Module 2: Financing Real Estate Transactions
Mortgages
The most common wayshomebuyers finance home purchases are with mortgages. A mortgage is a legalencumbrance on property – it is a loan for which property is the collateral.The lender loans money which must be paid back, with interest, over a set period.The lender does not have the right to enter or possess the property so long asthe borrower complies with the mortgage agreement’s terms.
The first benefit of amortgage is that mortgages are typically available with much lower interestrates than other types of loans. As of this writing, the average mortgage ratefor a 30-year fixed mortgage is about 4.5% Contract that with credit cardinterest rates, which are typically well over 10% and can be as high as 24% oreven higher.
Because real estatetypically appreciates, on average, at a rate of more than 5% per year,[1] low mortgage ratesencourage home ownership since expected appreciation is often more than themortgage interest paid for the investment. Moreover, except in the case of veryexpensive homes, mortgage interest qualifies as a Schedule A tax deduction,further encouraging home ownership through this tax break. In all, Americanshold over $14.5 trillion in mortgage debt, and this sum keeps increasing.[1]
While the borrower makesmonthly payments to repay the loan, he can use and occupy the land. However, ifa borrower violates the terms of a mortgage agreement by defaulting on apayment or using the property in a manner prohibited by the agreement, he riskslosing the property through foreclosure and public sale, with the proceedsapplied first towards the secured obligation.[2]
Creating aMortgage-Promissory Note
A borrower executes atleast two instruments to create a mortgage: a promissory note and a securityagreement.[3] A promissory note is a written document that guaranteesa lender’s right to be repaid the underlying debt. The document contains awritten promise to pay a predetermined amount to the lender at a specified dateor schedule of dates.[4] A promissory note canbe bought and sold,[5] and when the lender transfersit, the debt under the agreement is unaffected.
The promissory notewill have the borrower’s name, the property address, the loan amount, aninterest rate (fixed or adjustable), penalties that result from a failure topay, and a date by which the debt must be repaid.
Most states have usurystatutes, which penalize lenders for charging excessively high interest rates.For example, in California, an interest rate cannot exceed 10% per year. Ausurious interest rate makes a promissory note unenforceable and should alender violate a state’s usury laws, the penalties can be severe. In Florida,laws criminalize charging extremely high interest rates and not only will thelender forfeit interest, but a lender could face up to 60 days in prison forcharging a usurious interest rate. Lenders are responsible to be aware of therights and limitations that apply in their states.[6]
Creatinga Mortgage-Security Agreement
While the promissorynote is the document that contains the promise to repay the loan, anothersecurity instrument is needed to establish a lien on the real propertypurchased. A security agreement designates the property as collateralfor the loan[7] and conveys legaltitle from a borrower to the lender as security for the mortgage loan.
A security deed is atwo-party instrument. While title to theproperty remains with the homeowner, the lender is given a security interest,which is a legal interest in the property. Because it is a legal interest inproperty, it must conform to the formal requirements of the transfers ofinterests in real estate, including a writing requirement under the Statute ofFrauds.
Other Security Interests
Deed ofTrust
Another possiblefinancing strategy is to execute a deed of trust. A deed of trust is like amortgage because it pledges real property to secure a loan. However, unlike amortgage, where title to the collateral remains in the debtor and creates alien on the real estate in favor of the creditor, a deed of trust conveys titleto a third party known as the "trustee." The trustee holds the title in trust with thelender designated as the beneficiary. The deed of trust secures repayment ofthe loan created by the promissory note and guarantees the borrower’sperformance by holding the underlying property as collateral. If the borrowerdefaults on the mortgage, the trustee can sell the land and give the sale proceedsto the lender to offset the borrower's remaining debt.[8]
Regardless of whether thesecurity agreement is a deed of trust or mortgage, it must include the parties’names, words of conveyance or grant, a legal description of the property,legally-compliant execution and attestation.[9]
Securinga Loan with Personal Property
A borrower can secure aloan by using personal property with substantial value. For example, a borrowercan use items such as jewelry or art work as collateral. Article 9 of theUniform Commercial Code, a uniform commercial law adopted in every U.S. state, regulatessecured transactions.
Under Article 9, aborrower signs a security agreement conveying a security interest in personalproperty to the lender and then files a UCC-1 financing statement. A financingstatement itself won’t create the lien or security interest, but when properlyfiled, it gives notice of the security interest created in the securityagreement.
The UCC financingagreement will describe the borrower's collateral, describe the obligation itsecures, identify what constitutes a default, the rights of the creditor if theborrower defaults, the requirements of the debtor with respect to the care ofand insurance maintained on the collateral, and any other obligations in thetransaction.
Once she files thefinancing statement with the appropriate government office, usually thesecretary of state, the lender has a security interest in the personal propertyand if the borrower defaults, the holder can take possession of and to sell thecollateral apply the proceeds to the loan.[10]
While usually notnecessary in the case of mortgages, personal property collateral may benecessary where the house is undervalued. For example, assume that the house isworth $300,000 and the lender only wants to lend an amount that’s not more than80% of the value of the secured property ($240,000), but the borrower wants toborrow the full $300,000. If the borrower agrees to designate an additional $75,000worth of personal property as collateral for the loan (perhaps a boat orartwork), the $300,000 that the purchaser wants to borrow would now be 80% ofthe value of the collateral. It should be noted, though, that most banksrequire the house being financed to be of sufficient value to be the solecollateral.
