financing residential real estate lesson 5: finance instruments

Financing Residential Real Estate

Lesson 5:

Finance Instruments

Introduction

In this lesson, we will cover:

types of finance instruments

how they work

common provisions

Promissory Notes

Promissory note

A written promise to pay money.

Promissory Notes

Promissory note

Maker – one who makes the promise.

Promissory Notes

Promissory note

Payee – one to whom the promise is made.

Promissory Notes

Promissory note

Payee – one to whom the promise is made.

Note – evidence of debt and promise to pay.

Promissory Notes

A promissory note can be a brief and simple document.

It usually contains:

names of the parties,

Basic provisions

Promissory Notes

amount of the debt,

Basic provisions

Promissory Notes

amount of the debt,

interest rate,

Basic provisions

Promissory Notes

amount of the debt,

interest rate, and

how/when money is to be repaid.

Basic provisions

Promissory Notes

Promissory note must be signed by the maker.

A legal description isn’t required.

Basic provisions

Promissory Notes

Negotiable instrument

A written, unconditional promise,

to pay a certain sum of money,

on demand or on a certain date,

payable to order or bearer,

signed by the maker.

Negotiability

Promissory Notes

“Without recourse” endorsement

Means future payment is only between the maker and the third party the instrument is endorsed to.

Without recourse

Promissory Notes

“Without recourse” endorsement

Means future payment is only between the maker and the third party the instrument is endorsed to.

Original payee not liable if maker fails to pay.

Without recourse

Promissory Notes

Holder in due course

Someone who buys a negotiable instrument for value, in good faith, and without notice of defenses.

Holder in due course

Promissory Notes

Promissory notes are classified according to how principal and interest are paid off.

Types of notes

Promissory Notes

Straight note – periodic payments are interest only, with principal due on maturity date.

Types of notes

Promissory Notes

Straight note – periodic payments are interest only, with principal due on maturity date.

Installment note – periodic payments include both principal and interest.

Types of notes

Summary

Promissory Notes

Maker Payee Negotiable instrument Without recourse Holder in due course Straight note Installment note

Security Instruments

In real estate transactions, a promissory note is accompanied by a security instrument:

Mortgage

Deed of trust

Purpose

Security instrument gives the lender the right to foreclose on the property if borrower defaults.

Purpose

Security instrument gives the lender the right to foreclose on the property if borrower defaults.

Foreclosure = lender forces sale of property and collects debt out of sale proceeds.

Purpose

Lenders can enforce unsecured promissory notes by filing a lawsuit to obtain a judgment.

May not be able to collect without collateral.

Purpose

Lenders can enforce unsecured promissory notes by filing a lawsuit to obtain a judgment.

May not be able to collect without collateral.

Secured lender in much better position.

Real estate lenders always require borrowers to sign a security instrument.

Purpose

Personal property used as collateral for early forms of secured lending.

Historical background

Borrower gave lender property until loan was repaid.

Lender kept property if loan remained unpaid.

Hypothecation

Pledging property as collateral without giving up possession of it.

Hypothecation

Pledging property as collateral without giving up possession of it.

Became standard arrangement for borrower to retain possession of land.

Lender received title.

Legal title = when title is transferred only as collateral, without possessory rights.

Legal title = title transferred only as collateral, without possessory rights.

Equitable title = property rights retained by the borrower, without legal title.

Eventually, transfer of legal title wasn’t necessary.

Mortgage or deed of trust creates lien against borrower’s property.

Eventually, transfer of legal title wasn’t necessary.

Mortgage or deed of trust creates lien against borrower’s property.

Financial encumbrance on property owner’s title, allowing lienholder to foreclose on property to collect debt.

Depending on the state, a security instrument may or may not transfer legal title.

Title theory states – security instrument transfers legal title until loan is paid off.

Lien theory states – instrument creates lien and doesn’t transfer legal title.

Mortgage

Two-party security instrument in which borrower mortgages his property to lender.

Mortgages

Mortgage

Two-party security instrument in which borrower mortgages his property to lender.

