Chapter 5. Real Estate Finance Instruments. Chapter Objectives. Promissory Notes 10/11/2012

(1)

1

Mortgage Principles and Practices 4th Edition (02/21/2012)

Real Estate Finance

Instruments

Chapter 5

2

Chapter 5: Real Estate Finance Instruments

Chapter Objectives

• Contrast a financing instrument from a

security instrument.

• Discuss advantages and disadvantages of

trust deeds.

• Discuss advantages and disadvantages of

mortgages.

• Define the purpose of different types of

mortgages.

• Identify typical mortgage clauses.

Promissory Notes

• Maker: One promising to pay

• Payee: One to whom payment is promised

• Note: Basic evidence of debt – Date

– Names of the parties – Amount of the debt

• Note rate (interest rate that amortizes debt) – How and when the money is to be paid – What happens in the event of default – Signature of the maker

• Negotiable instruments – Freely transferrable

– Creditor can sell, as on secondary market

(2)

4

Promissory Notes

• Straight note or interest-only note – Payments of interest-only during loan term – Balloon payment to pay off principal – Usually short-term

• Installment note

– Payments of principal and/or interest at designated intervals – May require balloon payment

• Partially amortizing installment note

– Periodic payments of principal and interest during term – Balloon payment at end to pay off balance

• Fully amortizing installment note – Regular payment of principal and interest – Calculated to pay off entire balance by end of term

5

Security Instruments

• Accompanies promissory note

• Requires debtor to hypothecate property as a condition of a loan

– Debtor pledges personal or real property as security for a debt, typically without giving up possession of it

• Protects creditor

• Motivates debtor to fulfill terms

• Simply describes collateral for a note

• Note and security instrument cancelled when debt is repaid

• Main types are trust deeds and mortgages

Trust Deeds

• Places specific financial interest in property in hands of disinterested third party

– Borrower is trustor – Lender is beneficiary – Third party is trustee

• Borrower has possession and equitable title

• Legal title vested to borrower when debt repaid

• Trustee may initiate non-judicial foreclosure upon default

– Allows trustee to sell property without court – Authorized when lender declares note in default

(3)

7

Mortgages

• Borrower conveys interest in property to

lender as collateral

– Borrower is mortgagor

– Lender is mortgagee

• Creates voluntary lien on property

• Allows lender to accelerate entire debt upon

default

• Allows lender to commence judicial

foreclosure action through courts

8

Lien and Title Theory

• Lien theory

– Security instrument creates lien against property – Borrower hold title to property

– May require lengthy court proceeding upon default

• Title theory

– Security instrument gives actual title to property to lender while debt outstanding

– Borrower has equitable title and possession – Legal title reverts or is conveyed once debt repaid – May not require lengthy court proceeding upon default

• States may allow only one or both types of security instrument to be recorded

Judicial Foreclosure

• Creditor accelerates due date on default

• Files foreclosure action in county court

• If court finds in favor of creditor: – Creditor takes ownership

– Judge issues officer of court to seize property

• Creditor may choose to sell – Public notification

– Public auction

– Proceeds pay costs of sale, liens

• Overages go to debtor

• Creditor may ask for deficiency judgment

(4)

10

Judicial Foreclosure: Redemption

• May allow debtor to save property

• Lis pendens: Notice of pending legal action

• Equitable right of redemption

– Save property prior to confirmation of sale

• Statutory right of redemption – Save property after final sale

• Deed in lieu of foreclosure

– Debtor voluntarily convey property prior to final court decision

– Avoids record of foreclosure

– Creditor could pursue deficiency judgment

11

Mortgage Lien Position

• Establishes order in which liens are paid

• Real estate tax liens always first regardless

of recording order

• Lien that was recorded first paid in full

• Junior liens paid in order until funds

exhausted

• Senior / junior mortgage describes recording

order

• Subordination agreement allows lien

recorded later to take priority

Typical Clauses

• Acceleration clause

– Gives lender right to declare loan balance due immediately on default or breach of contract

• Alienation clause (due on sale clause)

– Gives lender certain rights upon transfer of

ownership without permission

• Accelerate debt

• Change interest rate

• Charge a fee

(5)

13

Typical Clauses

• Defeasance clause

– Makes document void in the event of stated condition

• Paying off debt voids security instrument

• Partial release, satisfaction, or reconveyance

clause

– Obligates creditor to release part of property and convey title to debt when provisions are satisfied

14

Case in Point

• Builder buys five acres of land

• Contract has partial release clause

• Clear title to one acre conveyed to

builder for each 20% of note paid

• Allows builder to sell specific acre free

and clear

Typical Clauses

• Prepayment clause

– Gives lender right to charge penalty for paying off loan early

• Refinance or sell, for example – Makes up for interest lost

– May be restricted to early years of loan – Prohibited in FHA and VA loans

(6)

16

Other Covenants

• Promises that may appear in deeds,

mortgages, other documents

• Compel or prevent certain actions/uses

• Typical covenants:

– Not committing waste – Maintain hazard insurance

– Agree to pay taxes and other assessments

• Failure to keep covenants could be

considered default

17

Types and Features of Mortgages

• Purchase money mortgage

– Generally describes mortgage given to lender or seller to purchase property

– If seller may also be known as a soft money loan – Can be first or junior mortgage

• Refinance mortgage

– Borrower replaces current mortgage with new – May allow better terms or to get cash out – MLO should be able to show net tangible benefit

Types and Features of Mortgages

• Home equity

– Secured by mortgage on principal residence – Typically attach as junior mortgages – Home equity loan

• Closed-end, fixed amount

• Regular payments over fixed term – Home equity line of credit (HELOC)

