Finance_05 Instructor Materials.docx

5. Finance Instruments Learning Objectives After completing this lesson, students should be able to... Identify the parties to and the basic provisions of a promissory note Distinguish between a straight note and an installment note Explain the purpose of having a security instrument accompany a loa...

5. Finance Instruments Learning Objectives After completing this lesson, students should be able to... Identify the parties to and the basic provisions of a promissory note Distinguish between a straight note and an installment note Explain the purpose of having a security instrument accompany a loan Define hypothecation and its relationship to the possession of property used as collateral Compare the parties involved in a mortgage with those involved in a deed of trust Contrast the advantages of judicial foreclosure and nonjudicial foreclosure Describe the three basic alternatives to foreclosure List typical clauses found in real estate finance instruments and describe their effects Discuss how an alienation clause affects the assumption of a loan Name the major types of mortgage loans and identify their characteristics Suggested Lesson Plan 1. Give students Exercise 5.1 to review the previous chapter, “The Mortgage Industry.” 2. Provide a brief overview of Chapter 5, “Finance Instruments,” and review the learning objectives for the chapter. 3. Present lesson content: Promissory Notes – Basic provisions – Negotiability – Types of notes EXERCISE 5.2 Promissory notes Security Instruments – Purpose – Mortgages – Deeds of trust EXERCISE 5.3 Secured and unsecured creditors Foreclosure – Judicial – Nonjudicial – Alternatives to foreclosure EXERCISE 5.4 Foreclosure methods Finance Instrument Provisions – Subordination – Late charge – Prepayment – Partial release – Acceleration – Alienation and assumption Types of Real Estate Loans EXERCISE 5.5 Buying land for development 4. End lesson with Chapter 5 Quiz. Chapter 5 Outline: Finance Instruments I. Promissory Notes A. A promissory note is basic evidence of a borrower’s legal obligation to pay a debt 1. The debtor (usually a buyer) is the maker of the note; the creditor (the lender) is the payee 2. The note will specify the names of the parties, the amount of debt, the interest rate, and how and when the money will be repaid B. The promissory notes used in real estate loans are negotiable, to facilitate resale of the loans on the secondary market 1. A negotiable instrument is freely transferable by the payee to a third party 2. If a promissory note is endorsed “without recourse,” the original payee will not be liable if the maker fails to make payments to the third party 3. A third party purchaser who buys a promissory note from a payee in good faith is known as a holder in due course C. Types of notes 1. Straight note: required payments are interest only, with a balloon payment at the end of the term 2. Installment note: payments include part of the principal as well as interest EXERCISE 5.2 Promissory notes II. Security Instruments A. A security instrument makes the borrower’s property collateral for the loan and gives the lender the right to foreclose in the event of default 1. Originally, under the theory of hypothecation, a borrower would transfer title to the property as security for the duration of the loan term 2. Now, in most jurisdictions, a mortgage simply creates a lien against the borrower’s property in favor of the lender B. Types of security instruments 1. Mortgage: a two-party security instrument where a borrower (the mortgagor) mortgages his property to the lender (the mortgagee) 2. Deed of trust: a three-party security instrument between the borrower (grantor) and the lender (beneficiary) where a third party (the trustee) holds the power of sale EXERCISE 5.3 Secured and unsecured creditors III. Foreclosure A. Types of foreclosure 1. Judicial foreclosure: a mortgagee files suit against a defaulting borrower, asking the court to order the property sold at a sheriff’s sale to satisfy the unpaid debt 2. Nonjudicial foreclosure: with a deed of trust, the lender does not need to file a lawsuit in the event of default; the trustee will arrange for the sale of the property through a trustee’s sale B. Judicial foreclosure process 1. In some states, the borrower may repay the delinquent amount and reinstate the loan at any point before the court hearing occurs 2. In other states, the borrower can’t reinstate the loan but may pay off the entire loan balance before the sheriff’s sale in order to stop the foreclosure; this is known as the equitable right of redemption 3. If the foreclosure action goes to trial, the judge will usually issue a court order called a writ of execution, ordering the sheriff to seize and sell the property 4. Proceeds from the sheriff’s sale will be used to pay off the mortgage and other liens, with any surplus going to the debtor 5. If the proceeds do not pay off the mortgage and other liens, the lender may also get