Common Real Estate Finance Methods - Module 1 of 5
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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 home buyers 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 home buyer 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 home buyer 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 home buyers 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
[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.
[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.