Highlights • Chapter 15 ½ 11
Chapter 15: mortgages and deeds of trust
Chapter Highlights
1. What documents are involved in a typical mortgage loan?
Many documents are involved in a typical mortgage loan. Two primary documents are a promissory note and a mortgage (or a deed of trust). The borrower assumes a personal obligation to repay the loan by signing a promissory note.
2. Explain a mortgage.
The mortgage creates a right, or security interest, in the real property for the lender. Specifically, a mortgage is used to pledge the borrower’s interest in the real property as security for a loan. When a mortgage is used, the party loaning the funds is referred to as the mortgagee, and the party receiving the loan is known as the mortgagor.
3. Why is it important to have the note and mortgage as separate documents?
First, by using both documents, the lender has two possible courses of action in the event the borrower does not perform as agreed: sue on the note, or repossess the property serving as collateral. Second, separate documents allow the lender to record the mortgage to give constructive notice of its security interest in the property without recording the note. Once a mortgage is recorded, it acts as a cloud on the owner’s title (preventing a subsequent transfer). Therefore, once the debt has been paid, it is important that a satisfaction of mortgage, a document that signifies that a mortgage debt has been satisfied (or forgiven) also be recorded in the same office as was the mortgage. Recording the promissory note would make the specifics of the loan agreement available to the lender’s competitors who may search the public records to locate potential clients for refinancing on more attractive terms. Lenders who search the public records in such a manner are raiding.
When the mortgage and note appear as separate documents, it is important that they refer to each other to make it clear that they are parts of the same transaction. It is equally important that the terms of the two documents do not conflict. If the terms do conflict, costly disputes between the parties are more likely to occur.
4. What do astute borrowers sometimes do?
Sometimes borrowers make payments larger than the amount owed but less than the remaining balance of the loan in order to reduce the principal faster than scheduled. Borrowers can greatly reduce the total amount of interest they must pay on a mortgage loan by making such payments. Astute borrowers will also completely pay off a loan when interest rates drop and refinance to lock in a lower rate.
5. Explain a prepayment penalty.
Not all mortgages allow prepayments without the borrower incurring an extra charge. Some contain a clause that imposes a monetary prepayment penalty, usually stated as a percentage of the loan balance at the time of prepayment. The prepayment penalty is intended to compensate lenders that planned to earn the original rate, but must now lend the prepaid amounts at a new, lower rate. Because a prepayment penalty may work to the disadvantage of the borrower, a loan with a prepayment penalty should carry a lower rate of interest compared with a loan with no prepayment penalty.
6. What is a due on sale clause?
It gives the lender the right (but not the duty) to demand payment in full if the subject property is sold. This provision is frequently referred to as the due on sale clause. Whether a lender exercises this option depends, in part, upon what has happened to interest rates since the loan was originated. If interest rates have increased, the lender is quite likely to demand full payment. If, instead the rates have decreased, the lender may be willing to let another party assume the payments, especially if the lender can obtain some assurance as to the credit worthiness of the new party.
7. What are the essential elements of a valid mortgage?
The Statute of Frauds requires that a mortgage be in writing, and the rules of contract law apply. Specifically, in the mortgage: the competent parties must be named; the subject property must be legally described; the amount of the debt must be stated; there must be some mention of consideration; and a mortgaging clause, which pledges the borrower’s interest in the subject property as collateral for the loan, must be included. In addition, the mortgage must be signed by the borrower(s).
8. What are provisions?
Some provisions specify the rights of the borrower, but most protect the lender. Some provisions, referred to as uniform covenants, are applicable to all transactions; other non-uniform covenants are used only in special cases. While the covenants contained in most mortgages are reasonable, all are subject to negotiation and if the parties agree, one or more covenants may be eliminated, or added, before the document is signed. It would be highly unusual, however, for a lender to agree to eliminate any of the uniform covenants. It is more common to see one or more of the nonuniform clauses struck from the mortgage simply because it does not apply.