a deficiency judgment against the borrower for the amount of the shortfall 6. The debtor may have an additional period of time after the sheriff’s sale to redeem the property, known as the statutory right of redemption 7. At the end of the statutory redemption period, the purchaser at the sheriff’s sale receives a sheriff’s deed to the property C. Nonjudicial foreclosure process 1. The trustee will provide notice of default to the borrower and then give notice of a trustee’s sale 2. In the period before the sale, the borrower may reinstate the loan by paying the delinquent amount plus costs 3. A deed of trust borrower does not have the right of redemption; the lender is typically not able to receive a deficiency judgment 4. When the property is sold at the trustee’s sale, title immediately passes to the winning bidder D. Alternatives to foreclosure 1. Loan workouts: the borrower may convince the lender to arrange a repayment plan to pay off past due amounts; alternatively, the borrower may try to convince the lender to modify the terms of the loan 2. Deed in lieu of foreclosure: the borrower can deed the property to the lender to satisfy the debt; if the property is worth less than the amount owed, the borrower may be required to sign a promissory note for the difference 3. Short sale: the borrower may obtain the lender’s consent to sell the home for what it will bring on the open market (usually something “short” of the full amount owed); the lender receives the sale proceeds and releases the borrower from the debt 4. Obtaining lender consent: the borrower may have to be at least 90 days behind on payments and prove financial hardship by filling out an application and providing copies of bank statements, pay stubs, and bills 5. Income tax implications: generally, borrowers receiving a reduction of debt are liable to the IRS for income taxes on the debt relief (this rule doesn’t apply to debt relief made between 2007-2017 on principal residences) EXERCISE 5.4 Foreclosure methods IV. Finance Instrument Provisions A. Subordination clause: allows an instrument recorded later to take priority over an earlier recorded instrument B. Late charge provision: adds a late fee to overdue payments C. Prepayment provision: may impose a penalty if the borrower repays some or all of the principal before it is due, in order to compensate the lender for lost interest D. Partial release clause: in a security instrument covering multiple parcels, provides for the release of part of the security property when part of the debt has been paid E. Acceleration clause: allows lender to declare the entire loan balance immediately due if the borrower defaults F. Alienation clause and assumption: “due on sale” clause limits the borrower’s right to transfer the property without the lender’s permission unless the loan is paid off first 1. If loan isn’t paid off, the new owner may take title subject to existing liens; the lender will retain the power to foreclose on the property 2. Alternately, the new owner may assume the loan; the new owner will take on responsibility for paying the loan while the former owner retains secondary liability 3. If the lender approves an assumption, it may charge an assumption fee or reset the interest rate V. Types of Real Estate Loans A. Junior or senior mortgage: a senior mortgage has first lien position, while a junior mortgage has lower lien priority B. Purchase money mortgage: in its narrower sense, a mortgage that a buyer gives to a seller in a seller-financed transaction C. Home equity loan: a loan using property that the borrower already owns as collateral D. Refinance mortgage: a new mortgage used to replace an existing mortgage on the same property, often used by borrowers when interest rates drop E. Bridge loan: a temporary loan used by buyers to purchase a new home before the sale of their old home closes F. Budget mortgage: a mortgage where payments include not only principal and interest, but also real estate taxes and insurance G. Package mortgage: a mortgage that covers the purchase of both real property and personal property (such as fixtures or equipment) H. Bi-weekly mortgage: a mortgage that requires a payment every two weeks instead of once a month I. Blanket mortgage: a mortgage containing a partial release clause that uses multiple properties as collateral J. Construction loan: a short-term loan used to finance construction of improvements on land already owned by the borrower K. Nonrecourse mortgage: a mortgage that does not allow for a deficiency judgment against the borrower; the lender’s only remedy is foreclosure L. Participation mortgage: a mortgage where the lender receives a percentage of earnings generated by the property as well as interest payments M. Shared appreciation mortgage: a mortgage where a lender is entitled to a portion of any increase in the property’s value N. Wraparound mortgage: a buyer’s new mortgage that includes or “wraps around” an existing mortgage; also called an all-inclusive deed of trust O. Reverse mortgage: a mortgage where the borrower (usually an older person) receives a lump sum, line of credit, or monthly payments; the home will typically be sold when the owner dies in order to satisfy the debt EXERCISE 5.5 Buying land for development Exercises EXERCISE 5.1 Review exercise To review Chapter 4, “The Mortgage Industry,” read the following True/False questions aloud to students and have them jot their answers down on a piece of paper; discuss the answers together. 