Chapter 12: Residential Mortgages Flashcards
Title Theory
Title theory is the oldest form of mortgaging, which originated under English common law. Under this system, the borrower was required to temporarily convey ownership of the property to the lender for the duration of the loan period. If the borrower defaulted on the loan during the loan period, the lender took possession of the property.
Deed of Trust
A deed of trust is used in title theory states in place of a mortgage. The deed of trust temporarily conveys title to a property to a third party called a trustee until the mortgage loan debt is repaid or until default occurs. The borrower is called a trustor; the lender is called the beneficiary. Upon satisfaction of the debt, the title is returned to the borrower by using a reconveyance deed.
Several states still use
Several states still use a modified form of the title theory of mortgaging. However, today, all states require some form of foreclosure in the event of a default. When the loan is satisfied, a reconveyance deed is executed to the borrower.
Lien Theory of Mortgages
Florida is a lien theory state. Lien theory allows the borrower to retain the ownership of the property during the loan period. The lender records the mortgage, which creates a lien against the property.
Under the lien theory, the foreclosure process is more involved than under title theory; the borrower is given the right to cure the default instead of simply forfeiting the property.
Promissory Notes
When money is borrowed to purchase real estate, the lender requires the borrower to sign a promissory note, also called a note or bond.
The promissory note is a legal instrument that includes the borrower’s promise to repay the loan with interest according to the terms of the note. The note is evidence of a personal debt, and contains the names of the parties, the rate of interest, the amount of money borrowed, and the loan repayment terms. The note is a contract between the lender and the borrower.
Note of Even Date
The promissory note is often identified as a note of even date, meaning that the promissory note was created on the same day as the mortgage. A promissory note provides no collateral to the lender other than the borrower’s promise to repay the loan. When the promissory note is unsecured, the lender is in a risky position if the borrower defaults and fails to repay the loan as agreed. Consequently, lenders prefer to have some security that helps assure repayment of the note.
Secured Note
A promissory note that is secured by a mortgage.
What is a Mortgage?
A mortgage accompanies a note and is security for its repayment. A mortgage is the borrower’s pledge of the mortgaged property to secure the repayment of the note. Obtaining the mortgage from the borrower reduces a lender’s risk of loss resulting from a borrower’s default on the loan. The lender records the mortgage on the public record, which creates a lien against the property. This gives the lender the ability to foreclose on the borrower’s property in the event of default. The proceeds of a foreclosure sale can be applied to the outstanding balance of the note.
Hypothecation
The pledge of property as security for a loan
Parties to a Mortgage
The property owner, the mortgagor, is the party who gives the mortgage to the lender to secure the loan. The lender, the mortgagee, is the party who receives the mortgage from the property owner. The mortgagor owns the real property, while the mortgagee owns the mortgage, which is personal property.
Requirements for a Valid Mortgage
A valid mortgage must:
• Be in writing,
• Be signed by the mortgagor,
• Conform to the same requirements as any valid contract,
• Contain the legal description of the property, and
• Be witnessed by two persons.
Recording the Mortgage
Normally, the mortgagee records the mortgage to provide constructive notice of the lien. The promissory note is rarely recorded, but the note is referred to in the recorded mortgage. Recording the note would allow other lenders to know the exact details of the loan, which would give them the ability to offer better terms and “raid” the originating lender’s customers.
Satisfaction of Mortgage
When a loan has been paid in full in a lien theory state, such as Florida, the mortgagor should receive a letter of satisfaction from the mortgagee within 60 days of the loan payoff. This letter states that the loan terms have been fully satisfied. It should be recorded in the public records to offset the lien that was created when the original mortgage was recorded.
First Mortgage
The first mortgage, also referred to as the first lien, is the primary claim on a property that takes precedence over all other subsequent (junior) mortgage claims and most other liens. A first mortgage is often used to purchase the property. In the case of foreclosure, the first mortgage will be paid first.
