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 A written promise to pay money. Maker – the one who makes the promise.

Promissory Notes Promissory note A written promise to pay money. Maker – the one who makes the promise. Payee – the one to whom the promise is made.

Promissory Notes Promissory note A written promise to pay money. Maker – the one who makes the promise. Payee – the one to whom the promise is made. Note – evidence of the debt and a promise to pay.

Promissory Notes A promissory note can be a brief and simple document. It usually contains:  names of the parties,  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 Promissory note must be signed by the maker. A legal description isn’t required. If promissory note meets certain requirements, it is a negotiable instrument. Right to receive payment can be transferred by endorsement. Basic provisions

Security Instruments In real estate transactions, a promissory note is accompanied by a security instrument:  Mortgage  Deed of trust Purpose

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

Security Instruments Security instrument gives 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

Security Instruments Even if debt unsecured (no collateral), lender can enforce promissory note. Lender sues borrower, obtains judgment. Purpose

Security Instruments Even if debt unsecured (no collateral), lender can enforce promissory note. Lender sues borrower, obtains judgment. But borrower may be “judgment-proof.” Purpose

Security Instruments Even if debt unsecured (no collateral), lender can enforce promissory note. Lender sues borrower, obtains judgment. But borrower may be “judgment-proof.” Secured lender much more likely to collect payment. So real estate lenders always require borrowers to sign a security instrument. Purpose

Security Instruments 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 Also must identify promissory note it secures. Basic provisions

Mortgages Mortgagor promises to:  pay property taxes,  keep property insured against fire and other hazards, and  maintain structures in good repair. Mortgagee has right to inspect property. Covenants

Mortgages If mortgagor fails to fulfill covenants imposed by mortgage, she is in default.  Mortgagee could foreclose (even if payments are being made as agreed). Covenants

Mortgages After mortgage agreement signed, mortgagee records document to establish priority of mortgagee’s security interest. 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

Security Instruments Deed of trust Similar to mortgage, but involves three parties, rather than two. Grantor (or Trustor) = Borrower Beneficiary = Lender Trustee = Neutral third party Trustee arranges for release of property or foreclosure, as necessary. Deeds of trust

Deeds of Trust Deed of trust usually includes same basic provisions found in a mortgage:  names of parties,  property description,  identification of promissory note,  grantor’s promises to pay taxes and insure property, and  beneficiary’s right to inspect property. Basic provisions

Deeds of Trust Deed of reconveyance Document releasing property from lien.  Executed by trustee when loan secured by deed of trust paid off.  Recorded by grantor. Reconveyance

Summary Security Instruments  Hypothecation  Legal title  Equitable title  Lien  Mortgage  Satisfaction of mortgage  Deed of trust  Deed of reconveyance

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

At one time, judicial foreclosure was only option.  Lender filed lawsuit against borrower.  Sheriff’s sale ordered by court if borrower found to be in default. Alternative to judicial foreclosure was eventually developed. Methods

Methods of Foreclosure Nonjudicial foreclosure is generally associated with deeds of trust.  Lender doesn’t have to file lawsuit.  Trustee arranges for property to be sold at trustee’s sale.  Property sold to highest bidder. Judicial vs. nonjudicial

Methods of Foreclosure Nonjudicial foreclosure can’t be used unless security instrument contains a power of sale clause. Power of sale clause authorizes trustee to sell the property in the event of default. All deeds of trust include a power of sale clause. Power of sale clause can be included in a mortgage, but in many states mortgages ordinarily don’t have one. Power of sale

Methods of Foreclosure Typical power of sale clause might 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.” Power of sale

Nonjudicial Foreclosure 1. Notice of default 2. Notice of sale 3. Cure and reinstatement 4. Trustee’s sale 5. Trustee’s deed Steps in a nonjudicial foreclosure

Steps in a Nonjudicial Foreclosure 1. Notice of default To begin nonjudicial foreclosure, trustee must give notice of default to grantor. Notice to borrower

