Real Estate Finance Instruments

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Real Estate Finance Instruments

Chapter 5

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

Chapter 5: Real Estate Finance Instruments

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Overview

• “Instruments" are written documents– integral part of most real estate financing

transactions– promissory notes, trust deeds, mortgages, types

and features of mortgages, and land contracts

• Types and features of mortgages– typical clauses in each



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Key Terms

• Acceleration Clause

• Alienation Clause

• Balloon Payment

• Construction Loan

• Equitable Right of Redemption

• Equitable Title

• Hypothecate

• Judicial Foreclosure



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Key Terms

• Land Contract

• Mortgage

• Negotiable Instrument

• Security Instrument

• Subordination Clause

• Trust Deed



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Finance Instruments

• Legal documents that establish the rights and duties of all parties involved in a transaction

• Two types of real estate finance documents:1. Financing instrument (promissory note)

2. Security instrument (mortgage)



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Promissory Notes

• Instruments that evidence a promise to pay a specific person within a specific time frame

−A written promise to pay money

• One promising to pay is the “maker,” usually buyer

• One to whom payment is promised is the “payee,” usually lender, which can also be the seller



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Promissory Notes

• Basic evidence of debt, showing who owes how much to whom

• Typical promissory note includes:– Date– Names of parties– Amount of debt (and the interest rate/note rate)– How and when money is to be paid– What happens in event of default– Signature of maker



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Negotiable Instruments

• Promissory notes or other finance instruments that are freely transferable from one party to another– Most notes used in real estate are negotiable

instruments– When a note is freely transferable, the lender

or other creditor can obtain immediate cash by selling the note



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Four Notes Used in Real Estate Transactions

1. Straight note: − Payments of interest-only during the note

term− Balloon payment at end of loan term

2. Installment note: − Periodic payments of principal and/or

interest− In reality, a balloon payment may be

required

Continued on next slide



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Four Notes Used in Real Estate Transactions

3. Partially amortized installment note or installment note with balloon:

− Periodic payments of principal and interest during loan term

− Balloon payment at end of term to pay balance

4. Fully amortized installment note: − Regular payment of principal and interest,− Calculated to pay entire balance by end of

loan term



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Security Instrument

• Allows creditor to take ownership of collateral through foreclosure to satisfy debt if borrower fails to pay according to terms of agreement

• Creditor can possess or sell the property

• Even without a security instrument, the debtor is still obligated to pay the note



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Security Instruments

• Usually accompany promissory notes– Security instruments allow debtor to hypothecate

property

• Hypothecate—Debtor can pledge property as security for debt without giving up possession– Serves as security for creditor and motivation for

debtor to fulfill terms of note

– Failure to do so could result in loss of possession



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Security Instruments

The two main types of security instruments

used in real estate transactions are:

1. Trust deeds

2. Mortgages



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Lien Theory and Title Theory

Regarding mortgages and mortgage laws, some states follow:

• Lien theory• Title theory• Combination of the two



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Lien Theory States

• The mortgage creates a lien against the property which must be repaid by debtor

• Property serves as collateral hypothecated to lender as security for debt

• Lender must go through foreclosure proceedings to obtain title in the event of default



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Title Theory States

• The mortgage instrument gives title to property to lender while debt is outstanding; owner gets only possession and use of land

• Once mortgage has been repaid, title reverts to owner

• Lender has restricted rights in the property, but does not have to go through foreclosure proceedings in the event of default

• Title theory is the oldest method, and not used in many states



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Lien Theory and Title Theory

• Most state laws are now a hybrid of lien theory and title theory

• Most states recognize mortgage as security, and real estate as collateral

• With a mortgage, procedure in event of default is judicial foreclosure– Judicial foreclosure under a mortgage

requires court-ordered sheriff’s sale of property to repay debt



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Trust Deeds

• Instruments held by third party as security for payment of a note. Also called deeds of trust

– Three-party device

– Borrower is trustor

– Lender is beneficiary

– Independent third party is trustee



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Trust Deeds

• Lien theory states: Trust deeds create a lien against property in favor of the beneficiary.

– Creditor has right to force the sale of property if debtor defaults on payments



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Trust Deeds

Distinguishing characteristic of trust deeds: • Creditor may begin non-judicial foreclosure

action when debtor defaults on loan payments− Authorized by power of sale clause

• Process of foreclosing and selling property through power of sale clause may be concluded more quickly

− Without the expense involved for court proceedings− Debtor can often stop the sale by making up back

payments (plus interest and fees) until a few days before the sale

− Can create issues of validity of sale in some states



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Mortgages

• Instruments that conveys in interest in real property to a lender as security for payment of a note

• Borrower (mortgagor) pledges property to lender (mortgagee) as collateral for debt, creating a voluntary lien

• Promissory notes usually accompany security instruments

– Gives creditor leverage against debtor– Gives debtor extra incentive to pay.