GuarantyAgreement
When a borrower doesn’thave an extensive credit history or if she poses additional financial risk, abank may also require a co-signer to support the agreement to reduce the creditrisk. Called a guaranty, it gives a lender the right to sue a third party, theguarantor (or co-signor), who signs an agreement to step in to pay back theborrower’s debts if he defaults.[11]
There are twocategories of guaranty notes which dictate how and when the third-party guarantorwill pay a lender. The first is a "payment guaranty" wherein, as soonas the borrower defaults, the guarantor’s obligation becomes fixed and she mustpay the lender directly.
The second category, a"collection guarantee", requires the guarantor to pay the lender onlyafter the lender has pursued legal action against the borrower and has obtaineda judgment for the outstanding balance that has been unsatisfied, or theborrower is insolvent, so a judgment ordering the lender to pay isn’tworthwhile.
Whenever there is a guarantynote, the guarantor must consent before changes can be made to it or to themortgage agreement. The guarantor’sconsent is necessary because modifying or amending the mortgage agreement inany way could substantially impact his rights and liabilities.[12]
Common Contractual Terms in MortgageAgreements
Promissory notes andsecurity agreements, together, create a mortgage between a bank and a realestate buyer.[13] Lenders differ on the keyterms and conditions necessary for these agreements, but certain ones areuniformly included.
A. Dragnet Clause
A mortgage agreement’s dragnetclause secures all debts that the borrower may owe to the lender at any time. Adragnet clause is so named because it "drags" in all other debt that hasbeen, or could be, incurred between the borrower and the lender.[14]
A dragnet clause isworded as follows: “the agreement is madeand intended to secure all indebtedness now or hereafter owing by the mortgagorto mortgagee." If a borrower takes out a mortgage with a dragnetclause and she returns to the same bank later to take out a personal loan, anymoney loaned as part of the personal loan will be dragged in to the mortgage’s balance.The clause also applies to late fees and other costs that are due to the bank.
B. Due on Sale Clause
A property owner whohas taken out a mortgage can sell her property even if she still has numerousmortgage payments to make. However, a mortgage agreement can inhibit the freetransfer of property if the underlying agreement includes a "due onsale" clause.
Such a clause willaffect both a borrower and a lender if a property owner wants to sell the propertywithout having paid back the entire loan. This clause allows the existinglender to call the entire loan due and payable if the homeowner transfers titleto the home without paying the loan in full.
However, it should be noted that federal law,under the Garn–St. Germain Depository Institutions Act of 1982, disallows theenforcement of due-on-transfer clauses when the transfers are made to certainclose relatives.[2]
C. “Subject to” or “An Assumption of” Mortgage Default Terms
If there is no due onsale clause, mortgages are easily transferrable. A transferable mortgage, also called anassumable mortgage, is a loan that one party can transfer to another. Thelender puts the loan in the transferee's name; the transferee takesresponsibility for repayment under same interest rate and other terms the originalborrower had.
Though the mortgage canbe transferred, its language determines subsequent purchaser's potentialliability for the original borrower’s debt. The key words here are “subject to” or “an assumption of.” If the property can be transferred "subjectto" a mortgage, the new owner cannot be held personally liable for theunderlying debt. If the subsequentholder of a "subject to" mortgage defaults, the lender can forecloseon the property will be foreclosed but the lander cannot sue him for anyremaining amount due on the debt after public sale. Rather, the lender canrecover any remaining damages from the original borrower.
On the other hand, ifthe subsequent holder of “an assumption of” mortgage defaults, she becomespersonally responsible for repaying the debt. The lender can foreclose and sellthe property and sue both the original borrower and the subsequent purchaserfor any amount still owed on the property.
SubsequentMortgages on the Same Property
A borrower may want totake out a second mortgage on his property.Unless the first mortgage agreement expressly prohibits him from doingso, he can mortgage his property as many times as he wants. It’s risky for alender to issue a second mortgage because the second mortgage terminates if theborrower defaults on the first. Every subsequent mortgage is inferior to theprior.
To mitigate this risk, theissuer of a second mortgage often requests estoppel certificates requiring thefirst mortgage holder to give notice of an impending default and give thesecond mortgage holder an opportunity to cure and prevent foreclosure.[15]
Foreclosure
If a borrower fails makemortgage payments in a timely manner, the lender has several options.Foreclosure is the most widely-recognized consequence for failing to pay amortgage when due. However, foreclosure is an extreme remedy for default and a defaultingborrower has contractual and due process rights before a lender can beginforeclosure.[16]
In a foreclosure sale,a mortgage holder will sell the real estate used to secure the loan and use theproceeds to satisfy the mortgage debt.If a foreclosure sale results in a sale price more than the mortgagedebt remaining, the borrower is entitled to the additional amount.