9. How many Uniform Mortgage Covenants are there and what are they?
There are twenty-one uniform covenants in a residential mortgage.
Payment of Principle, Interest, Escrow Items, Prepayment Charges, and Late Charges
Application of Payments and Proceeds
Funds for Escrow Items
Charges; Liens
Property Insurance
Occupancy
Preservation, Maintenance and Protection of the Property: Inspections
Borrower’s Loan Application
Protection of Lender’s Interest in the Property and Rights Under this Security Instrument
Mortgage Insurance
Assignment of Miscellaneous Proceeds; Forfeiture
Borrower Not Released; Forbearance By Lender Not a Waiver
Joint and Several Liability; Co-signers; Successors and Assigns Bound
Loan Charges
Notices
Governing Law; Severability; Rules of Construction
Borrower’s Copy
Transfer of the Property or a Beneficial Interest in the Borrower
Borrower’s Right to Reinstate After Acceleration
Sale of Note; Change of Loan Servicer; Notice of Grievance
Hazardous Substances
10. How are mortgages classified?
Mortgages can be classified based on a number of criteria, including whether the loan is supported by a government agency, by the priority of the mortgagee’s claim, and according to the manner in which the loan is to be repaid.
11. Explain a conventional mortgage loan.
A conventional mortgage, so called because it conforms to conventional lending standards, is used for real estate loans in which the government is not participating either as an insurer or guarantor of the debt. The conventional loan mortgagee can be either a private party or an institutional lender.
Conventional loans lack government sponsorship and, therefore, present more risk to the lender. To reduce the level of risk, down payment requirements on conventional loans tend to be higher than on government-sponsored loans. Currently, almost all conventional home loan mortgage originators require that borrowers make a minimum down payment of 20 percent of the purchase price, or require the borrower to purchase private mortgage insurance (described later) because the loan originator does not intend to hold the mortgages in its own portfolio. Instead, the mortgage is sold on the secondary mortgage market, and for a mortgage to qualify for secondary trading either the 20 percent down payment or private mortgage insurance is required.
12. Why are conventional loans more flexible than government loans?
While conventional loans are subject to state and/or federal regulation, these regulations are not as stringent as those that apply to government-sponsored loans. Therefore, conventional loans are more flexible with respect to lending terms compared with government- sponsored loans.
13. What is an open-end mortgage?
An expandable loan in which a credit limit is offered to the borrower, with each incremental advance secured by the same mortgage. An open-end mortgage may be attractive to one acquiring property and planning substantial renovations, because the use of an open-end loan reduces future appraisal and refinancing costs. The interest rate the lender charges on future advances against the credit limit are subject to negotiation. The lender may agree to charge the prevailing rate at the time the mortgage was signed, but it is more common to charge the market rate at the time of the future disbursement. Lenders must be particularly cautious when using an open-end mortgage because it is possible that liens recorded between advances on the mortgage may take priority over the advances.
14. Explain a package mortgage.
A package mortgage is often used in the sale of condominiums and new subdivision homes. Under this arrangement, the loan proceeds are used to finance not only the purchase of the home, but also the purchase of personal property such as a refrigerator, washer, dryer, and other appliances. These items are listed in the mortgage and declared to be fixtures (although they have not been installed at the time of the loan) and are, therefore, part of the mortgaged property.
Both the mortgagor and mortgagee derive benefits from a package mortgage. Some lenders believe that fewer defaults occur with package mortgages. The mortgagor benefits in that essential items can be acquired with no additional down payment, and financed over a longer period than is available through the typical consumer installment loan. In addition, unlike interest paid on a consumer loan, mortgage interest is deductible in calculating personal income tax. Of course, when personal assets are financed with a long-term loan, it is likely that the borrower will still be paying for them long after their useful life expires.