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Mortgages:Advantages and Disadvantages

For Lender• Main advantage: Right to accelerate entire debt

in event of default and authority of the court for judicial foreclosure

• Main disadvantage: Time and expense involved with judicial foreclosure



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Mortgages:Advantages and Disadvantages

For Debtor• Main advantage: Lengthy court

proceedings give debtor time to get the money together

• Main disadvantage: Lender’s right of acceleration can mean a buyer who misses one or two payments may have to pay off the entire debt to save the home



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Typical JudicialForeclosure Scenario

1. Borrower defaults2. Lender accelerates debt and files foreclosure action3. Court finds in favor of creditor, who takes ownership;

sheriff seizes property 4. If lender decides to sell, public is notified for specified

timeframe5. Public auction is held with minimum bid set6. Proceeds from highest bidder settle costs of the sale,

property taxes, mortgages and other liens7. Any surplus goes to borrower; deficits could result in a

deficiency judgmentKnow the law in the jurisdictions where you practice!



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Redemption

• Some states use the equitable right of redemption– Allows debtors to redeem (save) property from the time

a notice of a pending foreclosure (lis pendens) is filed until the confirmation of the foreclosure sale

• Other states use the statutory right of redemption– Allows debtors to redeem themselves after the final sale

• After redemption, court will set aside sale, pay parties, and debtor gets title again.



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Redemption

• Debtors may avoid foreclosure by making a a voluntary conveyance of property (also

called deed in lieu of foreclosure)– Debtors still lose property, but by conveying it

voluntarily before final court action, can avoid a foreclosure on their credit report

– After confirmation of sale, it is too late• Lender not obligated to accept deed in lieu

of foreclosure as full satisfaction of debt and could pursue deficiency judgment



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Typical Clauses in Finance Instruments

• Various clauses are used in mortgages to give certain rights to the lender or borrower

• Many can be found in the promissory note or security instrument– Often appear in both



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Acceleration Clause

• Gives lender right to declare entire loan balance due immediately because of borrower default

– Or violation of other contract provisions• Most notes, mortgages, trust deeds, and land

contracts contain this clause• Important to lenders upon default:

– Allows them to make all payments due—without filing a separate action for each missed payment



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Alienation Clause

• Gives lender certain stated rights when there’s a transfer of property ownership

– Also referred to as a due on sale clause• Designed to limit debtor's right to transfer property

without creditor's permission.• Depending on wording, alienation may be triggered

by:– Title transfer– Transfer of significant interest in the property– Abandonment of the property



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Alienation Clause

• Upon sale or transfer of interest, lender will often have right to accelerate debt, change interest rate, or charge an assumption fee

• Lender may choose which, if any, options stated in the contract it will enforce



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Defeasance Clause

• Defeats or cancels certain rights on the occurrence of a specific event

• Can appear in contracts or mortgages

• Gives borrower right to redeem real estate after default on a note by paying full amount owed plus fees and court costs

• Outlines circumstances, procedures, and rules for redemption to be successful.



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Partial Release, Satisfaction,or Conveyance Clause

• Obligates creditor to release part of the property from lien and convey title to that part back to debtor once certain provisions of the note or mortgage have been satisfied.

• Usually after a certain percentage of the mortgage balance has been paid.



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Partial Release, Satisfaction,or Conveyance Clause

• Important clause found in many blanket mortgages and some construction mortgages – Developer/builder can sell completed homes

with clear title before paying back entire amount borrowed

– If land is bought with a mortgage, construction financing is easier to obtain later when the builder owns part of land free of liens



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Prepayment Clause

• Gives lender right to charge borrower a penalty for paying off the loan early

• Time periods and amount of the penalty may vary

• Basic effect is to make up interest income the lender losses when debtor pays loan early



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Subordination Clause

• Gives a mortgage recorded at a later date the right to take priority over an earlier recorded mortgage

• Normally the first instrument or document to get recorded gets lien priority

– Lien priority determines who gets paid first out of the proceeds of foreclosure sale

– Property tax liens almost always first priority– Federal tax liens or other liens could take first

priority, depending on jurisdiction



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Subordination Clause

• Usually states instrument that contains clause will be subordinate (junior) to another lien (mortgage, trust deed, etc.,) to be recorded later

