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

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1 Chapter 5 Real Estate Finance Instruments 1 Chapter Objectives Contrast a financing instrument from a security instrument. Discuss advantages and disadvantages of trust deeds. Discuss advantages and disadvantages of mortgages. Define the purpose of different types of mortgages. Identify typical mortgage clauses. 2 Promissory Notes Maker: One promising to pay Payee: One to whom payment is promised Note: Basic evidence of debt Date Names of the parties Amount of the debt Note rate (interest rate that amortizes debt) How and when the money is to be paid What happens in the event of default Signature of the maker Negotiable instruments Freely transferrable Creditor can sell, as on secondary market 3 1

2 Promissory Notes Straight note or interest-only note Payments of interest-only during loan term Balloon payment to pay off principal Usually short-term Installment note Payments of principal and/or interest at designated intervals May require balloon payment Partially amortizing installment note Periodic payments of principal and interest during term Balloon payment at end to pay off balance Fully amortizing installment note Regular payment of principal and interest Calculated to pay off entire balance by end of term 4 Security Instruments Accompanies promissory note Requires debtor to hypothecate property as a condition of a loan Debtor pledges personal or real property as security for a debt, typically without giving up possession of it Protects creditor Motivates debtor to fulfill terms Simply describes collateral for a note Note and security instrument cancelled when debt is repaid Main types are trust deeds and mortgages 5 Trust Deeds Places specific financial interest in property in hands of disinterested third party Borrower is trustor Lender is beneficiary Third party is trustee Borrower has possession and equitable title Legal title vested to borrower when debt repaid Trustee may initiate non-judicial foreclosure upon default Allows trustee to sell property without court Authorized when lender declares note in default 6 2

3 Mortgages Borrower conveys interest in property to lender as collateral Borrower is mortgagor Lender is mortgagee Creates voluntary lien on property Allows lender to accelerate entire debt upon default Allows lender to commence judicial foreclosure action through courts 7 Lien and Title Theory Lien theory Security instrument creates lien against property Borrower hold title to property May require lengthy court proceeding upon default Title theory Security instrument gives actual title to property to lender while debt outstanding Borrower has equitable title and possession Legal title reverts or is conveyed once debt repaid May not require lengthy court proceeding upon default States may allow only one or both types of security instrument to be recorded 8 Judicial Foreclosure Creditor accelerates due date on default Files foreclosure action in county court If court finds in favor of creditor: Creditor takes ownership Judge issues officer of court to seize property Creditor may choose to sell Public notification Public auction Proceeds pay costs of sale, liens Overages go to debtor Creditor may ask for deficiency judgment 9 3

4 Judicial Foreclosure: Redemption May allow debtor to save property Lis pendens: Notice of pending legal action Equitable right of redemption Save property prior to confirmation of sale Statutory right of redemption Save property after final sale Deed in lieu of foreclosure Debtor voluntarily convey property prior to final court decision Avoids record of foreclosure Creditor could pursue deficiency judgment 10 Mortgage Lien Position Establishes order in which liens are paid Real estate tax liens always first regardless of recording order Lien that was recorded first paid in full Junior liens paid in order until funds exhausted Senior / junior mortgage describes recording order Subordination agreement allows lien recorded later to take priority 11 Typical Clauses Acceleration clause Gives lender right to declare loan balance due immediately on default or breach of contract Alienation clause (due on sale clause) Gives lender certain rights upon transfer of ownership without permission Accelerate debt Change interest rate Charge a fee 12 4

5 Typical Clauses Defeasance clause Makes document void in the event of stated condition Paying off debt voids security instrument Partial release, satisfaction, or reconveyance clause Obligates creditor to release part of property and convey title to debt when provisions are satisfied 13 Case in Point Builder buys five acres of land Contract has partial release clause Clear title to one acre conveyed to builder for each 20% of note paid Allows builder to sell specific acre free and clear 14 Typical Clauses Prepayment clause Gives lender right to charge penalty for paying off loan early Refinance or sell, for example Makes up for interest lost May be restricted to early years of loan Prohibited in FHA and VA loans 15 5

6 Other Covenants Promises that may appear in deeds, mortgages, other documents Compel or prevent certain actions/uses Typical covenants: Not committing waste Maintain hazard insurance Agree to pay taxes and other assessments Failure to keep covenants could be considered default 16 Types and Features of Mortgages Purchase money mortgage Generally describes mortgage given to lender or seller to purchase property If seller may also be known as a soft money loan Can be first or junior mortgage Refinance mortgage Borrower replaces current mortgage with new May allow better terms or to get cash out MLO should be able to show net tangible benefit 17 Types and Features of Mortgages Home equity Secured by mortgage on principal residence Typically attach as junior mortgages Home equity loan Closed-end, fixed amount Regular payments over fixed term Home equity line of credit (HELOC) Open-end, draw and pay back as used up to credit limit Draw period pays interest only Repayment period amortizes payments 18 6

7 Types and Features of Mortgages Blanket mortgage Covers multiple parcels of land Usually used to finance subdivisions Contain partial release clause Bridge mortgage Occurs between termination of one mortgage and beginning of next Designed to be temporary Commonly used for construction financing 19 Types and Features of Mortgages Open-end mortgage Allows borrower to request additional funds Usually sets predetermined loan-to-value Not the same as open mortgage (can be repaid at any time without penalty) Package mortgage Includes personal property as collateral Most commonly used for appliances and/or furniture 20 Types and Features of Mortgages Reverse mortgage Allows homeowners aged 62 or older to covert equity in home into cash/line of credit Generally repaid when borrower: Dies Does not live in home for 12 months Sells the home Refinances loan Equity participation mortgage Permits lender to share earnings, income, profit 21 7

