Finance Instruments PDF

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...

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. © 2018 Rockwell Publishing  Financing Residential Real Estate Instructor Materials 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  Chapter 5: Finance Instruments 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 borrow- er’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 3  Financing Residential Real Estate Instructor Materials 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 re- deem 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 typi- cally 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 4  Chapter 5: Finance Instruments 5. Income tax implications: generally, borrowers receiving a reduction of debt are li- able 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 re- sponsibility 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) 5  Financing Residential Real Estate Instructor Materials 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 earn- ings 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. 6  Chapter 5: Finance Instruments 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 to- gether 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 gen- erally 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. 7  Financing Residential Real Estate Instructor Materials 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 speci- fied 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 credi- tor. 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 promis- sory 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 8  Chapter 5: Finance Instruments 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 Te- resa’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 Nguy- ens 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. 9  Financing Residential Real Estate Instructor Materials 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 speci- fied 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. 10  Chapter 5: Finance Instruments Chapter 5 Quiz 1. In a deed of trust, the lender is referred to as 6. Borrowers are more inclined to refinance the: when: A. grantor A. market interest rates drop B. beneficiary B. a large balloon payment is due on the exist- C. trustee ing mortgage D. trustor C. a large downpayment is required D. Both A and B 2. The Duncans bought their home a few years ago with a conventional loan. Now they’re selling 7. A mortgage or deed of trust gives the lender the property to a buyer who wants to assume the right to: the loan. The lender could: A. foreclose A. accept the assumption without changing the B. enter the property terms of the loan C. sell the property B. accept the assumption but raise the interest D. None of the above rate to the current market level C. refuse to allow the assumption and accel- 8. If the maker of a note is able to raise defenses erate the loan, exercising the due-on-sale against the original payee, the holder in due clause course: D. Any of the above A. may not receive payments on the note B. must challenge the maker’s defenses before 3. In a real estate transaction, a promissory note receiving payment on the note is accompanied by a: C. must be paid by the maker A. negotiable instrument D. may demand payment from the payee B. bond C. security instrument 9. The payments under a straight note are made D. cashier’s check up of: A. principal only 4. The interest paid on a real estate loan is almost B. principal and interest always: C. interest only A. compound D. interest only for the first payment period B. variable and principal only after the first payment C. simple period D. None of the above 10. A mortgage must contain all of the following, 5. In a mortgage, the mortgagor promises to do all except: of the following, except: A. the names of the parties A. pay the property taxes B. an accurate legal description of the prop- B. maintain the structures in good repair erty C. grant access easements to neighboring C. the amount of the downpayment properties D. an identification of the promissory note D. keep the property insured against fire and other hazards 11  Financing Residential Real Estate Instructor Materials 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 bor- rower 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 12  Chapter 5: Finance Instruments Answer Key 1. B. A deed of trust involves three parties. 