Steps in a Nonjudicial Foreclosure 2. Notice of sale Trustee must wait certain length of time after notice of default before issuing notice of sale.  Usually between 3 to 6 months.  Minimum time period also required between notice of sale and date of sale. Notice to public

Steps in a Nonjudicial Foreclosure 3. Cure and reinstatement Grantor is allowed to cure default and reinstate loan by paying delinquent amounts plus costs.  Right ends shortly before trustee’s sale is held.  No statutory right of redemption after trustee’s sale. Stopping the foreclosure

Steps in a Nonjudicial Foreclosure 4. Trustee’s sale Like sheriff’s sale, trustee’s sale is public auction. Proceeds first applied to costs, then to debt, and then to junior liens. Any surplus goes to debtor. Sale of property

Steps in a Nonjudicial Foreclosure 5. Trustee’s deed Highest bidder receives trustee’s deed immediately after sale. Debtor’s title terminates immediately. Must vacate property in short period (for example, within 30 days). No post-sale redemption period

Nonjudicial Foreclosure State law may place restrictions on nonjudicial foreclosures, such as: Requiring a post-sale redemption period for agricultural property. Prohibiting beneficiary from obtaining deficiency judgment after sale. Restrictions

Judicial vs. Nonjudicial Foreclosure Advantages of judicial foreclosure:  Borrower can’t reinstate loan.  Right to deficiency judgment. Lender’s point of view

Judicial vs. Nonjudicial 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

Judicial vs. Nonjudicial Foreclosure Advantages of judicial foreclosure:  Slow process.  Post-sale redemption. Borrower’s point of view

Judicial vs. Nonjudicial Foreclosure Advantages of judicial foreclosure:  Slow process.  Post-sale redemption. Advantages of nonjudicial foreclosure:  Right to cure and reinstate. Borrower’s point of view

Summary Foreclosure  Judicial foreclosure  Equitable right of redemption  Sheriff’s sale  Deficiency judgment  Statutory right of redemption  Nonjudicial foreclosure  Power of sale  Cure and reinstatement  Trustee’s sale

Alternatives to Foreclosure Three alternatives allow borrowers on the verge of default to avoid foreclosure:

Alternatives to Foreclosure Three alternatives allow borrowers on the verge of default to avoid foreclosure: Loan workout

Alternatives to Foreclosure Three alternatives allow borrowers on the verge of default to avoid foreclosure: Loan workout Deed in lieu

Alternatives to Foreclosure Three alternatives allow borrowers on the verge of default to avoid foreclosure: Loan workout Deed in lieu Short sale

Alternatives to Foreclosure All three alternatives require lender’s cooperation and consent. Lender’s consent needed

Alternatives to Foreclosure All three alternatives require lender’s cooperation and consent. Lender’s incentives:  avoiding foreclosure costs  ending money-losing situation more quickly Lender’s consent needed

Alternatives to Foreclosure First step for borrower hoping to avoid foreclosure: asking lender for a loan workout. Two types of workouts:  Repayment plan  Loan modification Workouts

With a repayment plan, lender allows borrower to change the timing of a limited number of payments. Repayment plans

Workouts With a repayment plan, lender allows borrower to change the timing of a limited number of payments. For example, borrower might be allowed to: take additional time to make one or more payments, or Repayment plans

Workouts With a repayment plan, lender allows borrower to change the timing of a limited number of payments. For example, borrower might be allowed to: take additional time to make one or more payments, or skip one or more payments, with skipped payments added on to repayment period. Repayment plans

Workouts Borrower in more dire situation may need a loan modification: permanent change in the terms of repayment. Loan modifications

Workouts Borrower in more dire situation may need a loan modification: permanent change in the terms of repayment. Examples:  converting ARM to fixed-rate loan before payment resets higher  reducing interest rate  reducing principal owed Loan modifications

