Chapter 10
Chapter 10
Financing
Chapter Outline
Introduction
A. The lender requires two things:
1. a promise to repay the debt on agreed-upon terms and conditions evidenced in a written promissory note, and
2. a written financing or security instrument that pledges the real property as collateral for the loan debt, the instrument generally being either
a. a mortgage or
b. a deed of trust.
B. A promissory note is
1. the legal evidence of the borrower’s intentions to repay the debt.
2. a personal obligation, which means that if the borrower defaults on the loan, the lender may come after the borrower personally wherever the borrower may be located and seek a court judgment against the borrower.
a. Typically, the lender goes after the real property serving as collateral for the loan first
b. However, if the foreclosure sale on the property produces insufficient funds to cover the loan obligation plus fees and costs, the note allows the lender to seek a deficiency judgment against the borrower personally.
Legal Theories of Financing Instruments
C. Two legal theories pertain to financing instruments
1. Title theory: a legal theory that maintains that a financing instrument transfers conditional title in the secured real property to the lender.
a. The borrower retains possession of the real property and remains in possession as long as the borrower conforms to the terms of the loan agreement. When the loan is paid off, the legal title to the property is transferred to the borrower..
b. In some states adopting the title theory, in the event of default by the borrower, the lender can take possession of and sell the property without commencing a foreclosure suit.
2. Lien theory: a legal theory maintaining that a financing instrument serves as a lien on the secured property.
a. The borrower is giving the lender a lien only on the real property. The borrower obtains legal title to the property.
b. The lender perfects its lien by recording it.
c. The lender has the right to enforce the lien by bringing a foreclosure action if the borrower defaults.
Financing Sources
D. Terminology
1. Due-on-sale clause: a clause in a loan document that states that if the real property securing the loan obligation is sold, the total amount outstanding on the loan becomes due immediately.
2. Fiduciary lender: a lender that has a fiduciary duty to its principals.
3. Demand deposit: an account in which the depositor may take out his/her money on demand; a checking account.
4. Federal Deposit Insurance Corporation (FDIC): an institution that insures depositors’ accounts.
5. Bank Insurance Fund (BIF): a fund that insures depositors’ accounts.
6. Financial Institutions Reform, Recovery and Enforcement Act (FIRREA): a federal law that restructured the savings and loan regulatory and insurance systems, giving management of insurance funds for savings and loans to the FDIC.
7. Savings Association Insurance Fund (SAIF): a fund that insures savings and loan deposits.
E. Commercial banks
1. These banks are a major source of construction loans, short-term loans, and home-improvement loans.
2. A large portion of their deposits are demand deposits.
3. Depositors’ accounts are insured by the FDIC through the BIF.
4. They are either state-chartered or federally-chartered.
5. They may make conventional loans, FHA loans, or VA loans.
F. Savings and loan associations
1. They are either federally-chartered or state-chartered.
2. They primarily make conventional loans but on occasion make FHA or VA loans.
3. They specialize in residential, long-term loans.
4. Insurance funds for savings and loan associations are managed by the FDIC, which insures deposits through the SAIF.
G. Mutual savings banks
1. These banks are found primarily in the Northeast.
2. They are owned by their depositors, who are their investors and who receive a return on their investments through payment of interest on their savings accounts.
3. They operate similarly to savings and loan associations, but, unlike savings and loan associations, they make loans for both residential and income-producing properties.
4. They also gravitate to FHA and VA loans more than do savings and loan associations.
H. Insurance companies
1. These companies invest a large portion of premiums in real estate loans, primarily large commercial and industrial loans.
2. They also often purchase blocks of residential FHA and VA loans from secondary markets.
I. Other financing sources
1. Credit union: a cooperative association in which members make savings deposits. Credit unions pay interest on the savings accounts and permit members to borrow money for both short-term and long-term residential loans.
2. Retirement and pension plans accumulate large sums that are invested in both residential and commercial loans, often through the services of mortgage brokers.
3. Mortgage banking company: a private corporation that originates loans for other lenders and investors for which it receives a servicing fee.
4. Mortgage broker: a licensed individual who acts as a middleman in a financing transaction, bringing lenders and borrowers together in return for a placement fee. State statutes regulate their licensing requirements.
a. They do not service loans.
b. They are not lenders themselves; they act as intermediaries.
c. As mortgage markets become more competitive, the services of mortgage brokers become more popular.
d. They have access to wholesale capital markets and pricing discounts, and they can be competitive because they can reduce their profit margin in ways that large lenders often cannot.
e. They often are aware of niche markets for loans that are not known by laypersons.
f. They are helpful in obtaining financing if the property is unusual or the borrower has a difficult credit history.
g. The services performed by mortgage brokers include
1) assessing a client’s credit history,
2) finding a mortgage product that is appropriate for the client,
3) completing the lender’s pre-approval application,
4) collecting the documentation required by the lender,
5) completing the lender’s application form and submitting all materials to the lender, and
6) Explaining all documents to the client.