Mortgage liens are given priority by the date they were received. When a loan is used to finance a property, it is usually the first lien placed against the property and, therefore, has the highest priority over all liens with the exception of real estate taxes and special assessments.
Junior Mortgage
A junior mortgage is one that is subordinate to a first or prior (senior) mortgage. A junior mortgage often refers to a second mortgage, but it could also be a third or fourth mortgage. A home equity loan and home equity line of credit (HELOC) are two common types of junior mortgages.
Subordination Agreement
A subordination agreement is a written contract in which a lender who has secured a loan by a mortgage or deed of trust agrees with the property owner to subordinate the first loan to a new loan (giving the new loan priority in any foreclosure or payoff). The agreement must be acknowledged by a notary so it can be recorded in the official county records.
A subordination agreement is used to grant first lien status to a lienholder who would otherwise be secondary to a first lien.
A mortgage subordination agreement is frequently used when there are two mortgages on a property, a first mortgage and a second mortgage, and the mortgagor wants to refinance the first mortgage.
What happens if the holder of the second mortgage does not subordinate the lien of its mortgage to the new mortgage?
the new lender will not refinance the first mortgage. This is due to the fact that when the first mortgage is refinanced, it is essentially paid off and replaced with a new loan.
What was the second mortgage then becomes the first mortgage, and the newly refinanced mortgage would become a lower priority lien. The second mortgage holder does not want to incur the additional costs of releasing its mortgage and re-filing, so the second mortgage holder will subordinate its lien to the lien of the replacement (refinanced) mortgage to all the refinanced first mortgage to remain in first lien status.
What are the provisions designed to protect both the lender and the borrower?
Acceleration Clause Cognovit Clause Defeasance Clause Due-on-Sale Clause (alienation clause) Escalation (or Escalator) Clause Exculpatory Clause Insurance Clause or Covenant of Insurance Maintenance Clause or Covenant of good repair Open-End Clause Prepayment Clause Receivership Clause Release Clause Right-to-Reinstate Clause Subordination Clause Tax Clause or Covenant to Pay Taxes
Acceleration Clause
allows the lender to declare the entire outstanding balance due and payable immediately whenever default occurs. Without having this ability, the lender would have to sure each time the borrower defaulted, month after month. By calling the entire balance due at one time, this clause avoids the time and expense of that process.
Cognovit Clause
gives a lender the right to foreclose at its option by requiring a borrower to admit any future default at the time a loan is obtained. The borrower is prevented from defending against a foreclosure, which results in an automatic judgment in favor of the lender when the loan documents are presented in court. This is obviously a very harsh provision and is not allowed in Florida.
Defeasance Clause
provides protection for the borrower as it requires the lender to acknowledge performance by the borrower. The defeasance clause holds the lender’s rights in check as long as the borrower performs as agreed in the note and mortgage. The defeasance clause is the only legally necessary clause in a mortgage.
Due-on-Sale Clause or alienation clause
in a loan or promissory note stipulates that the full balance may be called due-on-sale upon transfer of ownership of the property used to secure the note. This clause prevents a borrower from transferring any interest in the mortgaged property without permission of the lender. If the property is sold, or any substantial interest in it is conveyed, the lender has the right to declare the entire loan balance due and payable immediately. The due-on-sale clause prevents an assumption of the mortgage by an unqualified borrower. Any borrower interested in assuming the existing loan would have to apply and be approved by the lender.
Escalation (or Escalator) Clause
allows a lender to increase the interest rate based on the occurrence of an event, such as a change in the use of the property or consistently late payments.
Exculpatory Clause
limits the lender’s rights in a foreclosure to the amount received from the sale of the foreclosed property. If the balance of the promissory note has not been paid in full from the proceeds of the sale, the lender cannot obtain a deficiency judgment for the unsatisfied amount. This is referred to as nonrecourse financing since the lender has no recourse against the borrower for the unsatisfied portion of the loan.
