Common Real Estate Finance Methods-Module 1 of 5

Common Real Estate Finance Methods-Module 1 of 5


Common Real Estate Finance Methods

 


Most people take out mortgage loans to help pay for real estate purchases just as people take out other loans to pay for other expenses. However, a mortgage arrangement is much more complex and nuanced than more common forms of consumer borrowing, which are often unsecured loans. These complexities and the originations, processes and operations of mortgages are the subjects of this course.

 

 This first module provides the basic knowledge, skills, and vocabulary needed to make sense of a mortgage loan. The discussion includes an overview of the types of real estate loan products commonly available, including the key features that distinguish them. However, before diving into the details of real estate finance, we’ll begin with an overview of the proper due diligence that every mortgage borrower should undertake before even applying for a home loan.


Before Applying for a Mortgage

 

            Buying a home is not only an exciting milestone for many people, it’s also a useful way to build financial stability and wellbeing.[1] However, purchasing real estate involves complex legal and financial issues. Taking out mortgages exposes homebuyers to risks of default, foreclosure, and bankruptcy. As a result, everyone should understand the legal and financial liabilities associated with real estate ownership before making the decision to buy a home.

 

            The amount of money taken as a loan to finance a real estate purchase is known as leverage. The amount of leverage allowed by a lender is determined by the bank’s loan-to-value ratio, which determines how much down payment is required. A typical loan-to-value ratio required by many banks is 80 percent, meaning that a 20 percent down payment is required to take out a mortgage loan.[2] However, there are additional expenses mortgage borrowers must be ready to pay beyond the down payment. For example, there are closing costs, attorney’s fees, bank fees, title insurance, inspection fees and homeowner’s insurance that all must be paid before or at the time of the mortgage closing.[3] Additionally, if a homebuyer takes out a loan with a loan-to-value ratio higher than 80 percent, he will often need private mortgage insurance (or “PMI”), which hedges the lender’s risk of giving a loan with a lower down payment by paying for insurance that will indemnify the bank in case of a default if the bank cannot recover its principal.[4] PMI is terminated automatically when the mortgage principal is paid down to 78 percent of the property’s value on the date it was mortgaged.[5]

 

            Once a buyer analyzes all direct and indirect costs of a home purchase, he must put to rest any questions regarding the title to the property. In most jurisdictions, buyers are responsible for title examinations, which are detailed studies of the property’s ownership records. This is necessary to ensure that the buyer is receiving good and marketable title to the real estate, as defects in title can interfere with the buyer’s ability to use and occupy the land. The type of deed used to convey the land impacts the seller’s guarantees regarding title, but buyers are responsible for any defects in title not guaranteed by the deed.[6] Once a title search is completed, a homebuyer secures title insurance protecting against any issues impacting title to the land that were not discovered in the search. While buyers of land are not obligated to purchase title insurance, lenders usually require the purchase of title insurance and may dictate its terms.[7]

 

            Once the homebuyer calculates the amount he can budget for the down payment, insurance, and installment payments for the mortgage, he should review his credit history for any inaccuracies or defects. Mortgage approval depends heavily on credit scores. Credit scores are composite scores that take into account six factors: percentage of available credit that is used, payment history, derogatory marks (such as collections or bankruptcies), average age of credit, total number of accounts held and number of recent “hard” credit inquiries.”[8] People seeking mortgages are wise to shore up their credit histories by paying off the debts they can and managing new loans to the best of their abilities.


Elements of a Mortgage Loan


Mortgage loans are the most common real estate financing method in the United States. A mortgage loan is an arrangement that transfers a security interest in land that secures a legal obligation to repay a loan.[9] There are usually two parties to the mortgage loan: the mortgagor, who is the real estate buyer who transfers the interest as security; and the mortgagee, the lender supplying the loan who receives the security interest. Mortgage loans are mainly governed by state law, but they may be subject to federal regulation depending upon how they are chartered or established.[10]

 

A mortgage has four distinct characteristics: the amount of the loan (also known as principal), the term of the loan, the schedule for the loan’s repayment and the interest rate.[11] While there is variety in types of loans and terms, over time, the legal documents necessary to secure mortgage loans have become relatively standardized. These documents evidence two legal commitments: a promise to pay the underlying loan and a security instrument that can be used to guarantee payment.


A Promissory Note is a contract that formalizes the buyer’s promise to repay the loan made by the lender.  The Promissory Note includes all the terms and conditions of the loan, including the interest rate, payment due dates, the location and method of payment, and what may occur if the payments are not made.[12] The promissory note must be accompanied by a security instrument to create a mortgage interest. The mortgage itself is the security instrument that entitles a lender to foreclose on the real estate in the event of a default on the terms of the promissory note.[13] A mortgage must include certain elements to be legally enforceable, including: the named parties to the agreement, words of conveyance, a valid description of the subject property, a valid execution, attestation and effective delivery.[14]

 

A mortgage creates an encumbrance on the subject property, meaning that it represents a third-party claim on real estate that runs with the land.[15] This encumbrance cannot be discharged until the mortgage loan is paid in full or discharged by other legal means. The mortgage interests can be transferred by the interest holders, and it is common for banks to sell their mortgage interests to other financial institutions.