Mortgagor = borrower

Mortgagee = lender

Mortgages

Mortgage must include:

names of parties,

accurate legal description of property, and

identify promissory note it secures.

Mortgages

Mortgagor promises to:

pay property taxes,

Covenants

Mortgages

pay property taxes,

keep property insured against fire and other hazards, and

Covenants

Mortgages

pay property taxes,

maintain structures in good repair.

Covenants

Mortgages

pay property taxes,

maintain structures in good repair.

Mortgagee has right to inspect property.

Covenants

Mortgages

If mortgagee fails to fulfill covenants imposed by mortgage, he is in default.

Mortgagee can foreclose.

Covenants

After execution, mortgagee records document to establish priority of mortgagee’s security interest.

Mortgage recording

Mortgages

Satisfaction of mortgage

Document given to mortgagor by mortgagee, after mortgage is paid off, releasing property from mortgage lien.

Satisfaction

Mortgages

Satisfaction of mortgage

Document given to mortgagor by mortgagee, after mortgage is paid off, releasing property from mortgage lien.

Mortgagor records document.

Satisfaction

Deed of trust

Similar to mortgage, but involves three parties, rather than two.

Deeds of trust

Deed of trust

Grantor (or trustor) = borrower

Deeds of trust

Deed of trust

Beneficiary = lender

Deeds of trust

Deed of trust

Beneficiary = lender

Trustee = independent third party, who arranges for release of property or foreclosure, as necessary.

Deeds of trust

Deeds of Trust

Usually include same basic provisions found in a mortgage, including:

names of parties,

property description,

identification of promissory note,

Deeds of Trust

Usually include same basic provisions found in a mortgage, including:

names of parties,property description, identification of promissory note, grantor’s promises to pay taxes and

insure property, andbeneficiary’s right to inspect

property.

Deed of reconveyance

Document releasing property from lien.

Executed by trustee when deed of trust loan is paid off.

Deeds of trust

Deeds of Trust

Deed of reconveyance

Document releasing property from lien.

Executed by trustee when deed of trust loan is paid off.

Recorded by the grantor.

Reconveyance

Summary

Hypothecation Legal title Equitable title Lien Mortgage Deed of trust Deed of reconveyance

Key difference between deeds of trust and mortgages: procedures used for foreclosure.

Foreclosure

Traditionally, judicial foreclosure was only option.

Lender filed lawsuit against borrower.

Sheriff’s sale ordered by court if borrower found in default.

Judicial foreclosure

Foreclosure

Traditionally, judicial foreclosure was only option.

Lender filed lawsuit against borrower.

Sheriff’s sale ordered by court if borrower found in default.

Alternative to judicial foreclosure was eventually developed.

Judicial foreclosure

Foreclosure

Nonjudicial foreclosure is generally associated with deeds of trust.

Lender doesn’t have to file lawsuit.

Trustee arranges for property to be sold at trustee’s sale.

Property sold to highest bidder.

Nonjudicial foreclosure

Typical clause may read:

“Upon default by Grantor in the payment of any indebtedness secured hereby or in the performance of any agreement contained herein, and upon written request of Beneficiary, Trustee shall sell the trust property, in accordance with the Deed of Trust Act of this state, at public auction to the highest bidder.”

Foreclosure

Some states don’t allow nonjudicial foreclosure.

In some circumstances, it might be preferable for lender to foreclose deed of trust or mortgage judicially.

Nonjudicial foreclosure

Foreclosure

Steps in judicial foreclosure:

1. Acceleration of debt

2. Foreclosure lawsuit

3. Equitable right of redemption

4. Order of execution

5. Public notice of sale

6. Sheriff’s sale

7. Statutory right of redemption

Judicial foreclosure procedures

Foreclosure

1. Acceleration of debt

If mortgagor defaults, mortgagee notifies mortgagor that entire outstanding loan balance is due.

Foreclosure

If mortgagor can’t pay off entire debt, mortgagee files foreclosure action in county where property is located.

