REAL ESTATE FINANCE Ninth Edition

REAL ESTATE FINANCE Ninth Edition John P. Wiedemer and J. Keith Baker

Chapter 6 The Mortgage Documents

LEARNING OBJECTIVES At the conclusion of this chapter, students will be able to: • Describe the development of lien theory as a key requirement for real estate lending. • Describe how the development of uniform loan origination documents and the expansion of the private mortgage insurance market impacted the growth of the secondary mortgage market. • Understand the key mortgage instruments for securing real estate and the effects of state real estate ownership laws on their application. • Describe the types of real estate financing contracts. • Explain the insurance requirements relevant to financing various types of real estate. • Describe the evolution, benefits, and types of uniform mortgage documents.

Introduction – History and Development • The use of real estate as the collateral security in real estate loans can be traced back as far as the ancient businessmen of Ur, the Pharaohs of Egypt, and the Romans of the pre-Christian era. • Even then, some form of promise or assignment of the property was used to ensure repayment of an obligation to the lender. • The development of this type of property assignment illustrates an interplay between the rights of a borrower and the rights of a lender. • In its earliest incarnation, the mortgage instrument as security for a loan actually granted title to the collateral property to the lender. • As time passed another form of mortgage pledge was introduced, granting the lender a lien on property pledged as collateral. • Both basic forms of mortgage pledges are in use today and their use is determined by state law.

State Laws Control Property Rights • Property rights in the U.S. are spelled out primarily under statelaws. • The local variations reflect the background and origins of the region. • English law guided the New England and Mid-Atlantic States. • French legal codes were reflected in the Louisiana Territory. • Spanish heritage colored the laws in the southwestern states.

The Mortgage as a Grant of Title (Title Theory) • Initially, a loan secured by real estate granted legal title to the lender. • Lender might even use the land and be entitled to any rent it produced. • The borrower held equitable rights and title was returned on repayment. • Aslight delay in payments, which might even be encouraged by the lender, could easily create a default and forfeit the land. • Dispossession could be made without notice, with no return of money. • Borrowers so deprived would appeal to an official for redress. • If a wrong had been committed, the borrower might be given a chance to redeem the land with a late payment of the obligation. • Thus the right of redemption came into being from medieval times.

The Mortgage as a Lien (Lien Theory) • Borrower retains title to the property and grants a lien to the lender. • The borrower retains the use of the real estate but the lender has the right to foreclose if the borrower fails to pay. • A lien constitutes an encumbrance on propertyand is a claim to land recorded in public record. • Title to the real property will remain in the name of the borrower and the lender takes a mortgage that allows them to foreclose. • Usually the lender must sue to foreclose and gain title. • A little less than half of the states are lien theory states.

The Mortgage Instrument • The transfer of property should be handled by qualified attorneys, skilled in interpreting these rights according to the laws of each state. • A mortgage is simply a pledge of property (collateral) to secure a loan. • It is not a promise to pay anything. • Without a debt to secure, the mortgage itself becomes null and void. • The French origin of the word “mortgage” comes from mort meaning dead, and gage, meaning pledge, so together indicates a “dead pledge”, one that dies when the loan is paid in full. A dead pledge

The Promissory Note • The promissory note is the lender’s evidence of the amount owed and who owes it. • A promissory note must contain the following basic provisions. • Name the maker (borrower) and the payee (the lender) • Name the amount of the debt (principal borrowed) • Specify how and when the money is to be paid with maturity date • Contain an acceleration clause • Contain a description of the payee’s remedies in case of default • It must be signed by the maker • Most mortgage promissory notes are negotiable, to allow transfer to secondary-market investors. • A lender must have both a promissory note and a mortgage to evidence the lender’s right to force the sale of the real estate upon default.

Conforming Loans • Fannie Mae and Freddie Mac created a series of uniform conventional mortgage documents. • No single mortgage form could be used throughout the country because of the variations in state property laws. • So the result has been a series of standardized mortgage instruments designed specifically to meet each state’s requirements. • Conforming mortgage instruments contain a section that covers universal standards and another section that covers state-specific. • Promissory notes are unilateral promises to pay and convey no property rights, so they contain fewer differences between the states. • Examples of a note and a mortgage appear in the Appendix of this text. • A conforming loan must meet Fannie Mae/Freddie Mac standards for borrowers, appraisals, and loan limits.