Alternatives to Foreclosure If borrower can’t negotiate a workout and will lose the property anyway, can offer lender a deed in lieu. Deed in lieu of foreclosure

Alternatives to Foreclosure If borrower can’t negotiate a workout and will lose the property anyway, can offer lender a deed in lieu. If lender accepts deed in lieu: borrower deeds property to lender debt satisfied Deed in lieu of foreclosure

Deed in Lieu of Foreclosure Lender agrees to release borrower even though property is usually worth less than amount owed. Lender could require borrower to sign a promissory note for the shortfall, but that isn’t typical. Settlement of debt

Deed in Lieu of Foreclosure Compared to foreclosure, deed in lieu is:  simpler  less public Impact on borrower

Deed in Lieu of Foreclosure Compared to foreclosure, deed in lieu is:  simpler  less public However, borrower’s credit rating suffers almost as much from deed in lieu as from foreclosure. Impact on borrower

Deed in Lieu of Foreclosure Lender who accepts deed in lieu takes title subject to other liens. Not like foreclosure, which extinguishes junior liens. Therefore lender will usually refuse deed in lieu if there are junior liens. Junior liens

Alternatives to Foreclosure Short sale: When borrower sells the property to a third party for less than the amount owed. Short sales

Alternatives to Foreclosure Short sale: When borrower sells the property to a third party for less than the amount owed. If borrower facing foreclosure can find a buyer, may ask lender to approve a short sale. Short sales

Alternatives to Foreclosure Short sale: When borrower sells the property to a third party for less than the amount owed. If borrower facing foreclosure can find a buyer, may ask lender to approve a short sale.  Lender receives sale proceeds and releases lien. Short sales

Alternatives to Foreclosure Short sale: When borrower sells the property to a third party for less than the amount owed. If borrower facing foreclosure can find a buyer, may ask lender to approve a short sale.  Lender receives sale proceeds and releases lien.  Might require borrower to sign a promissory note for the shortfall. Short sales

Short Sales Like ordinary sale, short sale doesn’t extinguish junior liens. If there are junior liens, short sale must be approved by all lienholders, not just lender threatening foreclosure. Junior lienholders unlikely to consent. Junior liens

Alternatives to Foreclosure To arrange a workout, offer a deed in lieu, or request approval of a short sale, borrower contacts loan servicer. May need approval from more than one department or entity. Obtaining lender’s consent

Obtaining Lender’s Consent Borrower must demonstrate financial hardship (inability to make payments). Application and documentation required. Application process

Obtaining Lender’s Consent Borrower must demonstrate financial hardship (inability to make payments). Application and documentation required. Some lenders won’t even consider borrower’s request until at least 90 days behind on loan payments. Application process

Obtaining Lender’s Consent Borrower who wants help with process should contact nonprofit HUD-approved housing counseling service. Assistance for borrowers

Obtaining Lender’s Consent Borrower who wants help with process should contact nonprofit HUD-approved housing counseling service. Problems in many places with predatory for-profit loan modification companies. Assistance for borrowers

Obtaining Lender’s Consent Borrower who wants help with process should contact nonprofit HUD-approved housing counseling service. Problems in many places with predatory for-profit loan modification companies. Many states now have “distressed property laws” regulating these companies. Assistance for borrowers

Obtaining Lender’s Consent If loan has been securitized, can be very difficult to obtain consent. Under some MBS contracts, any purchaser (investor) can object and prevent loan modification or settlement of debt. Securitized loans

Obtaining Lender’s Consent If loan has been securitized, can be very difficult to obtain consent. Under some MBS contracts, any purchaser (investor) can object and prevent loan modification or settlement of debt. Impossible or at least impractical to obtain consent of all investors. Securitized loans

Alternatives to Foreclosure IRS views debt relief (reduction in amount owed) as income. Borrower who enters into an arrangement that reduces amount owed on mortgage may have to pay income taxes on the debt relief. Income tax implications

Alternatives to Foreclosure Exceptions – Debt relief not taxable if: debt was secured by principal residence and forgiven since 2007, or Income tax implications

Alternatives to Foreclosure Exceptions – Debt relief not taxable if: debt was secured by principal residence and forgiven since 2007, or debtor was insolvent when debt forgiven. Income tax implications

Summary Alternatives to Foreclosure  Loan workout  Repayment plan  Loan modification  Deed in lieu  Short sale  Housing counseling service  Distressed property laws  Debt relief

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.

