CHAPTER
18

Financing and Mortgages

In This Chapter

Financing a home purchase is a daunting task, full of mortgage brokers, lenders, down payments, points, etc. Understanding the lending process—and better yet, being able to explain the process to someone else—is a great way for any real estate professional to help their client through the financing maze.

In this chapter, we will cover the basics of mortgages: what they are, how they are created, who they serve, and what happens if you fail to make your mortgage payments. We will discuss the many different types of mortgages and when they are used. We will also discuss foreclosures.

Promissory Notes

A promissory note, sometimes called a financing instrument or financing vehicle, is basically an IOU. It’s a written, signed, unconditional promise to pay a specific amount of money on demand at a specified time and is often used to borrow money or take out a loan for a specific purchase. Along with repaying the note, the borrower promises to pay interest as well.

Promissory Note Terms

When someone decides to borrow money from a lending institution, he seeks out the most favorable financing terms he can find, such as low interest rate, low down payment requirements, credit score flexibility, etc. The note outlines key terms both parties must agree upon, such as the amount borrowed; the interest rate; the prepayment penalties, if any; and the repayment period. The amount borrowed is called the principal of the loan and is based on the borrower’s needs, wants, and desires. The ratio of loan amount to the value of the collateral is called the loan-to-value (LTV) ratio. The higher the LTV, or the more money that’s loaned in relation to the value of the property, the higher the interest rate required. The theory is that at higher LTVs, a lender is taking more risk and, therefore, should be compensated better for that risk.

HELPFUL HINT

When determining the LTV of a loan, the bank will determine the value to be the lower of either the purchase price or the appraised amount.

Equity is the amount of the loan the borrower has paid off, either as an initial down payment at the closing or the accrual of principal after each payment. A conventional loan is considered the most secure loan due to the low LTV, typically 80 percent or less. Overall, the determining factors that drive the LTV and down payment are the ability of the borrower to repay the loan and the appraisal of the property being purchased. The borrower’s ability to repay the loan is usually based on such factors as job status, credit score, and current income earned. These will be checked and verified during the application process through tax returns, bank status, credit reports, pay stubs, etc. In some cases, the borrower may require a higher LTV due to lower cash reserves for a down payment; however, the bank might seek an insurance policy, known as private mortgage insurance (PMI), to protect itself should the borrower default on the loan. It covers the top 20 to 30 percent of the loan against the default of the borrower and allows lenders to make riskier loans than they may otherwise be comfortable making. When the borrower has accrued enough equity—typically 20 to 22 percent—the lender releases the PMI.

DEFINITION

Private mortgage insurance (PMI) is an insurance policy designed to protect the lender should the borrower default on the loan. Typically, the monthly premiums are paid by the borrower and added to the monthly note payments.

The Interest Rate

Interest is the charge a person pays to use another person’s money expressed as a percentage of the outstanding loan balance. Interest can be paid at the beginning of the payment period, called in advance, or at the end of the payment period, called in arrears. Whether paid at the end or the beginning of each payment only matters when a property is sold and the loan is paid off prior to its maturity date. Usury is the illegal activity of charging an interest rate higher than allowed by state law. As of March 1981, Title V of the Depository Institutions Deregulation and Monetary Control Act of 1980 exempts from the usury laws federally related loans made after that date for residential one-to-four-family first-lien loans.

DEFINITION

Usury laws regulate the maximum interest rates that can be set for loans to protect borrowers. A federally related loan is a loan made by a federally chartered bank, lending institution, or agency of the federal government.

The loan origination fee is what the lender charges the borrower for making the loan. The fee is expressed in terms of a point, or 1 percent of the loan amount. A discount point is a type of prepaid interest or fee mortgage borrowers can purchase that lowers the amount of interest they pay on each payment. The discount point is expressed as a point, or 1 percent of the total loan amount.

The Prepayment Penalty

A prepayment penalty is a clause in a loan stating that a penalty will be assessed if the loan is paid off within a certain time period. Typically, the penalty is based on a percentage of the remaining mortgage balance and has a short life span, ranging from 1 to 5 years. Loans with a prepayment penalty typically have a 1⁄4to 1⁄2 percent interest rate reduction, due to the fact the lenders know the borrower is locked in for at least a given period of time.

The Repayment Period

There’s a set time frame during which a borrower is obligated to repay the total amount of the principal plus the interest for a loan. The common residential loan is paid back in a 30-year term. However, other terms are available, such as 10, 15, and 20 years. The effect of the repayment period determines the monthly payment, so a longer repayment schedule lowers every month’s total payment.