1. Mortgage companies usually sell their loans on the secondary market, rather than keeping them in portfolio. 2. The four main types of residential lenders are commercial banks, thrift institutions, credit unions, and mortgage brokers. 3. Wholesale lending refers to pooling loans for sale as mortgage-backed securities. 4. An important alternative source of funding for residential loans is seller financing. 5. A loan originator makes the underwriting decision, approving or rejecting the buyer’s loan application. Answers: 1. TRUE. Mortgage companies typically sell their loans to secondary market investors. 2. FALSE. Mortgage brokers aren’t lenders, but rather intermediaries who bring together borrowers and lenders in exchange for a commission. 3. FALSE. While the loans may ultimately be securitized, wholesale lending involves large institutional lenders who make loans through a broker or loan correspondent. 4. TRUE. Seller financing can be especially important during periods of high interest rates. 5. FALSE. A loan originator is an intermediary who connects a borrower with a lender for a commission, but does not underwrite or approve the loan. EXERCISE 5.2 Promissory notes Match each of the following terms to one of the descriptions below. Holder in due course Installment note Negotiable instrument Without recourse Straight note 1. A written, unconditional promise to pay a certain sum of money on demand or by a certain date, payable to the order of the payee or to the bearer. 2. Periodic payments cover interest only. 3. Debt may be fully amortized to pay off principal by maturity date. 4. Someone who bought a note in good faith, without notice of defenses against it. 5. Prevents liability for the payee endorsing the instrument. Answers: 1. NEGOTIABLE INSTRUMENT. This is the definition of a negotiable instrument under the Uniform Commercial Code. Promissory notes used for real estate loans generally meet this definition—otherwise, it would be difficult to sell the loans on the secondary market. 2. STRAIGHT NOTE. With a straight note, the payments required during the term only cover interest, and the principal is due as a lump sum on the maturity date. 3. INSTALLMENT NOTE. An installment note calls for payments that include principal as well as interest. If the debt is fully amortized, the regular installment payments will pay off all of the principal and interest by the end of the repayment period. 4. HOLDER IN DUE COURSE. A third party who buys a negotiable instrument is a holder in due course if she purchases it for value, in good faith, and without notice of defenses. 5. WITHOUT RECOURSE. A payee can endorse a note “without recourse,” which means that if the holder has trouble collecting from the maker, the holder can’t sue the original payee for payment. EXERCISE 5.3 Secured and unsecured creditors Discussion Prompt: Harold borrowed $20,000 from Teresa and $20,000 from Ivan. For each loan, he signed a promissory note, agreeing to repay the money on specified terms. Teresa also required Harold to sign a mortgage, creating a lien in her favor against his house. Ivan didn’t do that. If Harold failed to pay Teresa, what legal recourse would she have? If Harold failed to pay Ivan, what legal recourse would Ivan have? Which creditor is in a better position, and why? Analysis: The mortgage makes Teresa a secured creditor. In other words, her lien is a security interest in Harold’s house. Ivan, on the other hand, is an unsecured creditor. If Harold doesn’t repay the loans as agreed, Teresa has a better chance than Ivan of collecting from Harold. If Harold failed to pay Teresa as agreed, she could foreclose on her lien instead of suing based on the promissory note. In the foreclosure proceedings, the court would order Harold’s house to be sold, and Teresa would be repaid from the sale proceeds. If Harold didn’t pay Ivan as agreed, Ivan could sue Harold based on his promissory note. The court would issue a judgment against Harold in favor of Ivan. The judgment would create a general lien against Harold’s property. If Harold didn’t pay Ivan’s judgment, Ivan could foreclose on the judgment lien. In the foreclosure proceedings, the court would order Harold’s property sold, and Ivan would be repaid from the sale proceeds. Since Ivan could eventually get a judgment lien, why is his position less favorable than Teresa’s? Because Harold won’t necessarily own any property at the time a court issues a judgment in Ivan’s favor. He might have lost