7. A. A security instrument, such as a mort- The lender is the beneficiary of the gage or deed of trust, gives the lender deed, the borrower is the trustor (or the right to foreclose on the property if grantor) and there is an independent the borrower doesn’t repay the loan. third party who is the trustee. 8. C. The maker of a note is required to 2. D. Conventional loan agreements usually pay a holder in due course even if the contain an alienation (due-on-sale) maker could raise defenses against the clause that allows a lender to call in original payee. the loan if the borrower sells the prop- erty. However, the lender also has the 9. C. The required payments under a straight option of allowing the new buyer to note are interest only, and the full assume the previous loan on the origi- amount of the principal is due in a nal terms of the loan or at an increased lump sum on the maturity date of the interest rate. note. 3. C. A promissory note used for a real estate 10. C. A valid mortgage must contain the transaction is almost always accompa- names of the parties, an accurate le- nied by a security instrument, either a gal description of the property to be mortgage or a deed of trust. mortgaged, and an identification of the promissory note it secures. 4. C. Most real estate loans are simple inter- est loans, which means that the interest 11. D. A holder in due course has purchased is computed annually on the remaining a negotiable instrument for value, in principal balance. Compound interest is good faith, and without notice of any computed on the principal amount plus defenses against the instrument. the accrued interest. 12. B. A lender can enforce a promissory note 5. C. A mortgagor promises to pay prop- even if the borrower has not executed a erty taxes, keep the property insured security instrument. The lender files a against hazards, and to maintain any lawsuit against the borrower to obtain a structures in good repair. judgment against the borrower, but can- not foreclose on the property purchased 6. D. When market interest rates drop, bor- by the borrower. rowers often choose to refinance to take advantage of the lower rates. 13. D. The trustee is an independent third par- If the payoff date for an existing ty who arranges for the property to be mortgage is approaching and a large released from the deed of trust when balloon payment is required, borrow- the loan is paid off or arranges for the ers often refinance in order to be able foreclosure of the property if the bor- to pay the balloon payment. rower defaults. 13  Financing Residential Real Estate Instructor Materials 14. A. A take-out loan is the permanent financing that replaces a construc- tion 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 fore- closure action, he also records a lis pendens to provide constructive notice to the public that the title might be af- fected by the pending lawsuit. 14  Chapter 5: Finance Instruments PowerPoint Thumbnails Use the following thumbnails of our PowerPoint presentation to make your lecture notes. Financing Residential Real Estate Lesson 5: Finance Instruments © 2018 Rockwell Publishing Introduction This lesson will cover: ⚫ types of finance instruments ⚫ how instruments work ⚫ common provisions © 2018 Rockwell Publishing Promissory Notes Promissory note: 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. © 2018 Rockwell Publishing 15  Financing Residential Real Estate Instructor Materials Promissory Notes Basic provisions Can be brief, simple document. Usually contains: ⚫ names of parties ⚫ amount of debt ⚫ interest rate ⚫ how/when money is to be repaid © 2018 Rockwell Publishing Promissory Notes Basic provisions Must be signed by maker. If certain requirements are met, it’s a negotiable instrument: right to receive payment can be transferred by endorsement. © 2018 Rockwell Publishing Promissory Notes Negotiability Negotiable instrument requirements: ⚫ written, unconditional promise ⚫ to pay a certain sum of money ⚫ on demand or on a certain date ⚫ payable to order or to bearer ⚫ signed by maker © 2018 Rockwell Publishing 16  Chapter 5: Finance Instruments Promissory Notes Without recourse “Without recourse” endorsement: issue of future payment strictly between maker and third party the instrument is endorsed to. ⚫ Original payee not liable if maker fails to pay. © 2018 Rockwell Publishing Promissory Notes Holder in due course Holder in due course: someone who buys negotiable instrument: ⚫ for value ⚫ in good