15. What is a blanket mortgage?
When several properties are used to secure a single mortgage, the mortgage is referred to as a blanket mortgage. Blanket mortgages are frequently used to obtain construction financing for condominium development projects and proposed housing subdivisions. Blanket mortgages can also be used when the equity in one property does not meet the lender’s requirements, or when one buys a house and adjacent vacant property. Blanket mortgages usually contain a partial release clause that enables the mortgagor to obtain a release from the mortgage for each unit according to a specified release schedule.
16. Explain a budget mortgage.
Many lenders require that each payment cover not only principal and interest, but also a portion of the property tax and casualty insurance premium for the subject property. The theory of this requirement is that it is easier for the borrower to make these payments in installments rather than pay the full amount annually or semiannually. This arrangement forces the mortgagor to include these sums in his or her monthly budget and is, therefore, referred to as a budget mortgage. Because private lenders originate virtually all government sponsored mortgage loans, they may also be budget mortgages.
17. What is the FHA-insured mortgage?
The FHA was established as a part of the National Housing Act of 1934 to address problems in the housing industry that developed during the Great Depression. Congress empowered the FHA to provide lenders with insurance against default losses to encourage them to make home loans and to stimulate the economy by encouraging the construction of new housing. The term to maturity on FHA loans was increased to twenty-five or thirty years, and the loans were paid on a fully amortized basis.
18. What is an amortized loan?
An amortized loan is one in which each payment consists of both interest and principal reduction. A fully amortized loan is one in which the principal reduction included in all periodic payments completely eliminates the debt.
19. Explain the impact of FHA loans on home financing.
FHA loans have had an important influence on home financing. The terms that now prevail in the conventional mortgage loan market mirror those the FHA implemented. Increasing the repayment period makes housing more affordable, and the possibility of defaults decreases with amortized loans.
20. How are borrowers currently required to pay the FHA insurance premium?
Currently, federal legislation requires an initial premium equal to 2.25 percent of the loan amount plus an annual premium equal to 0.5 percent of the remaining insured principal balance. FHA mortgage insurance is generally available only on owner-occupied dwellings with from one to four living units.
21. What are the FHA loan limits?
The size of an FHA mortgage is limited, with the limits dependent upon both the number of living units in the dwelling and the location of the property. The “standard limit” for a single-family dwelling under the most widely used FHA program, 203(b), is $132,000. However, the FHA increases the maximum loan amount above the “standard limit” on an area-by-area basis in order to meet local differences in housing costs.
22. Why are FHA loans attractive to borrowers?
The low down payment required on FHA loans is attractive to many borrowers. The use of an FHA mortgage does not eliminate the need for a down payment, but the amount of the required down payment may be significantly less than that required for a conventional loan.
23. What are the drawbacks to FHA financing?
At the time an FHA loan is made, no secondary financing is permitted. At closing, therefore, the borrower must pay the difference between the purchase price and the amount of the insured commitment in cash. Borrowers are, however, not prohibited from adding secondary financing after the FHA mortgage is in place. For lenders, low down payments may potentially create a problem because borrowers are more likely to default on loans if property values fall below the loan balance. The lower the amount of the down payment, the less property values must fall for borrowers to view default as a palatable option. Even though the loan is insured, the foreclosure process, described later in this chapter, is a headache for the lender.
24. Explain FHA loan assumptions.
When interest rates rise subsequent to the issuance of a fixed interest rate mortgage, assumable mortgages are attractive to buyers because they allow for monthly payments that are lower than they can obtain with a new mortgage. Subject to certain restrictions, any FHA loan may be assumed using one of two methods. Under either method, the interest rate charged on the loan remains the same as the original rate. One assumption method is a simple assumption that allows the loan to be assumed without notification to the FHA. Under this method, the original borrower remains liable for payment of the debt in the event that the party that assumes the loan defaults. The FHA does not allow simple assumptions during the first two years of a loan. Under the second assumption method, called a formal assumption, FHA notification is required. If the loan is current, the new buyer meets FHA qualification standards for credit worthiness, and agrees to the assumption, the FHA will approve the formal assumption. In the case of a formal assumption, the original borrower is not liable for a subsequent loan default.