8 Types and Features of Mortgages Wraparound mortgage Existing loan retained while lender gives borrower another, larger loan Payment options Borrower pays wraparound lender single payment for both loans If wraparound lender different, borrower pays wraparound lender who pays first lender May be used for refinancing or seller financing 22 Construction Mortgage Temporary loan used to finance construction of improvements on land Appraiser evaluates plans to provide subject to appraisal Replaced with permanent amortizing loan when complete May include extended rate locks Disbursement plans guard against overspending 23 Construction Mortgage: Disbursement Fixed disbursement Predetermined obligatory advances at various stages Release/draw as project is complete Lenders may hold final percentage to protect against unpaid mechanic s liens Voucher system Borrower pays own bills and submits receipts Warrant system Lender directly pays supplier/laborer bills 24 8

9 Construction Mortgage: Permanent Only one loan and one closing No take out loan Fixed disbursement Loan automatically converts to permanent upon completion 25 Graduated Payment Mortgage Specialized payment structure Allows borrower to make smaller payments in early years Unpaid interest added to balance Scheduled period of negative amortization Payments escalate at predetermined point to fully amortize loan 26 Key Term Review Acceleration Clause Alienation Clause Balloon Payment Construction Loan Equitable Right of Redemption Equitable Title Hypothecate Judicial Foreclosure Mortgage Negotiable Instrument Non-Judicial Foreclosure Note Rate Promissory Note Security Instrument Subordination Agreement Trust Deed (or Deed of Trust) 27 9

10 Summary 1. Real estate finance instruments: Finance instruments, written documents establishing rights and duties Promissory notes, written promises to pay Negotiable instruments, freely transferrable Maker is one promising to pay the lender (payee) Common note types: Straight, installment, installment with balloon, fully amortizing. Note rate, rate used to amortize loan and determine monthly payment. 28 Summary 2. Security instruments: Give creditor right to take ownership of property to satisfy debt is debtor does not pay as agreed Requires debtor to hypothecate property Pledge as collateral Does not give up possession Mortgages and trust deeds 3. Trust deeds (or deeds of trust): Some financial interest to third party as security for payment of note Allows for non-judicial foreclosure 29 Summary 4. Mortgages: Create lien against property as security for debt Allow for judicial foreclosure upon default Notice of default and foreclosure action filed Creditor takes ownership; may sell Order of execution; sale a public auction Sheriff s deed issued Debtor may redeem until sale confirmed (equitable right of redemption) Slow and expensive, but court authority Senior mortgage in higher lien position than junior mortgage (property tax always first) 30 10

11 Summary 5. Clauses: Acceleration lets lender call balance due Prepayment allows charged penalty for paying off loan early Alienation (due on sale) allows certain rights upon transfer of property Defeasance cancels repaid mortgage Subordination lets later-recorded mortgage take priority Partial release releases part of property from lien as balance is paid 31 Summary 6. Mortgage types: Purchase money Seller/lender takes mortgage for purchase Soft money Borrower gets credit instead of cash (compare to hard money, where borrower gets actual cash) Bridge Temporary loan between two others and repaid with later mortgage or sale proceeds Package Includes personal property Blanket For more than one land parcel Construction Temporary loan to finance construction of building improvements A promissory note calling only for payment of interest during its term is a(n) A. amortizing note. B. installment note. C.negotiated note. D.straight note

12 2. The clause that permits a lender to declare the entire unpaid balance on a loan due and payable at once on default of the borrower is a(n) A. acceleration clause. B. defeasance clause. C.escalation clause. D. forfeiture clause A clause that permits the lender to call the outstanding balance due and payable should the property be sold by the borrower is a(n) A. acceleration clause. B. alienation clause. C. balloon payment clause. D. exculpatory clause Which document accompanies the mortgage? A. abstract of title B. contract of sale C. deed D. promissory note 36 12

13 5. To foreclose a mortgage, the creditor A. files an attachment in the amount of the debt. B. files a court action. C.notifies the debtor of the default, waits ten days, publishes a notice of default in the paper, then claims a forfeiture. D. notifies the trustee of default A mortgage under which the debtor may re-borrow up to the original note amount under the same document is a(n) A. amortizing mortgage. B. hypothecated mortgage. C. open-end mortgage. D. package mortgage The type of mortgage that may provide the borrower with a monthly check instead of the borrower paying a monthly payment is known as a(n) A. blanket mortgage. B. graduated payment mortgage. C. interest only mortgage. D.reverse mortgage

14 8. A builder finances the construction of an apartment building through a local bank. If money is released to the builder at various stages of construction, these payments are called A. acceleration advances. B. obligatory advances. C. release payments. D. site drafts The term take out loan is most closely associated with A. construction loans. B. junior loans. C.loans against the land. D. Truth in Lending requirements Which term describes the process by which a borrower pledges property as security for a loan without giving up possession of it? A. defeasance B. hypothecation C. redemption D. subordination 42 14

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