faith ⚫ without notice of defenses Even if maker has defense against original payee, maker still required to pay holder in due course. © 2018 Rockwell Publishing Promissory Notes Types of notes Promissory notes classified as to how principal and interest are paid off. ⚫ Straight note: periodic payments are interest only, with principal due on maturity date. ⚫ Installment note: periodic payments include both principal and interest. © 2018 Rockwell Publishing 17  Financing Residential Real Estate Instructor Materials Summary Promissory Notes Maker Payee Negotiable instrument Without recourse Holder in due course Straight note Installment note © 2018 Rockwell Publishing Security Instruments Purpose In real estate transactions, promissory note is accompanied by security instrument: ⚫ mortgage ⚫ deed of trust Gives lender security interest in property, enabling lender to foreclose if borrower defaults. © 2018 Rockwell Publishing Security Instruments Purpose If no collateral, lender can still enforce promissory note. ⚫ Lender sues borrower, obtains judgment. ⚫ But borrower may be “judgment-proof.” Secured lender much more likely to collect payment. © 2018 Rockwell Publishing 18  Chapter 5: Finance Instruments Security Instruments Historical background Personal property used as collateral for early forms of secured lending. ⚫ Borrower gave lender possession of collateral property until loan repaid. ⚫ Lender kept property if loan wasn’t repaid. © 2018 Rockwell Publishing Security Instruments Historical background Hypothecation: pledging property as collateral without giving up possession of it. ⚫ For real property loans, became standard arrangement for borrower to retain possession of land. ⚫ Lender held title until debt repaid. © 2018 Rockwell Publishing Security Instruments Historical background Legal title: title transferred only as collateral, without possessory rights. Equitable title: property rights retained by borrower, without legal title. © 2018 Rockwell Publishing 19  Financing Residential Real Estate Instructor Materials Security Instruments Historical background Eventually, transfer of legal title wasn’t necessary. More common to place lien against borrower’s property. Lien: financial encumbrance on owner’s title, allowing lienholder to foreclose on property to collect debt. © 2018 Rockwell Publishing Security Instruments Mortgage Two-party security instrument in which borrower mortgages his property to lender. ⚫ Mortgagor = borrower ⚫ Mortgagee = lender © 2018 Rockwell Publishing Mortgages Basic provisions Mortgage must include: ⚫ names of parties ⚫ accurate legal description of property Also must identify promissory note it secures. © 2018 Rockwell Publishing 20  Chapter 5: Finance Instruments Mortgages Covenants Mortgagor promises to: ⚫ pay property taxes ⚫ keep property insured against fire and other hazards ⚫ maintain structures in good repair Mortgagee has right to inspect property. © 2018 Rockwell Publishing Mortgages Satisfaction Satisfaction of mortgage: document given to mortgagor by mortgagee after mortgage is paid off, releasing property from lien. ⚫ Mortgagor records document. © 2018 Rockwell Publishing Security Instruments Deed of trust Similar to mortgage, but involves three parties, rather than two. ⚫ Grantor/trustor = borrower ⚫ Beneficiary = lender ⚫ Trustee = neutral third party Trustee arranges for release of property or foreclosure, as necessary. © 2018 Rockwell Publishing 21  Financing Residential Real Estate Instructor Materials Deed of Trust Basic provisions Deed of trust usually includes same basic provisions found in mortgage: ⚫ names of parties ⚫ property description ⚫ identification of promissory note ⚫ grantor’s promises to pay taxes and insure property ⚫ beneficiary’s right to inspect property © 2018 Rockwell Publishing Deed of Trust Reconveyance Deed of reconveyance: document releasing property from lien, executed by trustee when loan is paid off. ⚫ Recorded by grantor. © 2018 Rockwell Publishing Summary Security Instruments Hypothecation Legal title Equitable title Lien Mortgage Satisfaction of mortgage Deed of trust Deed of reconveyance © 2018 Rockwell Publishing 22  Chapter 5: Finance Instruments Security Instruments Foreclosure Key difference between deeds of trust and mortgages: procedures used for foreclosure. © 2018 Rockwell Publishing Foreclosure Methods 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. © 2018 Rockwell Publishing Methods of