everything, or he might have deliberately disposed of his property to evade creditors’ claims. In that case, there would be nothing for Ivan’s judgment lien to attach to, nothing for him to foreclose on. Harold would be “judgment proof.” Although Harold would still have a legal obligation to pay Ivan, it might be very difficult to force him to do so. If Harold had a job, Ivan could garnish his wages; but with a garnishment, Ivan would probably get paid back very slowly. And Harold might not even have a job. Because Teresa got her lien (established her security interest) at the outset, when she made the loan—and at a time when Harold owned property—she can be significantly more confident that Harold will eventually be forced to pay her back. If Harold sells his house, he will have to pay off the liens against it (including Teresa’s) out of the sale proceeds in order to deliver clear title to the buyer. Also note that secured creditors are generally paid before unsecured creditors in bankruptcy proceedings. So Teresa would also be in a better position than Ivan if Harold declared bankruptcy. EXERCISE 5.4 Foreclosure methods Discussion Prompt: Parched Gulch Bank holds a deed of trust on the Nguyens’ land. The Nguyens still owe $250,000 on the loan and have been in default on their payments for six months. Parched Gulch is preparing to foreclose, but it estimates that the property will bring no more than $200,000 in a foreclosure sale. Should Parched Gulch pursue a judicial foreclosure or a nonjudicial foreclosure? Analysis: Nonjudicial foreclosure is generally quicker and cheaper, so Parched Gulch might choose to go that route. On the other hand, a deficiency judgment generally isn’t allowed after a nonjudicial foreclosure. Since the foreclosure sale proceeds will probably fall well short of the amount the Nguyens owe, the bank may choose judicial foreclosure and ask the court for a personal judgment against the Nguyens to make up the deficiency. Whether that would be worthwhile depends on the circumstances. For example, if the Nguyens are solidly employed, they may eventually be able to pay off a deficiency judgment. EXERCISE 5.5 Buying land for development Discussion Prompt: Some developers are buying a 10-acre parcel of land. They’re planning to eventually subdivide it into 20 lots, build a home on each one, and then sell the lots individually. When they borrow money to buy the land, what two special provisions should the developers make sure are included in the security instrument? Explain why each provision is needed. Analysis: The two provisions are a subordination clause and a partial release clause. Subordination clause: Because construction loans are considered somewhat risky, lenders generally require them to have first lien position. So when land is purchased for development, the mortgage or deed of trust securing the purchase loan should include a subordination clause. The subordination clause provides that the security instrument for the land purchase loan will have lower lien priority than the security instrument for a later loan to finance the construction (even though the documents for that loan will be executed and recorded after the security instrument for the land loan). Partial release clause: Since the developers will eventually sell individual lots to home buyers, the security instrument for the land purchase loan should include a partial release clause. This will permit lots to be released from the lien once specified amounts of the principal have been repaid. The developers will be able to convey each lot unencumbered by the lien for the land purchase loan. Chapter 5 Quiz 1. In a deed of trust, the lender is referred to as the: A. grantor B. beneficiary C. trustee D. trustor 2. The Duncans bought their home a few years ago with a conventional loan. Now they’re selling the property to a buyer who wants to assume the loan. The lender could: A. accept the assumption without changing the terms of the loan B. accept the assumption but raise the interest rate to the current market level C. refuse to allow the assumption and accelerate the loan, exercising the due-on-sale clause D. Any of the above 3. In a real estate transaction, a promissory note is accompanied by a: A. negotiable instrument B. bond C. security instrument D. cashier’s check 4. The interest paid on a real estate loan is almost always: A. compound B. variable C. simple D. None of the above 5. In a mortgage, the mortgagor promises to do all of the following, except: A. pay the property taxes B. maintain the structures in good repair C. grant access easements to neighboring properties D. keep the property insured against fire and other hazards 6. Borrowers are more inclined to refinance when: A. market interest rates drop B. a large balloon payment is due on the existing mortgage C. a large downpayment is required D. Both A and B 7. A mortgage or deed of trust gives the lender the right to: A. foreclose B. enter the property C. sell the property