• Open-end, draw and pay back as used up to credit limit

• Draw period pays interest only

• Repayment period amortizes payments

(7)

19

Types and Features of Mortgages

• Blanket mortgage

– Covers multiple parcels of land – Usually used to finance subdivisions – Contain partial release clause

• Bridge mortgage

– Occurs between termination of one mortgage and beginning of next

– Designed to be temporary

– Commonly used for construction financing

20

Types and Features of Mortgages

• Open-end mortgage

– Allows borrower to request additional funds – Usually sets predetermined loan-to-value – Not the same as open mortgage (can be repaid

at any time without penalty)

• Package mortgage

– Includes personal property as collateral – Most commonly used for appliances and/or

furniture

Types and Features of Mortgages

• Reverse mortgage

– Allows homeowners aged 62 or older to covert equity in home into cash/line of credit

– Generally repaid when borrower:

• Dies

• Does not live in home for 12 months

• Sells the home

• Refinances loan

• Equity participation mortgage

– Permits lender to share earnings, income, profit

(8)

22

Types and Features of Mortgages

• Wraparound mortgage

– Existing loan retained while lender gives borrower another, larger loan

– Payment options

• Borrower pays wraparound lender single payment for both loans

• If wraparound lender different, borrower pays wraparound lender who pays first lender – May be used for refinancing or seller financing

23

Construction Mortgage

• Temporary loan used to finance construction

of improvements on land

• Appraiser evaluates plans to provide “subject

to” appraisal

• Replaced with permanent amortizing loan

when complete

• May include extended rate locks

• Disbursement plans guard against over-

spending

Construction Mortgage: Disbursement

• Fixed disbursement

– Predetermined obligatory advances at various stages

– Release/draw as project is complete

– Lenders may hold final percentage to protect against unpaid mechanic’s liens

• Voucher system

– Borrower pays own bills and submits receipts

• Warrant system

– Lender directly pays supplier/laborer bills

(9)

25

Construction Mortgage: Permanent

• Only one loan and one closing

• No take out loan

• Fixed disbursement

• Loan automatically converts to permanent

upon completion

26

Graduated Payment Mortgage

• Specialized payment structure

• Allows borrower to make smaller

payments in early years

• Unpaid interest added to balance

• Scheduled period of negative amortization

• Payments escalate at predetermined point

to fully amortize loan

Key Term Review

• Acceleration Clause

• Alienation Clause

• Balloon Payment

• Construction Loan

• Equitable Right of

Redemption

• Equitable Title

• Hypothecate

• Judicial Foreclosure

• Mortgage

• Negotiable Instrument

• Non-Judicial Foreclosure

• Note Rate

• Promissory Note

• Security Instrument

• Subordination Agreement

• Trust Deed (or Deed of Trust)

(10)

28

Summary

1. Real estate finance instruments:

– Finance instruments, written documents

establishing rights and duties

– Promissory notes, written promises to pay – Negotiable instruments, freely transferrable – Maker is one promising to pay the lender

(payee)

– Common note types: Straight, installment, installment with balloon, fully amortizing. – Note rate, rate used to amortize loan and

determine monthly payment.

29

Summary

2. Security instruments:

– Give creditor right to take ownership of property to satisfy debt is debtor does not pay as agreed – Requires debtor to hypothecate property

• Pledge as collateral

• Does not give up possession – Mortgages and trust deeds

3. Trust deeds (or deeds of trust):

– Some financial interest to third party as security for payment of note

– Allows for non-judicial foreclosure

Summary

4. Mortgages:

– Create lien against property as security for debt – Allow for judicial foreclosure upon default

• Notice of default and foreclosure action filed

• Creditor takes ownership; may sell

• Order of execution; sale a public auction

• Sheriff’s deed issued

• Debtor may redeem until sale confirmed (equitable right of redemption)

• Slow and expensive, but court authority – Senior mortgage in higher lien position than

junior mortgage (property tax always first)

(11)

31

Summary

5. Clauses:

– Acceleration lets lender call balance due – Prepayment allows charged penalty for paying

off loan early

– Alienation (due on sale) allows certain rights upon transfer of property

– Defeasance cancels repaid mortgage – Subordination lets later-recorded mortgage

take priority

– Partial release releases part of property from lien as balance is paid

32

Summary

6. Mortgage types:

– Purchase money—Seller/lender takes mortgage for purchase

– Soft money—Borrower gets credit instead of cash (compare to hard money, where borrower gets actual cash)

– Bridge—Temporary loan between two others and repaid with later mortgage or sale proceeds – Package—Includes personal property – Blanket—For more than one land parcel

– Construction—Temporary loan to finance construction of building improvements

Chapter 5 Quiz

1. A promissory note calling only for

payment of interest during its term is

a(n)

A. amortizing note.

B. installment note.

C. negotiated note.

D. straight note.

(12)

34

Chapter 5 Quiz

2. The 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. defeasance clause.

C. escalation clause.

D. forfeiture clause.

35

Chapter 5 Quiz

3. A 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.

Chapter 5 Quiz

4. Which document accompanies the

mortgage?

A. abstract of title

B. contract of sale

C. deed

D. promissory note

(13)

37

Chapter 5 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.

38

Chapter 5 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. amortizing mortgage.

B. hypothecated mortgage.

C. open-end mortgage.

D. package mortgage.

Chapter 5 Quiz

7. The type of mortgage that may provide

the borrower with a monthly check

instead of the borrower paying a

monthly payment is known as a(n)

A. blanket mortgage.

B. graduated payment mortgage.

C. interest only mortgage.

D. reverse mortgage.

(14)

40

Chapter 5 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. site drafts.

41