5. Real Estate Investment Trust (REIT): a trust that accumulates funds by selling beneficial interests in the trust to members of the public. The trust then invests in various types of loans, typically construction loans and loans for larger real estate projects.
6. Purchase money mortgages may serve as a source of financing, either as a first loan or a junior mortgage loan; also referred to as seller financing. These loans generally are short-term loans and the seller receives a promissory note and mortgage instrument from the buyer.
Types of Financing Instruments
J. Mortgage
1. Definition: a two-party security instrument between the mortgagor (borrower) and mortgagee (lender) that describes the property serving as collateral for the loan and sets forth the rights of the lender should the borrower default.
2. A mortgage typically contains an acceleration clause: a clause in a financing instrument that permits the lender, at its option, upon default by the borrower, to accelerate the entire loan amount, making the full outstanding balance, plus interest and penalties, immediately due.
3. Upon default, the lender may bring a court action to foreclose on the real property and sell it at a public auction.
K. Deed of trust
1. Definition: a three-party financing instrument between the trustor/borrower, beneficiary/lender, and trustee. The borrower, as trustor, signs legal title to the real property in question to the trustee as collateral for the loan, while the borrower remains in physical possession of the property.
2. The trustee holds legal title to the property on behalf of the beneficiary/lender. The lender holds the promissory note that outlines the loan terms.
3. Upon payment in full of the loan, the trustee reconveys the real property to the borrower.
4. Deeds of trust contain a power-of-sale clause: a clause that gives the trustee the power to sell the property serving as collateral for the loan at a public auction if the borrower defaults.
Types of Loans
L. Conventional loan
1. Definition: a loan made by a private lender in which the lender usually does not have any insurance or guarantee from a third party, such as a government agency, backing the loan should the borrower fail to meet his/her loan obligations.
2. Loan-to-value ratio: the correspondence between the value of the real property to serve as collateral for the loan and the amount of the loan.
3. Traditionally, a lower percentage of the property value was loaned to correspondingly lower the risk to the lender. Commonly, the loan-to-value ratio was 80/20, which is lower than with FHA and VA loans.
4. To make conventional loans more competitive, private mortgage insurance (PMI) became available. PMI is insurance from private insurance providers that insures the portion of the loan that exceeds the typical conventional loan-to-value ratio. A borrower may pay the total PMI at closing or pay a certain percentage with the rest factored into the balance of the loan.
5. Historically, conventional loans were straight loans: loans in which the borrower made periodic interest payments, with the entire principal paid at the end of the loan term.
6. A similar structure is found in balloon mortgages: loans calling for periodic payments that are less than the amount required to pay off the loan completely at the end of the loan term. The remaining balance of the principal “balloons” into a single, large payment at the end of the loan term.
7. Today, conventional loans typically are amortized loans: loans in which level payments are made throughout the life of the loan.
8. Conventional loans typically require less paperwork than FHA or VA loans.
9. Conventional lenders charge a loan origination fee: a fee to process a loan application, usually 1% of the loan amount.
10. They may charge points (also known as discount points): a lending charge in which each point is equal to 1% of the loan amount. Points can be paid at closing or can be rolled into the actual loan payments. Note that if they are rolled in, the borrower is paying interest on this amount each month he/she is making a loan payment.
11. In addition, prior to closing on the loan, the lender will require a property appraisal and current credit reports. These, like the loan origination fee, become closing costs on the loan and can either be paid at closing or be financed into the loan. Again, if they are financed, the borrower continues to pay interest on them.
M. FHA loan
1. Definition: a loan insured by the Federal Housing Administration. The FHA does not lend money to borrowers. The FHA insures loans for owner-occupied one-to-four family dwellings.
2. Because the FHA stands behind the lender, insuring the lender against risk, the lender is willing to make loans with higher loan-to-value ratios, and thus the borrower has to make only a small down payment to purchase the property.
3. The FHA sets maximum loan amounts, which vary from area to area, and sets the minimum down payment required.
4. The FHA has a more relaxed standard for qualifying a borrower than is used by conventional lenders.
5. Borrowers are charged a mortgage insurance premium: an insurance premium collected into the FHA’s Mutual Mortgage Insurance Fund to insure lenders against bad loans.