Foreclosure

Defendants = mortgagor and junior lienholders

Foreclosure

Defendants = mortgagor and junior lienholders

Lis pendens = document recorded to give notice to prospective buyers of property

Foreclosure

3. Reinstatement v. equitable redemption

In some states, mortgagor has right to cure default while foreclosure lawsuit is pending.

Foreclosure

Mortgagor must pay delinquent payments, interest and costs incurred due to foreclosure.

Foreclosure

Mortgagor must pay delinquent payments, interest and costs incurred due to foreclosure.

Loan is reinstated and foreclosure is terminated.

Foreclosure

In other states, there is no right to cure. Instead, mortgagor has equitable right of redemption.

Foreclosure

Mortgagor must pay off entire outstanding balance, plus costs.

Foreclosure

Mortgagor must pay off entire outstanding balance, plus costs.

Redemption satisfies debt, stops foreclosure, and terminates mortgagee’s interest in property.

Foreclosure

4. Notice of sale

If loan not cured or redeemed, court schedules hearing to determine if default has occurred. If so, court issues writ of execution.

Foreclosure

4. Notice of sale

Sheriff authorized to conduct sheriff’s sale.

Foreclosure

4. Notice of sale

Sheriff authorized to conduct sheriff’s sale.

Notice posted on property, at courthouse, and in running advertisement.

Foreclosure

5. Sheriff’s sale

Public auction, usually held at county courthouse, where property is sold to highest bidder.

Purchaser given a certificate of sale.

Foreclosure

5. Sheriff’s sale

Proceeds of sale pay costs and debt.

Foreclosure

5. Sheriff’s sale

Junior liens paid in priority order.

Foreclosure

5. Sheriff’s sale

Junior liens paid in priority order.

Any surplus after all liens paid goes to debtor.

Foreclosure

5. Sheriff’s sale

If proceeds aren’t enough to pay off foreclosed mortgage, court may award deficiency judgment.

Foreclosure

5. Sheriff’s sale

If proceeds aren’t enough to pay off foreclosed mortgage, court may award deficiency judgment.

Gives lender a personal judgment against the debtor for amount of deficiency.

Foreclosure

6. Post-sale redemption

Debtor has additional period after sheriff’s sale to redeem the property.

Foreclosure

Debtor must pay purchaser the amount paid for the property plus accrued interest.

Foreclosure

Statutory right of redemption.

Foreclosure

Statutory right of redemption.

Redemption period is at least 6 months; sometimes 2 years.

Foreclosure

7. Rights of purchaser

Purchaser at sale may be entitled to either take possession or collect rent from debtor during redemption period.

Foreclosure

7. Rights of purchaser

Purchaser at sale may be entitled to either take possession or collect rent from debtor during redemption period.

Sheriff’s deed = deed given to purchaser at end of redemption period

Foreclosure

Nonjudicial foreclosure is very similar to judicial foreclosure:

1. Notice of default

2. Public notice of sale

3. Cure and reinstatement

4. Trustee’s sale

5. No post-sale redemption

Nonjudicial foreclosure procedures

Foreclosure

1. Notice of default

Trustee must follow similar steps to those taken by sheriff in a judicial foreclosure.

Trustee must give notice of default to trustor.

Foreclosure

2. Notice of sale

Trustee must wait certain length of time after notice of default before issuing notice of sale.

Foreclosure

2. Notice of sale

Usually between 3 to 6 months.

Foreclosure

2. Notice of sale

Usually between 3 to 6 months.

Minimum time period also required between notice of sale and date of sale.

Foreclosure

Grantor is allowed to cure default and reinstate loan by paying delinquent amounts plus costs.

Foreclosure

Right ends shortly before trustee’s sale is held.

Foreclosure

Right ends shortly before trustee’s sale is held.

No statutory right of redemption after trustee’s sale.

Foreclosure

4. Trustee’s sale

When property is sold, buyer is given trustee’s deed, which immediately divests debtor of title.