• Its inclusion must be negotiated at time of entering into the earlier transaction

• Once first instrument is recorded, usually too late to arrange with lender

• Also common in home equity loans or lines of credit, where holder of junior "second mortgage" agrees to subordinate position even if homeowner later refinances first mortgage



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Other MortgageClauses and Covenants

• In addition to the typical clauses that appear frequently in real estate mortgages, there are also a number of covenants

• Covenants are promises– Can appear in deeds, mortgages, or other

document – Can compel or prevent certain actions by the

property owner or uses for the property



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Typical covenants include provisions protecting lender's security interests in property:• Promising to keep property in good condition and

repair

• Not damaging or diminishing the property value

• Promising to keep fire, hazard, and flood insurance

• Agreeing to pay taxes and other assessments on time



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• Failure to keep these promises or covenants can be cited in the mortgage or note as causing the borrower to be in default

• Buyers should be aware of the clauses and covenants and understand them– They should be encouraged to consult legal

counsel before entering into a mortgage



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Mortgage Lien Terminology

• First Mortgage: A security instrument with a first lien position

• Second Mortgage: A security instrument in a second lien position

• Senior Mortgage: Any mortgage in a higher position– A first mortgage is always a senior mortgage

• Junior Mortgage: Any mortgage with a lower lien position than another– A second mortgage is a junior mortgage to a first

mortgage– A second mortgage is a senior to a third mortgage



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Types and Features of Mortgages

“Mortgage” is often prefaced with adjectives that describe the particular function it is serving, e.g.:• A construction ARM mortgage is an adjustable

rate mortgage used to secure a construction loan

• An interest-only blanket mortgage secures a loan with two or more parcels of land as collateral and the borrower pays only interest



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Purchase Money Mortgage

• Given by a buyer to a lender or seller to secure part or all the money borrowed to purchase property

• When given to a seller, can be called a seller-held mortgage or soft money mortgage– Borrower receives credit instead of cash

• Can be a first mortgage or a junior mortgage– Depends on its lien priority



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Refinance Mortgage

• Allows borrower to redo or expand loan• To get better interest rate or terms on new loan

compared to original mortgage– May be called no cash-out or rate/term

refinance– Usually a first mortgage

• To receive cash from equity in the home– May be called hard money mortgage or cash-

out refinance– Almost always a junior mortgage



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Home Equity Loan, Home Equity Line of Credit

• Secured by a mortgage on one's principal residence

• Home equity loan:– Typically closed-end, fixed amount amortized over

fixed period with regular payments

• Home equity line of credit (HELOC):– Open-end, borrower draws as needed

– Typically has two stages-draw and repayment

• Usually attaches a junior lien to the property



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Blanket Mortgage

• Covers more than one parcel of land or lot– Usually used to finance subdivision

developments

• Usually has a partial release clause– Allows borrower to pay a certain amount to

release some lots, with mortgage continuing to cover remaining lots



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Bridge Mortgage

• Occurs between termination of one mortgage and beginning of the next

• When next mortgage is taken out, bridge mortgage is repaid

• Designed to be temporary and used most commonly for construction financing.

• A less common use is to buy a new home before selling the old one



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Open-End Mortgage

• Allows borrower to request additional funds from lender, up to certain pre-defined limit

• Lenders typically will not advance funds in excess of original principal balance

• May limit loan amount based on LTV

• Could be used as a home equity line of credit



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Package Mortgage

• Includes personal property, like appliances, in the property sale and all are financed in one contract– Personal property also serves as collateral for

loan

• Common use is to buy a furnished condominium– Loan and mortgage documents may also recite

appliances and/or furniture as part of transaction.



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Reverse Mortgage

• Allows qualified senior homeowners over the age of 62 to convert equity into monthly income stream or line of credit– Borrower must have substantial equity in home

• Mortgage is repaid when:– Home is sold– Borrower does not occupy the home for 12

consecutive months– Borrower dies

• Also called: – Reverse annuity mortgage– Reverse equity mortgage– Home equity conversion mortgage



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Equity Participation Mortgage

• Permits lender to share part of the earnings, income, or profits from a real estate project

• Usually in addition to collecting principal and interest payments on the loan – For example, lender may receive 5% of gross

rents

• Done mostly for commercial real estate projects



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Wraparound Mortgage

• Describes financing arrangement in which existing loan is combined with a new loan

• Total debt (new + existing loan) treated as single obligation by buyer, with one payment made on entire debt