Foreclosure Judicial vs. nonjudicial 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. © 2018 Rockwell Publishing 23  Financing Residential Real Estate Instructor Materials Methods of Foreclosure Power of sale Nonjudicial foreclosure requires power of sale clause in security instrument. Power of sale clause: authorizes trustee to sell property in event of default. ⚫ All deeds of trust contain one. ⚫ May be included in mortgage, but usually not. © 2018 Rockwell Publishing Methods of Foreclosure Judicial foreclosure Judicial foreclosure used when: ⚫ state law doesn’t allow nonjudicial foreclosure ⚫ there’s no power of sale clause in security instrument ⚫ circumstances make it better choice for lender © 2018 Rockwell Publishing Judicial Foreclosure Steps in judicial foreclosure 1. Acceleration of debt 2. Foreclosure lawsuit 3. Equitable redemption or cure and reinstatement 4. Writ of execution 5. Sheriff’s sale 6. Statutory redemption 7. Sheriff’s deed © 2018 Rockwell Publishing 24  Chapter 5: Finance Instruments Judicial Foreclosure Steps Acceleration and lawsuit 1. Acceleration of debt: if mortgagor defaults, mortgagee notifies mortgagor that entire outstanding loan balance is due. 2. Foreclosure lawsuit: unless mortgagor pays off accelerated debt, mortgagee files foreclosure action. © 2018 Rockwell Publishing Judicial Foreclosure Steps Stopping a pending foreclosure 3. Equitable redemption vs. cure & reinstatement: while lawsuit is pending, mortgagor has right to stop proceedings by paying mortgagee. ⚫ Depending on state law, may be: ⚫ equitable right of redemption, or ⚫ right to cure and reinstate. © 2018 Rockwell Publishing Judicial Foreclosure Steps Stopping a pending foreclosure Equitable right of redemption: mortgagor’s right to stop proceedings by paying entire amount owed, plus costs. ⚫ Loan is paid off and property is redeemed. © 2018 Rockwell Publishing 25  Financing Residential Real Estate Instructor Materials Judicial Foreclosure Steps Stopping a pending foreclosure Cure and reinstatement: mortgagor may “cure” default by paying just delinquent amount plus costs. ⚫ Foreclosure proceedings terminate and loan is reinstated. © 2018 Rockwell Publishing Judicial Foreclosure Steps Court order 4. Writ of execution: if loan not cured or redeemed, judge schedules hearing to determine if default exists. ⚫ If so, judge issues writ of execution. ⚫ Directs sheriff to seize and sell property. © 2018 Rockwell Publishing Judicial Foreclosure Steps Sale of property 5. Sheriff’s sale: public auction where property is sold to highest bidder. ⚫ Purchaser given certificate of sale. ⚫ Proceeds of sale pay costs and debt. © 2018 Rockwell Publishing 26  Chapter 5: Finance Instruments Judicial Foreclosure Steps Sale of property If proceeds aren’t enough to pay off foreclosed mortgage, court may award deficiency judgment against debtor for amount of deficiency. © 2018 Rockwell Publishing Judicial Foreclosure Steps After sheriff’s sale 6. Statutory right of redemption: additional period after sheriff’s sale to redeem property. ⚫ Must pay purchaser amount paid at auction, plus interest. ⚫ Many states do not allow; states that do limit period to 6 months - 2 years. © 2018 Rockwell Publishing Judicial Foreclosure Steps Rights of sheriff’s sale purchaser 7. Sheriff’s deed given to purchaser at end of redemption period. ⚫ State law may allow purchaser to: ⚫ take possession of property immediately, or ⚫ collect rent from debtor during redemption period. © 2018 Rockwell Publishing 27  Financing Residential Real Estate Instructor Materials Nonjudicial Foreclosure Steps 1. Notice of default 2. Notice of sale 3. Cure and reinstatement 4. Trustee’s sale 5. Trustee’s deed © 2018 Rockwell Publishing Nonjudicial Foreclosure Steps Notice to borrower 1. Notice of default: to begin, trustee must give notice of default to grantor. 