Insurance Clause or Covenant of the Insurance
is the borrower’s promise to maintain adequate insurance coverage. Mortgages typically require the borrower to carry fire and hazard insurance in an amount at least equal to the unpaid balance of the loan. Should a property burn to the ground or be severely damaged in a storm, the borrower may not be financially able to replace or repair the structure, thereby exposing the lender to the possibility of loss.
Maintenance Clause or Covenant of good repair
is a provision that requires the borrower to maintain the property properly during the term of the loan, to protect the property’s value. If a property is not maintained properly and the value diminishes, a lender could lose money in a foreclosure action.
Open-End Clause
allows a borrower to borrow additional funds based on the same mortgage after the loan balance has been paid down. This ability is usually limited to the amount of the original loan amount. This can reduce the cost involved in obtaining an entirely new loan. The lender generally reserves the right to increase the interest rate. A mortgage containing this provision is similar to an equity loan or revolving line of credit.
Prepayment Clause
allows a borrower to pay off a loan early, thereby avoiding the interest that would otherwise have to be paid. In Florida, a borrower has the right to prepay a loan whether this right is expressed in the mortgage or not. When interest rates are high, lenders would prefer that a loan not be paid ahead of schedule. During these times, some loans may include a prepayment penalty clause within the prepayment clause. A penalty clause requires the borrower to pay a certain amount to the lender for the privilege of prepaying the debt.
Receivership Clause
is used in mortgages on income-producing real estate. If the investor should default, the lender may ask the court to appoint a trustee, referred to as a receiver, to manage the property during the foreclosure process, collect the rents, and maintain the property. This serves to protect the asset that serves as security for the loan. Without this provision, the borrower could pocket the rents and allow the property to deteriorate, thereby reducing its value.
Release Clause
is found in mortgages that cover more than one parcel of land, usually those given by builders and developers. A builder developing several lots in a subdivision under a construction loan that covers the entire project would not be able to sell a single lot if the buyer could not obtain a first mortgage loan. To resolve this problem, a release clause is used which releases the individual lot from the original loan upon payment to the construction lender of a specified amount of money.
Right-to-Reinstate Clause
is a loan clause that gives a borrower the right to cure a loan that is in default by paying loans payments that are in arrears, along with accrued interest, late payment charges, and legal costs incurred by the lender before the foreclosure is finalized. Once the borrower has done this, they can resume making scheduled loan payments.
Subordination Clause
allows a lien recorded earlier to be placed in a secondary position to a new lien. A subordination clause is commonly used to finance vacant land when development is planned. The seller voluntarily agrees to allow a mortgage that they hold on the land to be placed in lower propriety than another loan so that the developer can obtain a construction loan to complete the project.
Tax Clause or Covenant to Pay Taxes
consists of the borrower’s promise to pay the property taxes during the period of the loan. Should the borrower fail to pay the taxes as required, the property could be sold in a tax foreclosure sale, which would remove the lien created by recording the mortgage. The lender would have to seek enforcement of the promissory note and hope to collect any deficiency on the basis of a personal judgment.
Down Payment
A down payment is an upfront cash contribution that is made by the purchaser in order to qualify for a mortgage, lower payments, receive more favorable loan terms, or eliminate the need for mortgage insurance. The down payment plus the mortgage loan amount is the purchase price.
Equity
Equity is the difference between the current market value of a property and the amount the owner still owes on the mortgage. The initial down payment creates equity. The owner builds, or increases, equity with each mortgage payment that reduces the principal (loan balance). The loan-to-value ratio, reflects the degree to which a property is financed. As equity increases, the loan-to-value percentage decreases.
Interest
Mortgage interest is the compensation a borrower pays a lender for the use of the lender’s money to purchase a property. The interest rate is a percentage of the loan that must be paid in addition to the loan amount, or principal. The interest rate on a mortgage loan is determined by prevailing interest rate levels and by agreement between the lender and the borrower. The interest rate may be fixed or adjustable.