Foreclosure

4. Trustee’s sale

Debtor has short time to vacate property (20-30 days).

Foreclosure

4. Trustee’s sale

Proceeds first applied to costs, then to debt, and then to junior liens.

Foreclosure

4. Trustee’s sale

Proceeds first applied to costs, then to debt, and then to junior liens.

Any surplus goes to debtor.

Foreclosure

Entire nonjudicial foreclosure process may be completed in under a year, without many expenses.

Foreclosure

State may place variety of restrictions on nonjudicial foreclosures, including:

Requiring a post-sale redemption period for agricultural property.

Foreclosure

State may place variety of restrictions on nonjudicial foreclosures, including:

Requiring a post-sale redemption period for agricultural property.

Prohibiting beneficiary from obtaining deficiency judgment after sale.

Foreclosure

Advantages of judicial foreclosure:

Borrower can’t reinstate loan.

Right to deficiency judgment.

Lender’s point of view

Foreclosure

Advantages of judicial foreclosure

Borrower can’t reinstate loan.

Right to deficiency judgment.

Advantages of nonjudicial foreclosure:

Quick and inexpensive.

Lender’s point of view

Foreclosure

Slow process.

Post-sale redemption.

Borrower’s point of view

Foreclosure

Slow process.

Post-sale redemption.

Advantages of nonjudicial foreclosure:

Right to cure and reinstate.

Borrower’s point of view

A land contract serves purpose similar to that of a deed of trust or mortgage.

Land contract

Used in seller-financed transactions.

Land contract

Used in seller-financed transactions.

Buyer takes possession of property, but seller retains title until contract has been paid off.

Vendor = seller

Vendee = buyer

Land contract

Summary

Foreclosure and Land Contracts Judicial foreclosure Nonjudicial foreclosure Power of sale Acceleration Redemption Deed of reconveyance Deficiency judgment Redemption Sheriff’s deed

Finance Instrument Provisions

Rights and responsibilities of borrower and lender may be affected by:

subordination clause,

late charge provision,

prepayment provision,

partial release clause,

acceleration clause, and/or

alienation clause.

Subordination clause gives mortgage recorded earlier lower priority than another mortgage that will be recorded later on.

Subordination clauses

Subordination clause gives mortgage recorded earlier lower priority than another mortgage that will be recorded later on.

Common in construction financing.

Typical subordination clause:

“Lender agrees that this instrument shall be subordinate to a lien to be given by Borrower to secure funds for the construction of improvements on the Property, provided said lien is duly recorded and the amount secured by said lien does not exceed $125,000.”

Inclusion of these clauses must be negotiated during the earlier transaction.

Should be reviewed or drafted by real estate lawyer.

Promissory notes usually provide for late charges if borrower doesn’t make payments on time.

Late charge provisions

Promissory notes usually provide for late charges if borrower doesn’t make payments on time.

State laws may override late charge provision, to protect borrowers from excessive late charges.

Late charge provisions

Prepayment provision imposes penalty on borrower if she repays some or all of principal before it is due.

Prepayment provisions

Prepayment provision imposes penalty on borrower if she repays some or all of principal before it is due.

Prepayment deprives lender of some of the interest it expected to receive over loan term.

Typical prepayment provision:

“If, within five years from the date of this note, Borrower makes any prepayments of principal in excess of twenty percent of the original principal amount in any twelve-month period beginning with the date of this note or anniversary dates thereof (“loan year”), Borrower shall pay the Note Holder three percent of the original principal amount.”

No longer standard in residential loan agreements.

Fannie Mae/Freddie Mac promissory note gives borrower right to prepay.

Prepayment penalties prohibited with FHA and VA loans.

Penalties are usually charged only if loan is prepaid during first few years of loan term.

Unreasonable prepayment penalties are considered a predatory lending practice.

Some states limit the amount of such penalties.

Partial release clause obligates lender to release part of property from lien when part of debt is paid.

Partial release clauses

Partial release clause obligates lender to release part of property from lien when part of debt is paid.