Mortgage Instrument - Elements • Parties Involved • Names of all parties who have an ownership interest in the property. • These may not be the same as those obligated on the promissory note. • It is necessary to have all owners sign. • Identification of Property • Accurately described so as to distinguish it from any other property. • Referred to as a “legal description” (discussed in Chapter 10). • A street address is never acceptable. • Principal Amount Due • Only the principal balance then due can be conveyed. • The seller of a note must deliver accurate information on balance due. • With commercial loans some legal assurance is usually required.

Mortgage Instrument - Elements • Estoppel • The term estoppel is often applied to a mortgagee’s information letter. • Astatement from the lender on the current status of that loan. • Includes the amount of principal balance due at that time. • Prepayment Penalty • Lenders do not loan money for the purpose of recovering the principal. • So a penalty is charged for an early payoff. • No prepayment charges permitted on FHA, VA, or conforming loans. • Lock-In Provisions • Commercial loans do not have the restrictions found in residential. • Lock-in “locks” in the interest charge for a certain number of years. • Prepayment could cost all interest otherwise due for that time period.

Mortgage Instrument - Elements • Mortgage Covenants • These are promises (positive or negative) made by the borrower. • Positive covenant include a promise to keep the property insured. • Negative covenant might include a promise not to rent the property. • Acceleration Clause • Right to call the entire balance due upon borrower default. • Default could be failure to make payments or maintain the premises. • Alternative would be to foreclose each month as payments come due. • Right to Sell-Due-On-Sale (Alienation) Clause—Assumption • Lender may call the loan due in full upon sale or transfer of property. • If present, lender approval is required upon assumption. • If not present, the loan may be assumed at any time.

Mortgage Variations • Regular Mortgage • A two-party mortgage document. • The borrower, or mortgagor pledging the property as collateral. • The lender, or mortgagee making the loan and accepting the pledge. • Deed of Trust • A three-party mortgage document. • The borrower, grantor, mortgagor pledging the property as collateral. • The trustee, grantee, 3rd party that holds the property in trust. • The trustee is granted the “power of sale” in case of borrower default. • The lender, beneficiary, mortgagee making the loan. • Open-End Mortgage • Allows incremental advances up to the amount of the mortgage. • New money advanced may be at a different rate of interest. • Much like a line of credit.

Mortgage Variations • Construction Loan • A short-term loan used to cover the costs of building. • Funded through periodic advances as construction progresses. • Value of the building increases at the same rate as the loan amount. • Interim Loan • Any loan that is to be repaid from the proceeds of another loan. • Often used for short-term financing until regular financing is obtained. • Also called a gap or bridge loan. A construction loan is an interim loan. • Mortgage with Release Clauses • Aportion of the land is released as the loan balance declines. • Often used in subdivision development. • Lots must be completed and sold in an orderly manner.

Mortgage Variations • Junior Mortgage • Carry a lower priority than the prime or first mortgage. • Lower priority carries higher risk and higher interest rates. • Priority is established by the time of its recording. • Purchase Money Mortgage • Taken by the seller of property as all or part of the consideration. • Carries the special status of a vendor’s lien. • A second definition is a loan used exclusively to buy the property. • Chattel Mortgage • A mortgage on chattel, which is tangible personal property. • Likely to be used when additional security is needed for a loan. • Could also be used when personal property is included with real estate. • Chattel mortgages have been largely replaced by the bill of sale.

Mortgage Variations • Package Mortgage • Pledges both real and personal property to secure a loan. • Often found in the acquisition of a new house. • Normally calls for simple interest rather than the add-on interest. • Blanket Mortgage • A mortgage is not limited to pledging a single parcel of land. • Sometimes the security pledged may include several tracts of land. • When more than one tract is pledged, it is called a blanket mortgage. • “Subject To” Mortgage • The buyer is not accepting personal liability for payment of the note. • It in no way changes the claim of a lender holding the mortgage. • Liability remains with the original debtor. • Often used in a “wraparound” or “wrap”.