Loan Servicing
Loan servicing is the administration of a loan from the time the money is borrowed until the loan is paid off (satisfied). Loan servicing includes such things as sending monthly payment statements, collecting payments, maintaining records and balances, managing any escrow funds, collecting and pay taxes, forwarding net proceeds to the mortgage note holder, and following up on delinquencies. A loan servicer can be a financial institution or a lender. Loan servicers are typically compensated by retaining a percentage of each mortgage payment. In addition to collecting servicing fees, loan servicers also benefit from being able to invest and earn interest on a borrower’s escrow payments as they are collected until they are paid out for taxes and insurance.
Escrow (Impound) Account
An escrow, or impound account is established to hold money collected by the lender from the borrower to pay hazard insurance and property taxes when they become due. By ensuring that the taxes and insurance will be paid on time, the escrow account protects the lender from tax liens and uninsured losses that the borrower can’t repay.
PITI Payment (Principal, Interest, Taxes, and Insurance)
Many lenders require the borrower to pay a portion of the annual insurance premium and real estate taxes each month along with the principal and interest due for the period. This type of monthly payment is referred to as a PITI payment. This money is held in the escrow account. The lender assumes responsibility for the payment of these charges from the impound account, thereby avoiding the possibility that the borrower would fail to make the payments when required.
Take-Out Commitments
A take-out commitment is a type of mortgage purchase agreement. Under a take-out commitment, a long-term investor agrees to buy a mortgage from a mortgage banker at a specific date in the future. The investor is referred to as a take-out lender, and is usually an insurance company or other financial institution. A take-out commitment is an agreement to provide long-term financing to replace an interim short-term loan.
A take-out commitment may be made in construction or other projects when short-term financing, such as construction financing, is initially beneficial, but the borrower anticipates long-term financing to become more advantageous at a later date.
Mortgage Loan Fees
Mortgage loan fees are fees that are charged by the lender and paid by the borrower to cover overhead and administrative costs and to provide some amount of profit for the lender.
These fees have a serious effect on the cost of financing, which must be made clear to the borrower. Two such fees are generally charged as a percentage of the loan amount: loan origination fees and discount points. Real estate licensees should be able to discuss these fees and explain both their purpose and financial effect on the borrower (effective yield).
Loan Origination Fee
Mortgage lenders typically charge a loan origination fee to pay for the administrative costs of processing the loan. The loan origination fee pays the lender’s overhead for facilities, salaries, and commissions.
Loan origination fees are expressed as points. One point is 1% of the amount borrowed expressed in dollars. The loan origination fee is a one-time charge that must be paid by the borrower and is an additional cost necessary to obtain the loan. Anywhere from one to four points is not uncommon.
To include the loan origination fee
Unfortunately, many borrowers do not have the extra money on hand to pay these charges. It is not uncommon for a borrower to have to increase the amount of the loan to include the loan origination fee along with the amount needed to purchase the property. The borrower will then pay interest on the origination fee as well as the amount needed to buy the property.
Discount Points
Discount points are an upfront payment to the lender in exchange for a lower mortgage rate, which decreases the monthly mortgage payment for the life of the loan.
One discount point is an upfront payment of 1% of the loan amount (not the purchase price) which is paid at closing. The payment of discount points reduces the borrower’s interest rate, resulting in a lower monthly mortgage payment. Paying discount points does not reduce the amount borrowed.
The breakeven point for the borrower is dependent on the discount amount paid and the length of time of the loan. If the borrower keeps the mortgage for five to ten years, they will most likely save money in the long run by paying discount points. If the borrower keeps the loan for a short period-of-time, before the breakeven point, the lender would benefit from the upfront discount payment.