Mortgages and Deeds of Trust

A mortgage is a legal contract that conveys an interest or right of ownership on a piece of real property by its owner, the mortgagor, to a lender, the mortgagee, as security for a loan. The lender’s security interest is recorded as a matter of public record and is released when the loan is repaid in full, called a satisfaction of lien. The borrower then enters the satisfaction of lien into the public records to show full ownership of the property.

HELPFUL HINT

When a borrower needs money, they ask a bank for a loan, or IOU. You offer collateral to the bank for the IOU. The mortgage is the document that promises you’ll give them the collateral if you fail to make good on the IOU. Therefore, the borrower becomes the mortgagor. The bank, or lender, accepts the mortgage and becomes the mortgagee.

A deed of trust, although like a mortgage, is another method of achieving the same concept of home ownership. Sometimes called trust deed, a deed of trust is a deed wherein legal title to real property is transferred to a trustee, who holds it as security for a loan. The equitable title remains with the borrower. The borrower is referred to as the trustor, while the lender is referred to as the beneficiary. When the trustor pays off the loan amount, the trustee deeds the property back to the trustor, or the borrower, by a reconveyance deed. The borrower then enters the deed in the public records to show full ownership of the property.

The Lien Theory Versus Title Theory System

A main difference between the mortgage and deed of trust systems is the way they’re secured. The mortgage creates a lien that’s placed against the property in the public records naming the lender as the lien holder. The other method transfers ownership of the property to the trustee, as owner of the property via a deed of trust. Within the mortgage or deed of trust is a clause called the defeasance clause. This requires the trustee to transfer the property back to the original trustor upon fulfillment of the payment obligations required in the original loan.

DEFINITION

A defeasance clause is a provision included in a mortgage agreement that the borrower will be given the title to the property after all mortgage terms are met. The buyer has no right to the title until all principal and interest payments have been made.

Many obligations are required of the borrower, either as the mortgagor or trustor, in the document, such as:

The Default of Mortgage, or Deed of Trust, Clause

Default is defined within the mortgage, or deed of trust, and is typically 60 to 90 days without a payment. Once default occurs, other clauses can be activated as well. Should the borrower fail to pay real estate taxes, acquire or maintain homeowners’ insurance, or make necessary repairs on the property, the lender has the right to keep the property, which is the security of the loan, safe and viable.

The Acceleration Clause

The acceleration clause states that the lender has the right to call the loan due immediately. The amount called due can be the entire amount of the outstanding principal balance of the loan and not the sum of the remaining payments. This clause is to help protect the lender during the foreclosure process. Without the acceleration clause, the lender would have to sue the borrower after each missed payment.

The Assignment Clause

This clause allows the lender to assign the mortgage to another person. In this case, the loan is sold because it has value, while the mortgage that covers the loan is assigned. The mortgage is said to back the loan.

DEFINITION

Back the loan is a phrase that means “protect the loan by giving the lender a piece of collateral.” Sometimes it’s called a mortgage-backed security. This loan is the security backed by the mortgage as collateral.

Another clause within the mortgage is the alienation clause, or the due on sale clause. This clause protects the lender by requiring the borrower to pay the outstanding balance of the loan upon loss of beneficial interest, such as through a sale or gift. It also can be activated upon a land contract that transfers the beneficial interest to the vendee during the period of the land contract

DEFINITION

To record is to enter something into the public records to reflect the true nature, or intent, of the document being recorded.

The Tax and Insurance Reserves Clause

If the lender requires the borrower to escrow the real estate taxes and the homeowner’s insurance, this clause gives that power to the lender. Furthermore, the lender might require flood insurance reserves based on the location of the property. Loans and mortgages are placed in the public record by the date they were created. The first one created, or recorded, gets first priority. However, in some cases, a clause called a subordination clause allows recorded documents to switch priorities even though one may be younger than the other.

DEFINITION

A subordination clause allows two documents to switch priorities, regardless of the dates they entered the public records.

The Primary Mortgage Market

The primary mortgage market brings borrowers together with lenders, be they individuals, entities, or institutions, that have money to lend for real estate. The borrowers include individuals seeking funds to buy a new or existing home, investors seeking funds to buy investment properties, and businesses seeking funds to buy property.

Secondary Markets

The secondary mortgage market is a provider of funds to the primary mortgage market. The secondary market pools, or blocks, together loans to make packages of loans sold to an investor to generate income to replenish the primary market funds.

DEFINITION

A pool or block is when a maker of mortgages combines individual mortgages of similar interest rates and terms to form a bigger group to attract an investor. This group of loans is then packaged as a mortgage-backed security (MBS).