Finance Instrument Provisions Subordination clause gives a mortgage lower priority than another mortgage that will be recorded later on. Common in construction financing. Subordination clauses

Finance Instrument Provisions 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.” Subordination clauses

Finance Instrument Provisions Inclusion of subordination clause must be negotiated during the earlier transaction. If not, holder of earlier mortgage may be willing to sign a separate subordination agreement later on. Subordination clauses

Finance Instrument Provisions Promissory notes usually provide for late charges if borrower doesn’t make payments on time. State laws may override late charge provision, to protect borrowers from excessive charges. Late charge provisions

Finance Instrument Provisions Prepayment provision imposes penalty on borrower who 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. Prepayment provisions

Finance Instrument Provisions 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.” Prepayment provisions

Finance Instrument Provisions Not standard in residential loan agreements. Fannie Mae/Freddie Mac promissory note gives borrower right to prepay. Prepayment penalties prohibited with FHA and VA loans. Prepayment provisions

Finance Instrument Provisions Prepayment provision usually allows lender to charge penalty only if loan is prepaid during first few years of loan term. Unreasonable prepayment penalties are considered a predatory lending practice. Some states have laws limiting penalty amounts and imposing other restrictions. Prepayment provisions

Finance Instrument Provisions Partial release clause obligates lender to release part of property from lien when part of debt is paid. Typically found in deed of trust or mortgage that covers subdivision, allowing release of individual lot from lien when lot is sold. Partial release clauses

Finance Instrument Provisions 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.” Partial release clauses

Finance Instrument Provisions Acceleration clause allows lender to declare outstanding loan balance due immediately in the event of default.  Most lenders wait 90 days before accelerating.  Some states now have laws requiring lenders to wait a specified period. Acceleration clauses

Finance Instrument Provisions 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].” Acceleration clauses

Finance Instrument Provisions Alienation clause is designed to prevent borrower from selling the security property without lender’s permission unless loan is paid off at closing. If title transferred without permission, lender can accelerate loan. Also called a due-on-sale clause. Alienation clauses

Alienation Clauses Most alienation clauses are triggered not just by transfer of title, but by transfer of any significant interest. Includes long-term leases, or leases with options to purchase. Lender can’t forbid transfer, but can demand payment of loan. Triggered by transfer of any interest

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.” Typical clause

Alienation Clauses To understand purpose of alienation clause, consider what happens when borrower sells property without paying off loan. Transfer of title without loan payoff

Alienation Clauses Three possibilities: 1. New owner takes title subject to loan but does not assume it. Transfer of title without loan payoff

Alienation Clauses Three possibilities: 1. New owner takes title subject to loan but does not assume it. 2. New owner assumes loan but original borrower is not released. Transfer of title without loan payoff

Alienation Clauses Three possibilities: 1. New owner takes title subject to loan but does not assume it. 2. New owner assumes loan but original borrower is not released. 3. New owner assumes loan and lender agrees to release original borrower. Transfer of title without loan payoff

Transfer Without Loan Payoff If new owner takes title subject to an existing mortgage but does not assume it: New owner is not personally liable for payment of mortgage. But lender still has power to foreclose (transfer of title doesn’t extinguish lien). Taking title “subject to” loan