Effective Yield
Whether points are paid for origination fees or an upfront interest prepayment to discount the interest rate, there is a cumulative effect on the total amount paid by the borrower. In some cases, the upfront payment of points can effectively raise the rate of interest the lender receives above the borrower’s loan rate.
The effective yield is the rate of return received by the lender. The effective yield will very depending upon the number or points paid, the amount of any discount, and the length of time the borrower keeps the loan.
A simple rule of thumb calculation is sometimes used to approximate the change in interest payment over the life of the loan as a result of this upfront point payment. This approximation is based on the assumption that the borrower keeps the loan for eight years. The actual effective yield will be less for longer loan periods and more for shorter loan periods.
The rule of thumb is that for each point charged upfront by the lender, the rate of interest increases approximately 1/8 percent. The exact amounts will be calculated and provided by the lender.
The Need to Qualify the Property and the Applicant
Mortgage lenders are investors. They expect borrowers to pay back the amount borrowed plus interest in order to make a profit on the loan. Lenders do not want to go through a foreclosure any more than borrowers do. To minimize the risk of foreclosure, both the borrower and the collateral must be qualified before a loan will be approved.
Mortgage Underwriting
The application process begins when the potential borrower contacts a lender to inquire about available loans and loan terms. An application is generally taken by a loan processor and passed on to a mortgage underwriter. The mortgage underwriter reviews and verifies the information contained in the application to determine if the applicant is qualified for the loan requested. The process of risk evaluation is called mortgage underwriting, and is discussed later in this section.
The Loan Application
Whether or not the applicant will obtain a mortgage loan depends upon how complete, accurate, and truthful the application is. During the mortgage underwriting process, the information contained in the application is verified by contacting current and past employers and creditors.
Lender Risk
When a loan is approved, the lender assumes a number of risks. The primary risk is that the borrower may default on the loan. If the borrower defaults, the lender can sue to have the mortgaged property sold at foreclosure, but there is no guarantee that the proceeds of the sale will be sufficient to cover the loan balance.
Spouse Signatures
The signature of only one spouse is required on a mortgage loan application, unless state or local law dictates otherwise.
If the income of a spouse is required to meet the lending institutions’ credit standards for loan approval, the spouse must also sign the application. When both parties sign the loan documents, they become jointly (mutually) and severallyn(individually) liable for the debt.
The Equal Credit Opportunity Act (ECOA)
The ECOA requires lenders to judge every loan applicant on the basis of the applicant’s own credit rating and income. Lenders are required to consider a spouse’s income, part-time income, alimony, child support, or separate maintenance in the approval process. The ECOA allows the lender to question applicants on the stability and source of income, but the lender cannot refuse to consider income because of the source.
An applicant may request inclusion of another individual’s income or credit history in order to quality for a loan, in which case the lender will consider both the cosigner’s and applicant’s income and credit history.
Lenders Cannot Discriminate
Lenders cannot discriminate against borrowers on the basis of race, color, religion, national origin, sex, marital status, age, or receipt of income from public assistance programs.
The loan officer cannot ask questions regarding birth control practices, intentions concerning the bearing or rearing of children, or the capability of bearing children. They are prohibited from asking questions based on race, color, religion, national origin, or sex.
However, in order to avoid discrimination based on a borrower’s ethnic background, HUD requires lenders to ask about a borrower’s race. The lender is still prohibited from discrimination on the basis of race. HUD uses the information to review lender records to make sure that the lender is not routinely turning down minorities or charging them higher fees.
If an applicant request a lender to consider income derived from
alimony, child support, or separate maintenance payments in order to qualify for a loan, the lender can ask questions concerning the income source, duration of the income, and frequency of the payments.
Mortgage Underwriting
To assess the risk of default or collection problems, lenders evaluate both the applicant and the property before approving a mortgage loan. The process of qualifying the applicant and the property is called mortgage underwriting.