• May be used in lieu of traditional refinancing• Less often offered by seller with existing lower-

rate loan to make property more attractive to buyer



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Construction Mortgage

• A temporary loan to finance construction of improvements and buildings on land

• Also called an interim loan• When construction is complete, the loan is

replaced by permanent financing, called a take out loan

• New construction can take as long as a year to complete– Requires extended rate locks in most cases



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• Can be profitable, but regarded as risky• High interest rates and loan fees • Closely supervise funds disbursement to ensure

projects are completed• Danger borrower will overspend and exhaust loan

funds before construction is complete– In this case, lender will be left with partially

completed project that can't be sold easily in existing state, with very real possibility of foreclosure



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• To protect against this, lenders use plans for disbursing construction loan proceeds to guard against overspending by the borrower

• Three common disbursement plans are:1. Fixed disbursement plan

2. Voucher system

3. Warrant system



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Disbursement

Fixed Disbursement Plan• Pays a percentage of funds at a set time

• Series of predetermined disbursements, called obligatory advances, paid at various stages of construction– Example: Lender will release only 10% of the

funds when a project is 20% complete, with future draws of 20% each time construction progresses 20% more toward completion



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Disbursement

Voucher System • Requires contractor or borrower to pay

own bills and submit receipts to lender for reimbursement

Warrant System• Lender directly pays bills presented by

various suppliers and laborers on project



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Permanent Construction Loan

• A special type loan where there is only one loan and one closing, with no take out loan

• Fixed disbursement schedule for loan funds

• Loan automatically converts to a permanent first mortgage when construction is finished



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Graduated PaymentMortgage (GPM)

• A specialized payment structure, not a specific type of mortgage

• Allows borrowers to make smaller payments in early years

• Unpaid interest results in scheduled negative amortization

• At predetermined point, payments escalate until reaching a point they fully amortize



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Land Contracts

• Real estate installment agreements where buyer makes payments to seller for right to occupy and use property– No deed or title is transferred until all, or

specified portion of, payments are made• Another instrument to finance purchase of real

estate• Also called land installment contracts,

installment sales contracts, land sales contracts, real estate contract, and other names



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Land Contracts

• Different than mortgage or trust deed – Where debtor takes title to property, with

creditor holding mortgage or trust deed as security lien against it



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Land Contracts

• Under land contract:– seller (vendor) holds title to property as

security, not just a mortgage lien – Debtor (vendee) has right to possess and

enjoy land, but is not legal owner– Seller retains legal title to property– Buyer becomes owner in fact, having

possession and equitable title, but no title and no deed



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Land Contracts

• Equitable title: Interest in real property created on execution of valid sales contract whereby actual title will be transferred by deed at a future date

• Though actual title won't be transferred until future date, person who holds equitable title still enjoys certain rights and privileges



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Land Contracts

• Some risk that seller could mortgage property for an amount greater than his interest in it– Because the seller retains title to the property

• Under most state laws, seller can’t mortgage property for more than balance due without buyer’s consent

• Seller must give buyer a statement (at least once a year or as requested) showing the amount of payment that have been credited to principal and interest, and balance due



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Buyer Default

In many states, if contract is in effect for less than a certain number of years and buyer has paid less than a certain percentage of purchase price before default:• Seller may initiate forfeiture proceedings 30 days

after buyer’s default• Give buyer written notice of default and of seller’s

intent to declare the contract forfeited unless buyer corrects the default

continued on next slide



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Buyer Default

• Buyer has 10 days to correct default, reinstate contract terms, and retain rights

• If buyer fails to remedy default within 10-day notice period, buyer loses all rights to property, as well as all payments made to that point



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Buyer Default

• If contract has been in effect for more than the minimum number of years required under state law, or

• Buyer has paid at least the percentage of purchase price as required under state law, then:– On default, seller must use foreclosure

proceedings, same as under a mortgage, to protect buyer's substantial investment



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Land Contracts:Advantages and Disadvantages

For Seller• Main advantage: The right to hold title as security,

since buyer does not receive deed to property until all, or a specified portion of, contract purchase price is paid

• Main disadvantage: Expense and time required for foreclosure after under state law



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Land Contracts:Advantages and Disadvantages

For Buyer• Main advantage: Easier to qualify for than

a conventional loan• Main disadvantage: Lack of ownership,

making it difficult for borrower to obtain financing for the equity or improvements as banks are reluctant to lend to someone without legal title to property; also, offers little or no protection if not recorded



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Summary

1. Finance instruments are written documents establishing rights and duties of the parties. Promissory notes are written promises to pay money. They’re negotiable instruments and freely transferable so creditors can sell them for cash. The one promising to pay the money is called the maker of the note, usually the homebuyer. The one to whom payment is promised is called the payee, usually the lender. There are four common note types including straight note, installment note, installment note with balloon, and fully amortized note.



