

The outstanding principal balance for May was $73,300.

Profit or Loss Problems

Prof it or loss problems ask you to compare the cost or value of a

piece of property at an earlier point in t ime with its cost or value at a later

point. They can be solved using a variat ion on the percentage formula.

Instead of Part = Whole × Percentage , the formula is stated l ike this:

Now = Then × Percentage.

The Then spot in the formula is for the value or cost of the property at an

earlier t ime specif ied in the problem. The Now spot is for the value or cost at

a later t ime. The percentage is 100% plus the percentage of prof it or minus

the percentage of loss.

The idea is to express the value of the property af ter a prof it or loss

(Now ) as a percentage of the property’s value before the prof it or loss

(Then ). If there is no prof it or loss, the Now value is exactly 100% of the

Then value, because the value has not changed. If there is a prof it , the Now

value wil l be greater than 100% of the Then value, since the value has


Page 44 of 46

increased. If there is a loss, the Now value wil l be less than 100% of the

Then value.

Example: Bonnie bought a house f ive years ago for $150,000 and

sold it this year for 30% more than she paid for it . What did she sell

i t for?

1. Write down the formula . Now = Then × %

2. Substitute . To get the percentage, you must add the

percentage of prof it to or subtract the percentage of loss f rom

100%. In this case there is a prof it , so you add 30% to 100%,

then convert it to a decimal number (130% becomes 1.30):

Now = $150,000 × 1.30.

3. Calculate . $150,000 × 1.30 = $195,000

Bonnie sold her house for $195,000.

Example: Paul sold his house this year for $210,000. He paid

$262,500 for it two years ago. What was the percentage of loss?


2. Substitute . $210,000 = $262,500 × %

3. Calculate . The percentage is the unknown quan tity; thus, the

formula is rearranged to isolate the percentage:

$210,000 ÷ $262,500 = .80 or 80%.

The Now value is 80% of the Then value. Subtract 80% f rom 100%

to f ind the percentage of loss: 100% – 80% = 20% Loss.

Paul took a 20% loss on the sale of his house.

Let’s look at another example, except this t ime there is a prof it instead of

a loss.

Example: Martha bought her home six years ago for $125,800. She

sold it recently for $140,900. What was her percentage of prof it?


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2. Substitute . $140,900 = $125,800 × %

3. Calculate . Once again, the percentage is the unknown

quantity; thus, the formula is rearranged to isolate the

percentage: $140,900 ÷ $125,800 = 1.12 or 112%.

The Now value is approximately 112% of the Then value.

Subtract 100% f rom 112%, and you determine Martha received

100% of what she paid for the house, plus a 12% prof it .

Let’s try to solve one last variat ion of this type of problem.

Example: Ken sold his duplex for $280,000, which represents a

16% prof it over what he paid for it f ive years ago. What did Ken

originally pay for the property?


2. Substitute . $280,000 = Then × 116%

3. Calculate . In this instance, the unknown is the price Ken

originally paid for the duplex; so you isolate the Then part of

the equation: $280,000 ÷ 1.16 =$241,379.31.

The price paid by Ken was $241,379.31.

Some prof it or loss problems involve appreciat ion or depreciat ion that

has accrued at an annual rate over a specif ied number of years. You solve

this type of problem by applying the Then and Now formula one year at

a t ime.

Example: A property that is currently worth $174,000 has

depreciated 3% per year for the past four years. How much was

it worth four years ago?


2. Substitute . Because the property is worth 3% less than it

was one year ago, the percentage is 97%

(100% – 3% = 97%): $174,000 = Then × .97.


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3. Calculate . Rearrange the formula to isolate the unknown,

the Then value: $174,000 ÷ .97 = $179,381.44.

The property was worth $179,381.44 one year ago. Apply the

formula to $179,381.44 to determine the property’s value two

years ago. Repeat the process twice more to f ind the value four

years ago.

$179,381.44 ÷ .97 = $184,929.31

$184,929.31 ÷ .97 = $190,648.77

$190,648.77 ÷ .97 = $196,545.12

The property was worth about $196,545 four years ago.

(Rockwell, 529-532)

Cited Material:

Real Estate Principles . Bellevue, WA: Rockwell Publishing, 2014. . Print.