Qualifying the Property
The property that will serve as collateral for the loan is evaluated or appraised to determine if it is of sufficient value. The appraiser analyzes the property and issues a report giving an objective estimate of the property’s market value. The appraiser’s estimate will not necessarily be the price agreed upon between the seller and potential buyer. The underwriter is concerned with the market value of the property.
Redlining
When a lender refuses to loan based on the racial or economic factors of the neighborhood in which a property is located, the practice is called redlining, which is prohibited by federal law.
Loans cannot be refused based on the fact that a property is located in a certain geographical area, age of the property, income of residents in the area, or racial composition of the area.
Qualifying the Applicant
An applicant is evaluated to determine if they can repay the proposed loan. The lender evaluates the applicant’s credit history and employment record as indicators of the applicant’s desire and ability to repay the loan.
An applicant is evaluated by what criteria?
Credit History
Income
Other Assets
Credit History
the underwriter obtains a report from a credit-reporting agency and reviews the applicant’s credit history. The credit report includes information about debts and repayment for the preceding seven years. Negative information such as slow repayment, collections, repossessions, foreclosures, judgments, and bankruptcies may cause the underwriter to refuse the application.
A potential buyer’s credit score is used to evaluate the risk associated with a loan, whether or not the lender will make the loan, and if so, determines the rate of interest the lender will charge. Credit scoring was introduced by the Fair Isaac & Company (FICO) over 30 years ago. As a real estate licensee, it is important to have a fundamental understanding of this very important loan-qualifying tool.
FICO
- Payment History (35%)
- Outstanding debt (30%)
- Credit history age of open accounts (15%)
- Credit report inquiries (10%)
- Type of credit (10%)
The FICO score measures the borrower’s willingness to meet debt obligations and weighs heavily on the lender’s decision to underwrite a loan.
Fico scores can range from 300 up to 850; the higher the score, the lower the risk of default by the borrower. Different types of property, such as single-family versus two- or three-family homes, will typically be underwritten using different score requirements. Scores below 580 are considered to be poor and those above 660 are considered to be excellent.
Scores must be thought of as an indicator of risk. Applicants who have scores below 580 may not automatically be denied credit; however, the interest rate will probably be higher and the type of financing available may be limited.
Income
the applicant’s income must be enough to cover the proposed mortgage payment and other monthly expenses. The applicant’s source(s) of income must be reasonably dependable and stable. Continuous employment for at least two years in the same occupational field is generally used as criteria for loan approval. A person’s income indicates his or her ability to make the payments required to repay the loan. The applicant’s stable monthly income can be derived from regular wages from a full-time job, bonuses, commissions, overtime pay, part-time earnings, self-employment income, retirement income, alimony or child support, or investment income. Mortgage lenders will not accept income from temporary employment, unemployment compensation, or contributions from family members to meet the lender’s standards for making a loan.
Other Assets
the underwriter reviews the other assets of the applicant, such as other real estate, automobiles, stocks, bonds, artwork, and so on. The accumulation of assets is a strong indicator of future creditworthiness. These assets may also be attached in the event of a foreclosure and resulting deficiency.
Risk Evaluation
The risks facing lenders in making residential loans include default by the borrower, a decline in the value of the property that serves as security for the loan, and a lack of other assets that could be attached in the event of a foreclosure and subsequent deficiency.
Lending institutions have relatively consistent requirements that an applicant must meet before a mortgage loan will be originated. Mortgage lenders use income ratios and loan-to-value ratios to qualify a potential borrower for a loan.
Income Ratios
The income of an applicant is the primary consideration when underwriting a loan. It must be adequate to allow for the continued repayment of the loan. If a borrower’s expenses exceed certain percentages of his or her monthly income, the borrower may have difficulty making the required payments.
Ratios are a simple method used by lenders to evaluate a borrower’s financial ability to meet the financial obligation once a loan has been approved.
What are the two income ratios generally used to determine whether or not a loan will be approved?
Housing Expense Ratio
Total Obligations Ratio