2. Notice of sale: trustee must wait certain time after notice of default before issuing notice of sale. Usually 3 to 6 months. © 2018 Rockwell Publishing Nonjudicial Foreclosure Steps Stopping the foreclosure 3. Cure and reinstatement: grantor allowed to cure default and reinstate loan by paying delinquent amounts plus costs. ⚫ Right ends shortly before trustee’s sale. ⚫ No right of redemption after trustee’s sale. © 2018 Rockwell Publishing 28  Chapter 5: Finance Instruments Nonjudicial Foreclosure Steps Sale of property 4. Trustee’s sale: like sheriff’s sale, trustee’s sale is public auction. ⚫ Proceeds first applied to costs, then to debt, then junior liens. © 2018 Rockwell Publishing Nonjudicial Foreclosure Steps No redemption period 5. Trustee’s deed: highest bidder receives trustee’s deed immediately after sale. ⚫ Debtor’s title terminates immediately. ⚫ Must vacate property within short period (such as 30 days). © 2018 Rockwell Publishing Nonjudicial Foreclosure Restrictions State law may place restrictions on nonjudicial foreclosures, such as: ⚫ requiring post-sale redemption period for agricultural property ⚫ prohibiting beneficiary from obtaining deficiency judgment after sale © 2018 Rockwell Publishing 29  Financing Residential Real Estate Instructor Materials Judicial vs. Nonjudicial Lender’s point of view Judicial foreclosure advantages: ⚫ borrower can’t reinstate loan ⚫ right to deficiency judgment Nonjudicial foreclosure advantages: ⚫ quick and inexpensive © 2018 Rockwell Publishing Judicial vs. Nonjudicial Borrower’s point of view Judicial foreclosure advantages: ⚫ slow process ⚫ post-sale redemption Nonjudicial foreclosure advantages: ⚫ right to cure and reinstate © 2018 Rockwell Publishing 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 © 2018 Rockwell Publishing 30  Chapter 5: Finance Instruments Alternatives to Foreclosure Three alternatives allow borrowers who can no longer make payments to avoid foreclosure: ⚫ loan workout ⚫ deed in lieu ⚫ short sale © 2018 Rockwell Publishing Alternatives to Foreclosure Lender’s consent needed All three alternatives require lender’s consent. Lender’s incentives to cooperate: ⚫ avoiding foreclosure costs ⚫ ending money-losing situation more quickly © 2018 Rockwell Publishing Alternatives to Foreclosure Workouts First step for borrower hoping to avoid foreclosure: asking lender for loan workout. ⚫ Borrower will need to demonstrate inability to make current payments. Two types of workouts: ⚫ repayment plan ⚫ loan modification © 2018 Rockwell Publishing 31  Financing Residential Real Estate Instructor Materials Workouts Repayment plans / loan modifications With repayment plan, lender allows borrower to change timing of limited number of payments. Borrower in more dire situation may need loan modification: permanent change in terms of repayment (like reduced principal or interest rate). © 2018 Rockwell Publishing Alternatives to Foreclosure Deed in lieu of foreclosure If borrower can’t negotiate workout and will lose property anyway, can offer lender deed in lieu. If lender accepts deed in lieu: ⚫ borrower deeds property to lender ⚫ debt satisfied © 2018 Rockwell Publishing Deed in Lieu of Foreclosure Settlement of debt Lender agrees to release borrower even though property is usually worth less than amount owed. ⚫ Lender could require borrower to sign promissory note for shortfall, but that isn’t typical. © 2018 Rockwell Publishing 32  Chapter 5: Finance Instruments Deed in Lieu of Foreclosure Impact on borrower Compared to foreclosure, deed in lieu is: ⚫ simpler ⚫ less public Borrower’s credit rating suffers almost as much as from foreclosure. © 2018 Rockwell Publishing Deed in Lieu of Foreclosure Junior liens Lender takes title subject to other liens. ⚫ Not like foreclosure, which extinguishes junior liens. © 2018 Rockwell Publishing Alternatives to Foreclosure Short sales Short sale: when borrower sells property to third party for less than amount owed. ⚫ Borrower facing foreclosure may ask lender to approve short sale. ⚫ If lender approves buyer, lender receives sale proceeds and releases lien. © 2018 Rockwell Publishing 33  Financing Residential Real Estate Instructor Materials Short Sales Junior liens Like ordinary sale, short sale doesn’t extinguish junior liens. ⚫ If there are junior liens, short sale must be approved by all lienholders. ⚫ Junior lienholders unlikely to consent. © 2018 Rockwell Publishing Alternatives to Foreclosure Obtaining lender’s consent To arrange workout, deed in lieu, or short sale, borrower contacts loan servicer. ⚫ May need approval from more than one department or entity. © 2018 Rockwell Publishing Obtaining Lender’s Consent Assistance for borrowers Borrower wanting help with process for modification or other alternatives should contact nonprofit HUD-approved housing counseling service. ⚫ Problems with predatory for-profit loan modification companies. ⚫ Many states now have “distressed property laws” regulating them. © 2018 Rockwell Publishing 34  Chapter 5: Finance Instruments