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Summary

2. Security instruments give a creditor the right to sell collateral to satisfy the debt if the debtor doesn’t pay as agreed. A security instrument gives a debtor the right to hypothecate (pledge) property as collateral without giving up possession. Two types are trust deeds and mortgages. Trust deeds are three-party instruments, with non-judicial foreclosure via power of sale clause in the event of default. Trust deeds are rarely used in some states because they only use non-judicial foreclosure.



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Summary

3. Mortgages create liens against property as security for debt. If in default, judicial foreclosure ensues: Notice of default, foreclosure action filed, order of execution has sheriff sell property, advertising, and public auction (minimum bid based on percentage of appraised value, confirmation of sale to highest bidder, sheriff’s deed issued.) Debtor has equitable right of redemption to regain property until confirmation of sale. Process is slow and expensive, but has court authority. The order of mortgage is important: A senior mortgage is any mortgage in a higher lien position; a junior mortgage is in a lower lien position.



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Summary

4. Many clauses are common in real estate contracts. An acceleration clause lets the lender call the loan balance due if in default. A prepayment clause lets lenders charge a penalty for paying off a loan early. An alienation clause gives lenders some stated rights if the property is transferred (also called due on sale clause). A defeasance clause is used to defeat or cancel a certain right on the occurrence of a specific event. Subordination lets a later-recorded mortgage take priority over an earlier one. A partial release is when a lien is released from part of land if some part of balance is paid.



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Summary

5. Mortgage can be prefaced by different words describing its type or function. Purchase money mortgage, seller takes mortgage for part of purchase price. Soft money mortgage, borrower gets credit instead of cash. Hard money mortgage, borrower gets actual cash (e.g., cash-out mortgage). Bridge mortgage, temporary mortgage between two others and repaid with a later mortgage. Package mortgage, includes personal property. Blanket mortgage, for more than one land parcel. Construction mortgage, temporary loan to finance buildings.



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Summary

6. Land contract is a real estate installment agreement. Buyer makes payments to seller for right to occupy land, but no title is transferred until all, or part of, payments are made. Buyer has equitable title under a land contract. States differ in how they treat land contracts. The main problem for the buyer is that he or she can’t borrow against equity with a land contract.



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Quiz

1. A promissory note calling only for payment of interest during its term is a(n)

a. amortized note.

b. installment note.

c. negotiated note.

d. straight note.



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Quiz

2. The mortgage clause that permits a lender to declare the entire unpaid balance on a loan due and payable at once on default of the borrower is a(n)

a. acceleration clause.

b. escalation clause.

c. defeasance clause.

d. forfeiture clause.



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Quiz

3. A mortgage clause that permits the lender to call the outstanding balance due and payable should the property be sold by the borrower is a(n)

a. acceleration clause.

b. alienation clause.

c. balloon payment clause.

d. exculpatory clause.



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Quiz

4. Which document accompanies the mortgage?

a. abstract of title

b. contract of sale

c. deed

d. promissory note



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Quiz

5. To foreclose a mortgage, the creditor a. files an attachment in the amount of the

debt.

b. files a court action.

c. notifies the debtor of the default, waits ten days, publishes a notice of default in the paper, then claims a forfeiture.

d. notifies the trustee of default.



80

Quiz

6. A mortgage under which the debtor may re-borrow up to the original note amount under the same document is a(n)

a. amortized mortgage.

b. hypothecated mortgage.

c. open-ended mortgage.

d. package mortgage.



81

Quiz

7. A budget mortgage is best defined as one that

a. includes payments for principal, interest, taxes, and insurance.

b. includes personal as well as real property.

c. includes principal and interest payments.

d. is made to people with lower incomes.



82

Quiz

8. A builder finances the construction of an apartment building through a local bank. If money is released to the builder at various stages of construction, these payments are called

a. acceleration advances.

b. obligatory advances.

c. release payments.

d. sight drafts.



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Quiz

9. The term take out loan is most closely associated with

a. construction loans.

b. junior loans.

c. loans against the land.

d. Truth in Lending requirements.



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Quiz

10. Money obtained from a foreclosure sale in excess of the debt and court costs belongs to the

a. court.

b. debtor.

c. lender.

d. sheriff.


Documents

Real Estate Finance Instruments