The three largest investors of the primary mortgage market are the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal National Mortgage Association (Fannie Mae), and the Government National Mortgage Association (GNMA).

Freddie Mac was created by Congress in 1970 and purchases single-family, multifamily, and home-improvement conventional mortgage loans. It also purchases conventional single-family mortgages under optional delivery programs.

Fannie Mae was created by Congress in 1938 as a wholly owned governmental corporation. Fannie Mae purchases single-family, multifamily, FHA, VA, and conventional mortgages.

GNMA has authority to purchase subsidized and unsubsidized single-family, multifamily, FHA, and VA mortgages and, at times, conventional mortgages. GNMA guaranties pass-through certificates as well. The securities are issued by mortgagees approved by the U.S. Department of Housing and Urban Development (HUD) and guaranteed by GNMA.

DEFINITION

A pass-through certificate is a type of investment issued by the GNMA that earns income from the interest and principal payments made on mortgages by mortgage holders and passed through to the investor.

While making risky loans is more profitable, a severe problem occurred when the subprime mortgage crisis exploded. As housing prices fell in 2006, the value of their loans dropped tremendously. If they hadn’t been nationalized, there essentially would have been no housing market whatsoever because banks just stopped lending without government guarantees.

HELPFUL HINT

In 2006, the U.S. government bought all the stock of FNMA and FHLMC entities and nationalized them for the good of the people. GNMA has always been wholly owned by the government.

Common Financing Types

Many different types of mortgages are available to home buyers. The loan type can depend on many factors, such as property type, price range, location, and more. Figuring out what kind of mortgage works best for each individual requires research.

Fixed-Rate Loans

A fixed-rate loan is the most common loan. The distinguishing factor of a fixed-rate mortgage is that the interest rate over every time period of the mortgage is known at the time the mortgage is originated. The fixed-rate loan is usually amortized over some time period.

DEFINITION

Amortization is the reduction of debt by regular payments of interest and principal sufficient to pay off a loan by maturity.

Adjustable-Rate Loans

An adjustable-rate loan has some features that must be understood, including the index rate, the margin or spread, the interest rate caps, and the conversion. The index rate is the financial vehicle the loan is based on. Lenders base adjustable-rate loan rates on a variety of indices, the most common being rates on 1-, 3-, or 5-year Treasury securities. The margin, or spread, is the number of percentage points lenders add to the index rate to determine the borrower’s ultimate interest rate. Interest rate caps are the limits on how much the interest rate payment can change over the life and each single change of the index. Conversion is a clause that allows the buyer to convert the adjustable-rate loan to a fixed-rate mortgage at some designated time.

Private Loans

Many people believe a bank is the only place to get a home loan, but that’s not true. Anyone can make a loan. The good thing about private loans is that they can take the form of any of the other loans: fixed-rate, adjustable-rate, conventional, etc.

Other Financing Types

I previously discussed the common types of home loans and accounted for a majority of all loans made. However, many other loans can be used for other specific situations.

Blanket Loans

A blanket loan is secured by multiple properties as collateral for the loan. This is a great loan for investors who may be buying several properties at once, or it can be used to consolidate several loans into one loan. A partial release of lien is required if you need to sell or refinance one specific property; you can get the lien released from that property with a substantial pay down of the outstanding principal due.

Construction Loans

A construction loan is a short-term, high-interest-rate loan designed to pay for the construction of a new home. It may be offered for a set term, usually 1 year at maximum, to allow you the time to build your home. At the end of the construction process, when the house is done, you need to get a new loan to pay off the construction loan. This is called a permanent loan or take-out loan.

Home-Equity Loans

Home-equity loans allow you to borrow against the equity accrued in your property. These loans appeal to borrowers because they can borrow relatively large amounts of money in a shorter time period. They’re also easier to qualify for than other types of loans because they’re secured by an asset you already own, such as your primary residence. A home-equity loan acts like a second-lien mortgage.

Open-End Loans or Home-Equity Lines of Credit

If you don’t need all the money at once, you can consider a home equity line of credit (HELOC), or open-end loan. This option provides a pool of money you can draw from if and when you need it. You only pay interest on the principal money you’ve actually borrowed and not the entire amount that was approved.

Package Loans

A real estate loan is used to finance the purchase of both real property and personal property, such as a new home plus carpeting, window coverings, and major appliances. Typically, real property is sold via a mortgage, and the personal property is sold via a bill of sale. A package loan allows a borrower to mortgage personal and real property.

DEFINITION

A bill of sale is a document that details, in writing, a sale of goods transferred from one party to another. A typical retail purchase receipt can be considered a bill of sale because it details the specific goods sold to the buyer and the specific price paid.