Obtaining Lender’s Consent Securitized loans If loan has been securitized, it’s difficult to obtain consent. ⚫ Under some MBS contracts, any purchaser (investor) can object and prevent loan modification or settlement. ⚫ Impractical to obtain consent of all investors. © 2018 Rockwell Publishing Alternatives to Foreclosure Income tax implications Generally, IRS views debt relief (reduction in amount owed) as income. ⚫ Borrower who enters arrangement reducing amount owed may have to pay income tax on debt relief. © 2018 Rockwell Publishing Alternatives to Foreclosure Income tax implications Exceptions: debt relief not taxed if: ⚫ debt was secured by principal residence and forgiven between 2007-2017 ⚫ debtor was insolvent when debt forgiven © 2018 Rockwell Publishing 35  Financing Residential Real Estate Instructor Materials Summary Alternatives to Foreclosure Loan workout Repayment plan Loan modification Deed in lieu Short sale Housing counseling service Distressed property laws Debt relief © 2018 Rockwell Publishing 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 ⚫ alienation clause © 2018 Rockwell Publishing Finance Instrument Provisions Subordination clauses Subordination clause: gives a mortgage lower priority than another mortgage that will be recorded later on. ⚫ Common in construction financing. © 2018 Rockwell Publishing 36  Chapter 5: Finance Instruments Finance Instrument Provisions Late charge provisions Promissory notes usually provide for late charges if borrower doesn’t make payments on time. State laws may override late charge provision, to protect borrowers from excessive charges. © 2018 Rockwell Publishing Finance Instrument Provisions Prepayment provisions Prepayment provision: imposes penalty on borrower who repays some or all of principal before due. Prepayment deprives lender of some of interest it expected to receive over loan term. © 2018 Rockwell Publishing Finance Instrument Provisions Prepayment provisions Most residential loan agreements don’t have. ⚫ Mortgages with prepayment penalties aren’t eligible for sale to Fannie Mae/Freddie Mac. ⚫ Prepayment penalties prohibited with FHA and VA loans. ⚫ Dodd-Frank Act places restrictions on prepayment penalties. © 2018 Rockwell Publishing 37  Financing Residential Real Estate Instructor Materials Finance Instrument Provisions Partial release clauses Partial release clause: obligates lender to release part of property from lien when part of debt is paid. ⚫ Typically found in deed of trust or mortgage that covers subdivision, allowing release of individual lot from lien when lot is sold. © 2018 Rockwell Publishing Finance Instrument Provisions Acceleration clauses Acceleration clause: allows lender to declare outstanding loan balance due immediately in event of default. ⚫ Most lenders wait 90 days before accelerating. ⚫ Some states now have laws requiring specific waiting period. © 2018 Rockwell Publishing Finance Instrument Provisions Alienation clauses Alienation clause: prevents borrower from selling security property without lender’s permission unless loan paid off at closing. ⚫ If title transferred without permission, lender can accelerate loan. ⚫ Also called due-on-sale clause. © 2018 Rockwell Publishing 38  Chapter 5: Finance Instruments Alienation Clauses Triggered by transfer of any interest Most alienation clauses triggered by transfer of any significant interest in property. ⚫ Includes long-term leases, or leases with options to purchase. ⚫ Lender can’t forbid transfer, but can demand payment of loan. © 2018 Rockwell Publishing Alienation Clauses Transfer of title without loan payoff To understand purpose of alienation clause, consider what happens when borrower sells property without paying off loan. © 2018 Rockwell Publishing Alienation Clauses Transfer of title without loan payoff 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. © 2018 Rockwell Publishing 39  Financing Residential Real Estate Instructor Materials Summary Finance Instrument Provisions Subordination clause Late charge provision Prepayment provision Partial release clause Acceleration clause Alienation clause Assumption © 2018 Rockwell Publishing Types of Real Estate Loans Junior or senior mortgage Junior mortgage: mortgage with lower lien priority than another against same property. Senior mortgage: mortgage with higher lien priority than another on same property. ⚫ At foreclosure, junior mortgage paid only after senior has been paid in