Transfer Without Loan Payoff If new owner assumes loan: New owner takes on primary liability for repaying loan. Unless lender agrees to a release, original borrower is secondarily liable. Original borrower can be forced to pay deficiency judgment if new owner doesn’t. Assumption without release

Transfer Without Loan Payoff Alienation clause allows lender to evaluate creditworthiness of proposed buyer. If buyer not creditworthy, lender tells original borrower loan will be accelerated if sale goes forward. If buyer is creditworthy, lender approves assumption and releases original borrower. Original borrower has no further liability. Assumption and release

Assumption and Release Lender will charge new owner an assumption fee, which is typically as large as an origination fee. Assumption fee

Assumption and Release Lender will also provide an estoppel letter, which acknowledges transfer of ownership and waives lender’s right to accelerate loan. Lender estopped from trying to enforce alienation clause later on. Lender may charge fee for estoppel letter. Estoppel letter

Summary Finance Instrument Provisions  Subordination clause  Late charge provision  Prepayment provision  Partial release clause  Acceleration clause  Alienation clause  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

Types of Real Estate Loans Junior mortgage Mortgage with lower lien priority than another mortgage or deed of trust against same property. Senior mortgage Mortgage with higher lien priority than another mortgage or deed of trust against same property. Junior or senior mortgage

Types of Real Estate Loans The lien having the most senior (first) position is called the first mortgage. Junior mortgages may be referred to as second mortgage, third mortgage, etc. First position mortgage

Types of Real Estate Loans Property may be encumbered with two or more mortgages in various situations: 1.Junior mortgage provides secondary financing to supplement primary loan. 2.Purchase mortgage is subordinated to a construction mortgage. 3.Borrower takes out home equity loan secured by same property as purchase loan. Junior or senior mortgage

Types of Real Estate Loans 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. Junior or senior mortgage

Types of Real Estate Loans Purchase money mortgage: 1.Any mortgage loan used to finance the purchase of the property that is the collateral for the loan. 2.A mortgage that buyer gives to seller in seller-financed transaction. Purchase money mortgage

Types of Real Estate Loans 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

Types of Real Estate Loans Home equity loan may be used for: remodeling or property improvements, or expenses unrelated to property (such as paying off credit cards). Interest rates on home equity loans are higher than rates on purchase loans. Home equity loan

Types of Real Estate Loans 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

Types of Real Estate Loans Refinancing refers to a new loan used to pay off existing mortgage against same property. Often used: to take advantage of market interest rate drop; or when large balloon payment is required on existing mortgage. Refinance mortgage

Types of Real Estate Loans 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 home equity while also refinancing. Refinance mortgage

Types of Real Estate Loans Bridge loan provides cash for purchase of new home pending sale of old home.  Secured by equity in old home.  Usually has interest-only payments.  Also called swing loan or gap loan. Bridge loan

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

Types of Real Estate Loans Construction loan is a short-term loan used to finance construction of improvements on land already owned by borrower. Construction loans:  are considered high-risk loans  typically have high loan fees and interest rates Construction loan

Types of Real Estate Loans Fixed disbursement plan: typical disbursement schedule for construction loans. Calls for a series of predetermined disbursements (obligatory advances) at certain stages of construction. Interest starts to accrue at first disbursement. Construction loan

Types of Real Estate Loans Once construction is completed, construction loan is replaced by a take-out loan. Borrower repays amount borrowed over specified term. Construction loan

Types of Real Estate Loans Reverse equity mortgage provides elderly homeowners with a source of income, without requiring them to sell their home. Homeowner borrows against equity. Receives monthly check from lender, rather than making monthly payments. Borrower typically required to be over a certain age. Home sold after death to repay loan. Reverse equity mortgage

Summary Types of Real Estate Loans  Purchase money mortgage  Home equity loan or HELOC  Refinancing  Bridge loan  Budget mortgage  Package mortgage  Blanket mortgage  Construction loan  Nonrecourse mortgage  Wraparound mortgage  Reverse equity mortgage