Purchase Money Mortgages

A purchase money mortgage (PMM) is a mortgage made at the closing table by the seller to help bridge the gap between the total money the seller can bring to the table and a loan acquired from another source. The PMM acts like a second mortgage for the seller and requires the same documents as the primary loan.

Reverse Mortgages

A reverse mortgage is a loan available to homeowners 62 years or older that allows them to convert part of the equity in their homes into cash. The loan is called a reverse mortgage because instead of making monthly payments to a lender, as with a traditional mortgage, the lender makes payments to the borrower. The borrower is not required to pay back the loan until the home is sold, typically upon the death of the owner, or otherwise vacated. The borrower must remain current on property taxes, homeowners’ insurance, and homeowner association dues.

Wraparound Loans

With a wraparound loan, a borrower takes out a second mortgage without paying off the original mortgage. The borrower makes payments on both mortgages to the new lender, called the wraparound lender. The wraparound lender then makes the payments to the original mortgage lender.

Governmental Loans

In most cases, the U.S. government does not actually lend money. Instead, loans are offered by traditional lenders and backed, or insured, by the government. That guarantee reduces the risk for the lenders and makes them more willing to lend at attractive rates and in situations when a borrower might not qualify for a loan otherwise.

Federal Housing Administration Loans

The Federal Housing Administration (FHA), which is part of HUD, doesn’t actually make the loan but rather insures the loan. The typical down payment required is considerably lower than conventional lending practices—currently 3.5 percent. Also, an FHA-insured loan is prohibited from having a prepayment penalty. However, because of the high LTV of the loan, the lender charges a mortgage insurance premium (MIP) that must be paid up front or rolled into the loan. Lenders are allowed to charge origination and discount points to the borrower for the loan as well. If the borrower chooses to use an FHA loan, the house he or she is getting the loan on must be appraised by an FHA-approved appraiser, and the borrower must meet certain credit qualifications set forth by the FHA.

Veterans Affairs Loans

The U.S. Department of Veterans Affairs (VA) is authorized to guarantee loans for eligible individuals. VA home loans are provided by private lenders, such as banks and mortgage companies. The VA guarantees a portion of the loan, enabling the lender to provide more favorable terms. The VA does not require a minimum credit score for a loan, but lenders generally have their own internal requirements. Borrowers must show sufficient income to repay the loan and shouldn’t have excessive debt, but the guidelines are usually more flexible than for conventional loans. A positive feature is that the VA guidelines allow veterans to use their home-loan benefits a year or two after bankruptcy or foreclosure. A VA loan is available only to finance a primary home and cannot be used to purchase or refinance vacation and investment homes. Lenders are required to get proof of a veteran’s service during the VA loan process. The Certificate of Eligibility serves as that proof and tells a lender that an applicant has officially met the minimum service requirements.

DEFINITION

A Certificate of Eligibility certifies that a veteran qualifies for a VA loan by meeting one of these requirements: 181 days of service during peacetime, 90 days of service during war time, or 6 years of service in the Reserves or National Guard. Some surviving spouses of veterans killed in the line of duty are eligible as well.

When a borrower makes an offer on a property using a VA loan, the lender has the property appraised according to their standards. The VA seeks a certificate of reasonable value (CRV) in addition to the bank’s appraisal.

U.S. Department of Agriculture or Rural Loans

U.S. Department of Agriculture (USDA) loans, sometimes called Farmer MAC loans, are mortgages backed by the USDA as part of its USDA Rural Development Guaranteed Housing Loan program. USDA loans are available to home buyers with below-average credit. To qualify for the USDA’s Rural Housing Program, the home must be in a rural area. However, the USDA’s definition of rural is liberal. The two areas where USDA loans are different are with respect to the loan type and down payment amount. With a USDA loan, you don’t have to make a down payment, and you’re required to take a fixed-rate loan. Adjustable-rate mortgages aren’t available via the USDA rural loan program. However, USDA loans require PMI.

Financing Legislation

The federal government regulates financing and lending practices of mortgage lenders through the Truth in Lending Act (TILA), Real Estate Settlement Procedures Act (RESPA), Equal Credit Opportunity Act (ECOA), and the Community Reinvestment Act of 1977 (CRA).

Truth in Lending and Regulation Z

TILA is a federal law designed to promote the informed use of consumer credit by requiring disclosures about its terms and costs to the borrower. The regulations implementing the laws are known as Regulation Z. Effective July 21, 2011, TILA’s general rule-making authority was transferred to the Consumer Financial Protection Bureau (CFPB), whose authority was established pursuant to provisions enacted by the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in July 2010. Under TILA, a borrower must be fully informed of all the charges necessary to finance a loan as well as the true costs associated with the loan before closing. In the case of a lender making a mortgage to finance the purchase of a home, the annual percentage rate (APR) must be disclosed as well.