full. © 2018 Rockwell Publishing Types of Real Estate Loans First mortgage Lien having most senior (first) position is called first mortgage. ⚫ Junior mortgages may be referred to as second mortgage, third mortgage, etc. © 2018 Rockwell Publishing 40  Chapter 5: Finance Instruments Types of Real Estate Loans Purchase money mortgage Purchase money mortgage: any mortgage loan used to finance purchase of property that is collateral for loan. ⚫ A mortgage that buyer gives to seller in seller-financed transaction. © 2018 Rockwell Publishing Types of Real Estate Loans Home equity loan Home equity loan: loan secured by mortgage against borrower’s equity in home she already owns. (Interest rates higher than on purchase loans.) Equity: difference between property’s market value and total liens against it. © 2018 Rockwell Publishing Types of Real Estate Loans Home equity loan Home equity line of credit (HELOC): line of credit with limit and minimum monthly payments; homeowner can draw upon as needed. ⚫ Automatically secured by borrower’s home. © 2018 Rockwell Publishing 41  Financing Residential Real Estate Instructor Materials Types of Real Estate Loans Refinance mortgage Refinancing: new loan used to pay off existing mortgage against same property. Often used: ⚫ to take advantage of market interest rate decrease ⚫ when balloon payment due on existing loan © 2018 Rockwell Publishing Types of Real Estate Loans Bridge loan 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. © 2018 Rockwell Publishing Types of Real Estate Loans Budget mortgage Budget mortgage: loan with monthly payments that include property taxes and hazard insurance. ⚫ Lender holds tax and insurance portions of borrower’s payments in impound account until payments due. © 2018 Rockwell Publishing 42  Chapter 5: Finance Instruments Types of Real Estate Loans Package mortgage Package mortgage: loan secured by personal property as well as real property. Alternatively, personal property may be financed separately, using separate security agreement. ⚫ Lender must file financing statement with Secretary of State. © 2018 Rockwell Publishing Types of Real Estate Loans Bi-weekly mortgage Bi-weekly mortgage: requires a payment every two weeks, so that loan is paid off on accelerated schedule. Borrower pays off loan faster and with less total interest. © 2018 Rockwell Publishing Types of Real Estate Loans Blanket mortgage Blanket mortgage: loan secured by more than one parcel of land; contains partial release clause. Partial release clause: requires lender to release some of security property from lien when portion of debt is paid off. © 2018 Rockwell Publishing 43  Financing Residential Real Estate Instructor Materials Types of Real Estate Loans Construction loan Construction loan: short-term loan used to finance construction on land already owned by borrower. Once construction completed, construction loan replaced by take-out loan. ⚫ Borrower repays amount over specified term. © 2018 Rockwell Publishing Types of Real Estate Loans Nonrecourse mortgage Nonrecourse mortgage: loan that gives lender no recourse against borrower. ⚫ Lender’s only remedy in event of default is foreclosure on collateral property. ⚫ Borrower not personally liable for loan repayment. © 2018 Rockwell Publishing Types of Real Estate Loans Participation / shared appreciation Participation mortgage: allows lender to participate in earnings generated by mortgaged property, in addition to collecting interest payments. Shared appreciation mortgage: entitles lender to share of increase in property’s value. © 2018 Rockwell Publishing 44  Chapter 5: Finance Instruments Types of Real Estate Loans Wraparound mortgage Wraparound mortgage: new mortgage that includes existing first mortgage on property. ⚫ Used almost exclusively in seller- financed transactions. © 2018 Rockwell Publishing Types of Real Estate Loans Reverse mortgage Reverse mortgage: provides elderly homeowners source of income, without requiring sale of home. ⚫ Homeowner borrows against equity. ⚫ Can get a monthly check from lender. ⚫ Borrower required to be over certain age. ⚫ Home sold after death to repay loan. © 2018 Rockwell Publishing Summary Types of Real Estate Loans Purchase money Bi-weekly mortgage mortgage Blanket mortgage Home equity loan or Construction loan HELOC Nonrecourse Refinancing mortgage Bridge loan Wraparound Budget mortgage mortgage Package mortgage Reverse mortgage © 2018 Rockwell Publishing 45