 

Mortgage Payments


The most common mortgage type utilized in the United States is that of a fixed-rate mortgage with a 15 or 30-year term, in which every payment is the same amount and each payment has a component of interest in a component of principal.[16] However, there are several variations on traditional mortgage loans.


Fixed-Rate and Adjustable-Rate Mortgages

 

Mortgage loans are divided into two broad categories: fixed rate loans and adjustable rate loans. Fixed rate mortgage loans are valued for their stability. Under these arrangements, the interest rate on the loan does not change, so monthly payments remain constant throughout the term of the agreement.[17] In contrast, an adjustable rate mortgage (sometimes called an “ARM”) has an interest rate that changes during the term of the agreement. Typically, the interest rate on an ARM is tied to the interest rate set by the “prime” rate, which is the interest rate the commercial banks charge their most creditworthy customers.[18] They can be set up in any number of ways. For example, ARM loans often start with lower interest rates, which are commonly known as “teasers” because they incentivize buyers with low introductory payments. These loans carry a heavy risk of default since their payments invariably increase dramatically later in the lives of the loans.

 

“Convertible” ARM loans include options to convert the loan’s adjustable interest rate to a fixed one, typically for a fee. Combination Fixed Rate/ARM loans typically begin as a fixed-rate loan that converts to an adjustable rate after a set period. Interest-only ARMs require borrowers to pay interest on the loan, but not principal, for a fixed time, meaning that installment payments will increase once principal payments kick in. Payment-option ARMs are arrangements in which the interest rates are adjusted over time, but the minimum payments remain fixed. These types of loans are very risky, as the mortgage balance may increase over time if the minimum monthly payments are not sufficient to cover the interest of the loan.[19]

 

Amortization and Balloon Payments

 

            Mortgage loans are made up of the principal, which is the amount borrowed to purchase the property, and interest, which is what the bank charges for lending out the money. Loans are usually repaid according to an amortization schedule, which sets forth the installment payments. Fixed rate mortgages have level amortization schedules and monthly payments are made in the same amount each month. Under this arrangement, a loan is “fully amortized,” meaning that the balance is paid off when the last installment payment is made.[20]

 

Payments made pursuant to a fixed-rate mortgage start as mostly interest payments because the principal balance is highest at the outset of the loan. Over time, while the amounts of the monthly payments remain the same, the principal contingent of each payment becomes higher and the interest contingent becomes lower, as the principal balance decreases. The last few mortgage payments on an amortized long-term loan are virtually all principal.

 

Rather than fully amortizing their loans, some homebuyers prefer an amortization schedule with a balloon payment. Under this arrangement, installment payments made on the mortgage do not cover the entire principal and interest accrued. As a result, homeowners must make a large payment, or a “balloon payment,” at the end of the loan to repay the remaining balance.[21] Mortgages with balloon payments may come with certain tax benefits and they are often well-suited for people who plan to sell their homes within a few years of buying them. However, homeowners who are unable to make the large balloon payment due at the end of the term face increased risk of default and foreclosure.

 

Second Mortgages and Home Equity Loans

           

In most cases, borrowers can take out multiple mortgages on real estate. However, real estate lenders take on increased risk when issuing second mortgages, as mortgage superiority is based on which agreement was first in time. In other words, if the real estate owner defaults on a first mortgage and the property is foreclosed, the second mortgage is terminated. As a result, it can be very difficult to take out second or third mortgages. When lenders do agree to issue a second mortgage, they commonly require an estoppel certificate from the first mortgage lender. An estoppel certificate requires the first mortgage lender to notify the second mortgage lender if a default occurs. This gives the second mortgage holder an opportunity to recover before its rights are terminated by foreclosure.[22] Second mortgage lenders may also only provide loans to the extent that the total amount owed on the house is limited to a percentage of the home’s value. For example, a second mortgage lender may require that the homeowner maintain at least 20% equity in the house. If a house is worth $500,000, for example, and the homeowner already owes $340,000 on a first mortgage, the second mortgage lender may limit the amount of the second mortgage to $60,000 or less to ensure that the total value of the mortgages does not exceed 80% of the home’s value, or in this case, $400,000.

 

Second mortgages are often referred to as “home equity loans” because they require building up of equity before the banks will issue them. Some home equity loans are “revolving,” which means that the buyer may withdraw up to a maximum amount and will make monthly interest payments to cover the interest on the balance. The borrower may repay the principal at will, though many such loans require that the buyer commence paying principal after a given number of years.[23] Because these home equity loans behave like a line of credit, they are often called “home equity lines of credit” or HELOCs.

 

While in the process of making amortized payments on a loan, a buyer may choose to refinance, usually to take out more money or to take advantage of lower available interest rates. The refinancing process requires payment in full of the first mortgage and the simultaneous receipt of the new mortgage loan.