Typically found in deed of trust or mortgage covering subdivision in the process of being sold.

Partial release clauses

Typical partial release clause:

“Upon payment of all sums due with respect to any lot subject to this lien, Lender shall release said lot from the lien at no cost to Borrower.”

Acceleration clause allows lender to declare outstanding loan balance due immediately in event of default.

Acceleration clauses

Acceleration clause allows lender to declare outstanding loan balance due immediately in event of default.

Most lenders wait 90 days before accelerating.

Acceleration clauses

Typical acceleration clause:

“In case the Mortgagor [or Trustor] fails to pay any installment of principal or interest secured hereby when due or to keep or perform any covenant or agreement aforesaid, then the whole indebtedness hereby secured shall become due and payable, at the election of the Mortgagee [or Beneficiary].”

Alienation clause (due-on-sale clause) is designed to limit borrower’s right to transfer title to property without lender’s permission.

Alienation clauses

When borrower transfers security property without paying off loan, either:

1. new owner takes title subject to loan;

Alienation clauses

2. new owner assumes loan without release of original borrower; or

Alienation clauses

2. new owner assumes loan without release of original borrower; or

3. assumption and release.

Alienation clauses

If new owner takes title subject to any existing liens:

Lender still has power to foreclose on property.

Alienation clauses

Assumption

New owner takes on primary liability for repaying loan.

Alienation clauses

Assumption

Unless lender agrees to release, original borrower is secondarily liable.

Alienation clauses

Assumption

Unless lender agrees to release, original borrower is secondarily liable.

Original borrower can be forced to pay deficiency if new owner doesn’t.

Alienation clauses

Most alienation clauses are triggered by transfer of any significant interest in property.

Includes long-term leases, or leases with options to purchase.

Alienation clauses

Most alienation clauses are triggered by transfer of any significant interest in property.

Includes long-term leases, or leases with options to purchase.

Lender can’t forbid a sale, but can demand payment of loan.

Alienation clauses

Typical alienation clause:

“If all or any part of the Property or an interest therein is sold or transferred by Borrower without Lender’s prior written consent, Lender may, at Lender’s option, declare all the sums secured by this instrument to be immediately due and payable.”

Lender may charge assumption fee, which may be as substantial as loan origination fee.

Alienation clauses

Estoppel letter

Acknowledges transfer of ownership and waives lender’s right to accelerate loan.

Lender estopped from trying to enforce alienation clause later on.

Alienation clauses

Real estate agent should always ask seller about existing financing.

If assumption is arranged, both parties should seek legal advice and agreement should be drawn up by lawyer.

Alienation clauses

Summary

Subordination clause Late charges Prepayment Partial release clause Acceleration clause Alienation Assumption Estoppel letter

Types of Real Estate Loans

Junior mortgage

Mortgage with lower lien priority than another mortgage or deed of trust against same property.

Junior or senior mortgage

Junior mortgage

Mortgage with lower lien priority than another mortgage or deed of trust against same property.

Senior mortgage

Mortgage with first lien position.

Also called a first mortgage.

Property may be encumbered with two mortgages in several situations:

1. Junior mortgage provides secondary financing to supplement primary loan.

2. Purchase mortgage is subordinated to a construction mortgage.

3. Home equity loan.

After foreclosure, junior mortgage paid only after senior lender has been paid in full.

If proceeds insufficient, junior lender receives nothing.

Junior lender can still sue borrower, but debt is now unsecured.

Purchase money mortgage:

1. Any mortgage loan used to finance purchase of property that is collateral for loan.

Purchase money mortgage

Purchase money mortgage:

1. Any mortgage loan used to finance purchase of property that is collateral for loan.

2. A mortgage buyer gives to seller in seller-financed transaction.

Purchase money mortgage

Home equity loan is loan secured by mortgage against borrower’s equity in home she already owns.

Home equity loan

Home equity loan is loan secured by mortgage against borrower’s equity in home she already owns.

Equity = difference between property’s current market value and liens against it

Home equity loan

Often used to finance remodeling or property improvements.