D. None of the above 8. If the maker of a note is able to raise defenses against the original payee, the holder in due course: A. may not receive payments on the note B. must challenge the maker’s defenses before receiving payment on the note C. must be paid by the maker D. may demand payment from the payee 9. The payments under a straight note are made up of: A. principal only B. principal and interest C. interest only D. interest only for the first payment period and principal only after the first payment period 10. A mortgage must contain all of the following, except: A. the names of the parties B. an accurate legal description of the property C. the amount of the downpayment D. an identification of the promissory note 11. To be a holder in due course, a third party purchaser of a negotiable instrument: A. may buy the instrument for less than market value B. must have notice of any defenses against payment of the instrument C. may purchase the instrument in bad faith D. None of the above 12. Which of the following statements is not true? A. A security instrument makes the property the collateral for a loan B. A lender cannot enforce a promissory note without a security instrument C. The lender has the right to foreclose under a security instrument D. A deed of trust is an example of a security instrument 13. In a deed of trust, the role of the trustee is to: A. hold funds in trust on behalf of the borrower B. arrange for the release of the lien when the loan is paid off C. conduct foreclosure proceedings in the event that the borrower defaults D. Both B and C 14. When construction is finished, a construction loan is often replaced by a: A. take-out loan B. nonrecourse mortgage C. package mortgage D. bridge loan 15. A lis pendens is recorded by the mortgagee in order to: A. establish lien priority for the deed of trust B. trigger the right of statutory redemption C. provide public notice of the foreclosure action pending against the property D. All of the above Answer Key 1. B. A deed of trust involves three parties. The lender is the beneficiary of the deed, the borrower is the trustor (or grantor) and there is an independent third party who is the trustee. 2. D. Conventional loan agreements usually contain an alienation (due-on-sale) clause that allows a lender to call in the loan if the borrower sells the property. However, the lender also has the option of allowing the new buyer to assume the previous loan on the original terms of the loan or at an increased interest rate. 3. C. A promissory note used for a real estate transaction is almost always accompanied by a security instrument, either a mortgage or a deed of trust. 4. C. Most real estate loans are simple interest loans, which means that the interest is computed annually on the remaining principal balance. Compound interest is computed on the principal amount plus the accrued interest. 5. C. A mortgagor promises to pay property taxes, keep the property insured against hazards, and to maintain any structures in good repair. 6. D. When market interest rates drop, borrowers often choose to refinance to take advantage of the lower rates. If the payoff date for an existing mortgage is approaching and a large balloon payment is required, borrowers often refinance in order to be able to pay the balloon payment. 7. A. A security instrument, such as a mortgage or deed of trust, gives the lender the right to foreclose on the property if the borrower doesn’t repay the loan. 8. C. The maker of a note is required to pay a holder in due course even if the maker could raise defenses against the original payee. 9. C. The required payments under a straight note are interest only, and the full amount of the principal is due in a lump sum on the maturity date of the note. 10. C. A valid mortgage must contain the names of the parties, an accurate legal description of the property to be mortgaged, and an identification of the promissory note it secures. 11. D. A holder in due course has purchased a negotiable instrument for value, in good faith, and without notice of any defenses against the instrument. 12. B. A lender can enforce a promissory note even if the borrower has not executed a security instrument. The lender files a lawsuit against the borrower to obtain a judgment against the borrower, but cannot foreclose on the property purchased by the borrower. 13. D. The trustee is an independent third party who arranges for the property to be released from the deed of trust when the loan is paid off or arranges for the foreclosure of the property if the borrower defaults. 14. A. A take-out loan is the permanent financing that replaces a construction loan after construction has been completed. The borrower repays the amount borrowed, plus interest, over a specified term, much like an ordinary mortgage. 15. C. When the mortgagee files the foreclosure action, he also records a lis pendens to provide constructive notice to the public that the title might be affected by the pending lawsuit.