 

Homeowners often choose to borrow money against the equity in their homes (either through refinancing of a bigger loan or opening a home equity line of credit) to improve the property or consolidate more expensive debt.[24] Keep in mind that unsecured loans such as credit card debt usually charge much higher interest rates than mortgage loans. So, paying off high interest loans through money obtained from mortgages is often an excellent way to save money.

 

Reverse Mortgages

 

            A reverse mortgage is a specialized loan available to those age 62 and over. Under a reverse mortgage, a homeowner accepts a line of credit or receives regular installment payments that are repaid when the home is sold, or the homeowner passes away. Reverse mortgages are repaid from the proceeds of the sale of the property or the property owner’s estate, but only up to the amount of the property’s value. While reverse mortgages can be excellent opportunities for seniors to gain access to needed income, because interest accrues until repayment, there is often surprisingly little equity remaining in the house when it is sold. Reverse mortgages raise issues regarding estate planning and insurance coverage beyond the financial and legal liabilities typically incurred when someone takes out a loan. As such, counseling is usually required before taking out a reverse mortgage.[25]

 

 

Conclusion


            Mortgage agreements are the most common ways people finance their homes. Despite being so common, these transactions are very complex. They are subject to several consumer protection laws and financial regulations that are discussed throughout the remainder of this course. However, at the end of this preliminary discussion, you should have a basic grasp of the vocabulary and concepts relevant to mortgages.

 



[1] Mark W. Olson, Governor, Fed. Reserve Bd., Speech at the Community Development Policy Summit, Cleveland, Ohio: Exploring the Benefits and Challenges of an Ownership Society (June 23, 2005) (transcript available at http://www.federalreserve.gov/boarddocs/speeches/2005/20050623/default.htm); Liz Pulliam Weston, Why It’s Smarter to Buy than Rent, MSN MONEY, Jan. 15, 2006, http://moneycentral.msn.com/content/Banking/Homebuyingguide/P72655.asp.

[2] Loan-to-Value Ratio – LTV Ratio, Investopedia (2018) https://www.investopedia.com/terms/l/loantovalue.asp,

[3] American Bar Association, Mortgage Loans, “Loan Features” (2018) available at https://www.americanbar.org/groups/business_law/migrated/safeborrowing/mortgage/features.html.

[4] Id.

[6] American Bar Association, Residential Real Estate FAQs (2018) available at https://www.americanbar.org/groups/real_property_trust_estate/resources/real_estate_index/real_estate_residence_faqs.html.

[7] American Bar Association, Mortgage Loans, “Loan Features” (2018) available at https://www.americanbar.org/groups/business_law/migrated/safeborrowing/mortgage/features.html.

[8] Toddi Gutner, “Anatomy of a Credit Score,” Bloomberg Businessweek (Nov. 27, 2005) available at https://www.bloomberg.com/news/articles/2005-11-27/anatomy-of-a-credit-score

[9] Cornell Law School, “Mortgage” Wex Legal Dictionary (2018) available at https://www.law.cornell.edu/wex/mortgage.

[10] Federal agencies commonly involved in mortgage financing include the Federal National Mortgage Association (“Fannie Mae”), the Federal home Loan Mortgage Corporation (“Freddie Mac”), the Government National Mortgage Association (“Ginnie Mae”), the Federal Housing Administration (“FHA”), and the Department of Veterans Affairs (“VA”). Id.

[11] What is a Mortgage?, Consumer Financial Protection Bureau (February 2017), available at https://www.consumerfinance.gov/ask-cfpb/what-is-a-mortgage-en-99/.

[12] Definition, “Promissory Note.” American Bar Association, “Glossary,” Mortgage Loans (2018) available at https://www.americanbar.org/groups/business_law/migrated/safeborrowing/mortgage/glossary.html#closed

[13] In some jurisdictions, the mortgage security instrument is a “deed of trust,” but these documents serve the same function as a mortgage in other jurisdictions. Definition “Mortgage” Id.

[15]  Cornell Law School, “Encumbrance” Wex Legal Dictionary (2018) available at https://www.law.cornell.edu/wex/encumbrance.

[17] American Bar Association, “Glossary,” Mortgage Loans (2018) available at https://www.americanbar.org/groups/business_law/migrated/safeborrowing/mortgage/glossary.html#closed

[19] American Bar Association, Mortgage Loans, “Loan Features” (2018) available at https://www.americanbar.org/groups/business_law/migrated/safeborrowing/mortgage/features.html.

[20] American Bar Association, “Glossary,” Mortgage Loans (2018) available at https://www.americanbar.org/groups/business_law/migrated/safeborrowing/mortgage/glossary.html#closed

[21] Id.

[22] Hinkel, supra note 14 at 194/

[23] American Bar Association, Mortgage Loans, “Loan Features” (2018) available at https://www.americanbar.org/groups/business_law/migrated/safeborrowing/mortgage/features.html.

[24] American Bar Association, Mortgage Loans (2018) available at https://www.americanbar.org/groups/business_law/migrated/safeborrowing/mortgage/loans.html.

[25] Id.

 

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