A valid foreclosuresale extinguishes all the borrower’s ownership rights and divests all juniorencumbrances on the property, meaning all subsequent mortgages, easem*nts, liens,created after the date of the mortgage in default are terminated at the time ofthe sale. A federal tax lien, however, cannot be divested through foreclosureunless the mortgage holder gives the Internal Revenue Service at least 25 days’notice of the sale.
Borrowers default for avariety of reasons. Most of the time,borrowers default by failing to make the payments required under the agreement,but default can result from a violation of any condition in the mortgage. Forexample, failing to pay taxes on a property can result in default, as couldfailing to insure the property, failing to keep the property in good repair, orin some cases, transferring the property without the lender's permission.
Depending on where the propertyis, a foreclosure can be either court-ordered or accomplished throughcontractual power of sale. A court-ordered, or judicial, foreclosure requiresthe lender to file a lawsuit against the borrower in default.
Judicial action is thesole foreclosure method in some states. A typical judicial foreclosure involvesa lengthy series of steps: the filing of a foreclosure complaint and notice,the service of process on all parties whose interests are affected by ajudicial proceeding, a hearing before a judge or a master in chancery whor*ports to the court, the entry of a decree or judgment, a notice of sale, apublic foreclosure sale conducted by a sheriff, and the post-sale adjudicationas to the disposition of the foreclosure proceeds.[17] The borrower can avoidforeclosure by refinancing the debt and becoming current on payments, so whilea judicial foreclosure is time consuming, it affords substantial due processand opportunities for remediation[18]
In jurisdictions thatdo not practice judicial foreclosure, the mortgage holder has a contractualpower to foreclose and sell mortgaged property. While a court won’t review thissale, states impose strict standards on non-judicial foreclosures. For example,in Arkansas, the mortgage holder must file a notice of default with the countyrecords office and must sell the property for no less than two thirds of theappraised value.[19]
Federaland State Limits on Foreclosure
A borrower has theright of redemption, which means that he can recover the property before theforeclosure is completed by paying off the mortgage at any time prior toforeclosure.
Several states have enactedlaws permitting a mortgage borrower to recover it even after a foreclosuresale. This post-foreclosure redemption can only be exercised for a limitedamount of time though, and laws vary by state. Following the mortgage crisis of2008-2009, many states passed laws limiting the rights of lenders to forecloseon residential property. These laws often impose waiting periods of up to 120days before a lender can foreclose on a property. Some states require mortgagelenders to negotiate with borrowers in default in good faith to modify theterms of the loan and prevent foreclosure. [20]
On the federal level,the Homeowner Affordability and Stability Plan provides a borrower who isbehind on mortgage payments access to low-cost mortgage refinancing options. Thislaw has assisted millions of American homeowners threatened with foreclosure bymaking lenders responsible for lowering total monthly payments to a proportionof the borrower’s income and requiring banks to modify loans to help a borrowerremain current on payments.[21]
[1] U.S. Federal Reserve, “Mortgage DebtOutstanding,” Board of Governors of theFederal Reserve System (Sept. 21, 2017) https://www.federalreserve.gov/data/mortoutstand/current.htm
[2] Conley v. Barton, 260 U.S. 677 (1923)
[3] See e.g.Livonia Property Holdings, L.L.C. v. 12840-12976 Farmington Road Holdings, L.L.C., 717 F. Supp.2d 724 (E.D. Mich. 2010) (holding that a mortgage cannot exist separately fromthe underlying promissory note).
[5] Renuart, E., Uneasy Intersections: The Right to Foreclose and the U.C.C., 48 Wake Forest L. Rev. 1205, 1216-17 (2013).
[7] Renuart, E., Uneasy Intersections: The Right to Foreclose and the U.C.C., 48Wake Forest L. Rev. 1205, 1212 (2013).
[9] Hinkel,D., Essentials Of Practical Real Estate Law 189 (6th ed. 2016).
[10] Id. at 196.
[11] See Ameris Bancorp v. Ackerman, 674S.E.2d 358 (Ga. 2009),cert. denied, (June 1, 2009).
[12] Hinkel,D., Essentials Of Practical Real Estate Law 188 (6th ed. 2016).
[13] See e.g. Livonia Property Holdings,L.L.C. v. 12840-12976 Farmington Road Holdings, supra note 4.
[14] Boyette v. Cardin, 347 So.2d 759 (Fla.1977).
[15]Hinkel, D.,Essentials Of Practical Real Estate Law194 (6th ed. 2016).
[16] Renuart, E., Uneasy Intersections: The Right to Foreclose and the U.C.C., 48Wake Forest L. Rev. 1205, 1212 (2013).
[17] Nelson, G., Reforming Foreclosure: The Uniform Nonjudicial Foreclosure Act, 53Duke L.J. 1399, 1405 (2004).
[18] Hinkel,D., Essentials Of Practical Real Estate Law 198 (6th ed. 2016).
[19] Arkansas Foreclosure Laws, https://www.realtytrac.com/real-estate-guides/foreclosure-laws/arkansas-foreclosure-laws/
[20] Id at 199-201.
[21] Homeowner Affordability and Stability Plan, P.L 111-22 (May 20, 2009).