DEFINITION

Annual percentage rate (APR) is the interest rate of the loan if you include the cost of the loan as part of the calculation.

Regulation Z, or Reg Z, provides for strict regulation of advertising in all media, specifically when pertaining to home loans. General terms may be used, such as terms available; however, if any details are given in the ad, the ad must be complied with in its entirety. Using trigger terms like down payment, financing charges, monthly payment, loan term, or interest rate requires the advertisement to disclose the following as well:

Creditors and Requirements

TILA applies to each individual or business that offers or extends credit when four conditions are met:

  • The credit is offered or extended to consumers.
  • The credit is extended more than 25 times per year or more than 5 times for transactions secured by real property.
  • The credit is subject to a finance charge or is payable by written agreement in more than four installments.
  • The credit is primarily for personal, family, or household purposes.

Credit Fraud and Protection

The Federal Trade Commission (FTC) prohibits credit discrimination based on race, color, religion, national origin, sex, marital status, age, or dependence on public assistance. Creditors may ask you for one or all of these pieces of information, but they may not use it when deciding whether to give you credit, nor can they use it for discrimination when setting the terms of your credit.

Consumer Finance Protection Bureau (CFPB)

In 2014, Congress established the Consumer Financial Protection Bureau (CFPB) through the Dodd-Frank act. The CFPB requires mortgage lenders to provide all borrowers with a pamphlet that explains the information they are required to provide along with their contact information. The pamphlet also must include information on how to initiate a complaint should the lender not be following the rules laid out by the CFPB. The lender must:

The Closing Disclosure and Loan Estimate forms are the result of the new requirements for disclosure, called TILA-RESPA Integrated Disclosure (TRID), also known as the Know Before You Owe (KBYO) mortgage initiative. The new KBYO, or TRID, rules and forms took effect on October 3, 2015.

Foreclosures

A foreclosure is the legal right of a mortgage holder or other third-party lien holder to gain ownership of the property, sell the property, and use the proceeds to pay off the mortgage if the mortgage or lien is in default. Foreclosure proceedings typically start with a formal demand for payment, which is usually a letter issued from the lender. This letter of notice is referred to as a notice of default (NOD).

Types of Foreclosures

The mortgage or lien holder can usually initiate foreclosure any time after a default has been declared by the lending institution. There are several types of foreclosure, including foreclosure by judicial sale, foreclosure by power of sale, and strict foreclosure. The most important type is foreclosure by judicial sale. It involves the sale of the mortgaged property done under the guidance of a court. Non-judicial foreclosure, called foreclosure by power of sale involves the sale of the property by the mortgage holder without the guidance or supervision of a court. Strict foreclosure in another type of foreclosure and is only available in limited states. Under strict foreclosure, when a mortgagor defaults, a court orders the mortgagor to pay the mortgage within a certain time period. If the mortgagor fails to pay, the mortgage holder automatically gains title, with no obligation to sell the property.

Short Sales

A short sale is an option some homeowners use when their mortgage lender provides them with the option of selling their home to a third party at a price that’s much lower than the remaining principal on the loan. Homeowners who are trying to avoid getting caught up in a foreclosure proceeding often opt for short sales.

HELPFUL HINT

Think of a short sale as selling the property short of the outstanding balance owed to the lender.

Two major facets must be considered when a short sale is granted by the lender: deficiency judgment or waiver of deficiency judgment. With deficiency judgment, the homeowner is held liable to pay whatever the difference, called the deficiency, between the short sale amount received and the amount owed on the loan. The waiver of deficiency judgment is the most popular choice among homeowners but it’s the least popular for the lender. The mortgagor isn’t liable for any deficiency created due to the short sale. This means they are free and clear of obligations after their property sells.

The Least You Need to Know

  • A note is a financing instrument for real property; while the mortgage is the document pledging the collateral for the note.
  • Interest is the money you pay to borrow money and usury is an illegal activity charging too much interest.
  • The primary mortgage market provides the bulk of the money used in consumer mortgages, while the secondary mortgage market buys loans in pools from the primary mortgage market.
  • FHA, VA, and USDA are not lenders, but rather are guarantors or insurers of loans made by lenders.
  • Regulation Z, of the truth in lending law, requires lenders to be honest and fair in their advertisements.
  • Foreclosure is the process by which a lender sues to obtain their outstanding loan balance or regain control of a property.