Interest rates higher than purchase loans.

Also used to pay off credit cards.

Home equity loan

Home equity line of credit (HELOC)

Line of credit with a limit and minimum monthly payments that homeowners can draw upon as needed.

Automatically secured by borrower’s home.

Home equity loan

Refinancing refers to a new loan used to pay off existing mortgage against same property.

Refinance mortgage

Often used:

to take advantage of market interest rate drop;

Refinance mortgage

Often used:

to take advantage of market interest rate drop; or

when large balloon payment is required on existing mortgage.

Refinance mortgage

Cash-out refinancing

New loan amount is more than amount of existing mortgage balance, so borrowers receive cash from refinance lender.

A way to tap into equity of home.

Refinance mortgage

Bridge loan provides cash for purchase of new home pending sale of old home.

Secured by equity in old home.

Usually has interest-only payments.

Also called swing loan or gap loan.

Bridge loan

Budget mortgage is mortgage in which monthly payments include property taxes and hazard insurance.

Budget mortgage

Impound account = lender places tax and insurance payments in account and pays

premiums out of it

Budget mortgage

Impound account = lender places tax and insurance payments in account and pays

premiums out of it

PITI payments = payments on a budget mortgage (principal, interest, taxes, and insurance)

Budget mortgage

Package mortgage is secured by personal property as well as real property.

Package mortgage

Package mortgage is secured by personal property as well as real property.

Alternatively, personal property may be financed separately, using a separate security agreement.

Lender must file financing statement with Secretary of State.

Package mortgage

Key advantage of package mortgage:

Mortgage term is generally much longer than with ordinary loan for personal property.

Package mortgage

Key advantage of package mortgage:

Mortgage term is generally much longer than with ordinary loan for personal property.

Interest rate may also be lower.

Package mortgage

Blanket mortgage is secured by more than one parcel of land and contains a partial release clause.

Blanket mortgage

Blanket mortgage is secured by more than one parcel of land and contains a partial release clause.

Partial release clause = requires lender to release some of security property from lien

when portion of debt is paid off

Blanket mortgage

Construction loan is a short-term loan used to finance construction of improvements on land already owned by borrower.

Construction loan

Construction loan is a short-term loan used to finance construction of improvements on land already owned by borrower.

Considered high risk loans.

High loan fees and interest rates.

Construction loan

Fixed disbursement plan

Common disbursement schedule for construction loans that calls for a series of predetermined disbursements (obligatory advances) at certain stages of construction.

Construction loan

Fixed disbursement plan

Common disbursement schedule for construction loans that calls for a series of predetermined disbursements (obligatory advances) at certain stages of construction.

Interest starts to accrue at first disbursement.

Construction loan

Once construction is complete, the construction loan is replaced by take-out loan.

Borrower repays amount borrowed over specified term.

Construction loan

Nonrecourse mortgage gives lender no recourse against borrower.

Lender’s only remedy in event of default is foreclosure on collateral property.

Borrower is not personally liable for loan repayment.

Nonrecourse mortgage

Participation mortgage allows lender to participate in earnings generated by mortgage property, in addition to collecting interest payments.

Participation mortgage

Shared appreciation mortgage entitles lender to a share of increases in property’s value.

Shared appreciation mortgage

Wraparound mortgage is new mortgage that includes existing first mortgage on property.

Used almost exclusively in seller-financed transactions.

Wraparound mortgage

Reverse equity mortgage provides elderly homeowners with a source of income, without having to sell their home.

Reverse equity mortgage

Homeowner borrows against equity.

Receives monthly check from lender, rather than making monthly payments.

Borrower typically required to be over certain age.

Home sold after death to pay loan.

Summary

Types of Loans Purchase money mortgage Home equity loan HELOC Refinancing Bridge loan Budget mortgage Package mortgage Blanket mortgage Construction loan Nonrecourse mortgage Participation/share appreciation mortgage Wraparound mortgage

financing residential real estate lesson 5: finance instruments

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