Contract for Deed • Allows the purchase price of property to be paid in installments. • It is not a mortgage. • Buyer receives only the rights of possession and enjoyment. • Buyer has equitable title to the property during the payment period. • After the payments have been made the seller delivers legal title. • State law varies on contracts for deed. • The risks that most concern a buyer in a contract for deed: • 1. Title is not delivered until after payment has been made. • 2. An underlying mortgage by the seller may go unpaid. • The risks that most concern a seller in a contract for deed: • 1. If a buyer defaults there could be a problem clearing title. • 2. Law offers differing interpretations on contracts for deed. • 3. May trigger the due-on-sale clause in most mortgages. • Legal counsel is advisable before entering into such an agreement.

Property Insurance • The mortgage will require property insurance coverage for both the lender’s and the borrower’s protection. • This is also termed hazard insurance. • It includes fire and extended coverage in an amount at least equal to the loan (even though the loan includes the value of the land). • Lender generally requires a full year’s paid-up insurance policy before releasing loan proceeds. • Lender also requires two months of the annual premium to be paid into an escrow account as a cushion at closing. • Then, added to each monthly payment, one-twelfth of the annual premium must be paid. • Lender makes premium payments from the escrow account.

Minimum Requirement for Hazard Insurance • Insurance regulators set some minimum standards for coverage. • Therefore insurance companies have a required minimum coverage. • Such a clause will require an amount not less than a given percentage of the actual cash value of the building at the time of loss. • Known as coinsurance, average, & reduced rate contribution clauses. • A common minimum amount is 80% of the actual cash value. • By carrying less than the minimum, the property owner cannot collect in full for a loss but will have to bear a part of the loss personally. • Insurance liability is limited to the same percentage of the loss that the amount of insurance carried bears to 80% of the property’s cash value.

Disbursement of Hazard Insurance Proceeds • Another insurance problem involves determining just how the proceeds should be paid in case of an actual loss. • Earlier mortgages required payment of the insurance money to the lender, who decided how to apply the funds, repair or pay off the loan. • Today most mortgages give the borrower a stronger position in the distribution of insurance proceeds, as in Fannie Mae/Freddie Mac conforming mortgage covenants. • This Covenant states, “Any insurance proceeds, shall be applied to restoration or repair of the Property, if the restoration or repair is economically feasible and Lender’s security is not lessened.”

Flood Insurance • Property located in a flood-prone area serving as collateral for a loan handled by a federally related institution must carry flood insurance. • The National Flood Insurance Program (NFIP) places responsibility on the lender to force-place the necessary insurance. • The lender may rely on the Federal Emergency Management Agency (FEMA) to determine whether or not the building is in a flood area. • A real possibility exists that the NFIP, may eventually be a casualty of attempts to reduce the federal deficit.

Property Taxes • Becomes a specific lien on the date the tax is assessed. • Release of lien is automatic upon payment of the tax. • If the tax is not paid, the property is subject to foreclosure. • Property taxes take precedence even over a first mortgage lien. • Lenders normally require tax payments as part of the escrow account. • One-sixth of the annual tax is deposited with the lender at closing. • The tax escrow at closing includes the amount accrued to that date. • Then one month’s worth of taxes is added to each monthly payment. • Once in escrow, the lender is responsible for making tax payments.

Federal Tax Claims • A tax claim by the federal government is considered a general lien, but only when it is filed of record. • Such a lien would carry a higher priority than other liens or a mortgage lien in a foreclosure proceeding. • If there is still equity in the property, the IRS has 120 days to redeem. • If there is a great deal of equity in the property, the IRS can use that money to satisfy any tax liens. • This is a rare but possible occurrence. • State property taxes have priority over all other claims regardless of when they were recorded. • A federal lien becomes a prior claim on any property acquired. • Title companies now check tax records for federal liens.

Recording • Recording is the act of entering into the public record a written instrument that affects title to property. • State laws define what is necessary for an instrument to be recorded; generally, it must be in writing and properly acknowledged. • Instrument must be recorded in the county where the land is located. • Recording a document gives constructive notice to the world of the existence of the document and its contents. • Failure to record a document does not invalidate the document. • If a document is not recorded it generally is void as against any subsequent purchaser, lessee, or mortgagee acting in good faith.

Priority • Recording gives priority to documents based on the time recorded. • There are liens whose priority is not based on time of filing. • This includes tax liens, mechanics liens, and special assessment liens that are a matter of public record.

Releases • It is also important to record a release when a claim has been satisfied. • If a claim is based on a written document, the release should be written. • Recording a release is most important when dealing with a mortgage. • While it is true that payoff of a mortgage note voids the mortgage pledge, the document remains a matter of record and a cloud on title. • Releases must be in a recordable form. • Sometimes notes marked “paid in full,” are thought to be a release. • That kind of release is valid between the parties involved, but it takes recorded documents to actually clear title to property.

Subordination • Subordination is a method of altering the priority of claims to property by a written agreement. • Commonly used in development when the land is seller-financed. • The land seller would hold a purchase-money mortgage on the land. • The land seller agrees to subordinate in favor of a construction lender. • This allows the developer/purchaser to obtain a first mortgage loan to build the intended improvement. • A subordination clause can be included in a mortgage instrument permitting a subsequent mortgage to take a higher priority. • This is a fairly standard type of clause found in a junior mortgage when an existing prior mortgage is recognized in the junior instrument.

Standardizing Loan Documentation • Documentation for residential loans has become more uniform throughout the country. • Regulators and the industry have promoted standard procedures. • Uniform methods make it easier for consumers to better understand the process and enable more accurate comparisons between lenders. • Standardization has become a necessity for loan pools. • Commercial loans are still mostly one-of-a-kind types of transactions and are not subject to the regulations imposed on residential loans. • Three standardized instruments are now required for residential loans. • The relevant forms are reproduced in the Appendix of this text.

Uniform Residential Loan Application • The Equal Credit Opportunity Act imposed certain nondiscriminatory requirements that must be incorporated in residential loan apps. • The form used to implement the requirements is a modified version of Fannie Mae’s Form 1003 and Freddie Mac’s Form 65.

Uniform Residential Appraisal Report (URAR) • FIRREA set standards for appraisals for federally regulated lenders. • The requirements resulted in a revision of the URAR form. • The new form is required for all loans involving Fannie Mae, Freddie Mac, VA, FHA, and RHS. • It is used in more than 90% of all residential mortgage loans.

HUD-1 Settlement Statement • RESPA sets standards for closing all residential loans, and one of its requirements is the use of a HUD-1 Settlement Statement. • The purpose is proper disclosure of information to a borrower. • It is an itemized listing of the consideration tendered in closing a transaction and how the money is distributed to the various parties. • Chapter 16 covers the details of HUD-1.

GSE-Conforming Loans as a Catalyst for Uniform Loan Documentation • Conforming procedures allow loan originators to avoid the time- consuming examinations necessary for nonconforming loans. • Conforming loans require more than uniform documentation. • Aloan must also meet the not-to-exceed loan limits set annually, plus property standards and borrower qualification guidelines. • In addition to the three standardized documents listed in the preceding section, Fannie Mae and Freddie Mac require the use of their own: • Verification of Employment • Verification of Deposit • State-specific mortgage instrument • Promissory note that complies with state requirements

Loan Document Mandate • In practice, loan originators retain considerable freedom in loan documentation because there are many secondary-market purchasers who do not require conforming loan standards. • Basically, residential loans need only two mandated forms: • 1. Uniform Residential Loan Application, and • 2. HUD-1 Settlement Statement. • Standardized documents become important when a loan originator wants to sell a loan; at that point it becomes necessary to meet the requirements of whoever purchases the loan.

Questions for Discussion What procedure is used in your state to handle a pledge of collateral for a mortgage loan? Explain the relationship and purpose of a promissory note and the two primary forms of security instruments. In a foreclosure, how are priorities determined among lien claimants on the collateral property? What is the underlying purpose of requiring a borrower to escrow money each month for the payment of property taxes? Describe the difference between a buyer taking title subject to the mortgage versus assuming the mortgage. Explain the difference between the equity right of redemption and the statutory right of redemption. Explain the differences between a regular mortgage and a deed of trust. What is the principal risk for the buyer/borrower in a contract for deed? Describe a conforming loan. What is the purpose of recording documents?

REAL ESTATE FINANCE Ninth Edition