6. FHA lenders are allowed to charge a 1% loan origination fee and are allowed to charge points.
7. All mortgage loan payments are PITI payments. PITI: a loan payment composed of principal, interest, taxes, and insurance.
8. No prepayment penalties.
9. FHA loans typically are assumable.
N. VA loan
1. Definition: a loan made to veterans by approved lenders for residential, owner-occupied property and guaranteed by the Veterans Administration.
2. Veterans are not required to make a down payment; however, the VA collects a funding fee that may be paid by the borrower at closing or added into the total loan amount.
3. The VA sets limits on the amount it guarantees, but not on the price of the property. The Veterans Benefits Improvement Act of 2004 has tied increases in the VA guaranty limit to increases in the Federal Home Loan Mortgage Corporation’s conforming loan limit to allow the VA to keep pace with increases in home values.
4. A veteran wishing to apply for a VA loan must apply for two certificates:
a. Certificate of eligibility: a certificate that states the maximum available loan guaranty entitlement for a veteran.
b. Certificate of reasonable value: a certificate that sets forth the current market value of the property to be purchased.
5. There are no prepayment penalties.
6. Generally, these loans are assumable by non-veterans; however, the veteran originating the loan will remain primarily liable unless the VA issues a release from liability.
O. Adjustable rate loan
1. Definition: a loan in which the interest rate typically starts lower than that of a fixed rate loan, and then periodically changes in relation to an index rate, such as the rate on Treasury securities.
2. Adjustment period: the time between one rate change and the next for an adjustable rate loan.
3. Margin: the amount of percentage points a lender adds to the index rate to come up with an ARM interest rate.
4. Interest rate cap: a limitation on the amount an interest rate can increase on an adjustable rate loan.
The Lending Process
P. Loan application and related documents
1. The loan officer requires certain information and documentation to complete a loan application, including, but not limited to, the contract for sale and purchase, assets and debts of the borrower, and employment data and history.
2. The borrower may request certain various documents, including a request for credit reports, request for verification of employment, request for verification of deposits, request for verification of rent (if applicable), and a general certification and authorization form.
3. The loan officer than determines, with the lender, the amount of loan the borrower qualifies for with the lender.
4. An appraisal of the property will be ordered to determine its present value, and credit reports will be ordered to verify the borrower’s credit.
5. Once the loan application package is complete and accepted, the borrower will receive a loan commitment: a document outlining the terms under which the lender will lend a specified amount to the borrower. Once accepted by the borrower, it becomes a contract.
6. Lenders are looking at the borrower in terms of
a. income-to-debt ratio,
b. overall debt load,
c. employment history.
d. overall net worth, and
e. credit history.
7. In looking at credit history, lenders rely heavily on credit scoring that uses statistical samples to predict the likelihood that a borrower will pay back a loan. The scoring assigns a weight to various characteristics that are predictors of this.
a. The most commonly used credit scoring system today is known as FICO (which stands for Fair Isaac Corporation, the company that provides the formula and software for scoring). FICO scores range from approximately 300 to 850. The higher the score number, the better risk the borrower is and the greater is the chance that the borrower will receive favorable terms from a lender.
b. The three major credit bureaus, Transunion, Experian, and Equifax, each have their own credit scoring systems, based on FICO’s model, but none are identical, and thus a borrower’s credit score can differ from one credit bureau to the next. The three bureaus recently formed a new entity, VantageScore Solutions, LLC, to market VantageScore. VantageScore uses a wider range of scores than FICO, and its scores range from 500 to 990.
8. The most common reasons for loan refusal include lack of financial earning ability, lack of financial resources, frequent changes in employment, poor credit history, and excessive installment purchases.
Q. Government regulation
1. Federal Truth in Lending Act
a. It also is referred to as Regulation Z.
b. This is a federal law requiring lenders to make full disclosure of all costs incurred in obtaining credit.
c. It requires lenders to disclose the annual percentage rate: the true interest rate on a loan, which includes charges added, such as points and mortgage insurance.
d. It requires complete disclosures regarding ARMs.
e. Violation of the act can result in both civil and criminal penalties.
2. Real Estate Settlement Procedures Act (RESPA)
a. This is a federal law requiring the lender to provide the borrower with a good faith estimate of closing costs within 3 days from the date the loan application is submitted.
b. It requires the use of a uniform settlement statement for all nonexempt transactions.
c. It requires lenders to provide borrowers with a Mortgage Servicing Disclosure Statement, which informs the borrower of the lender’s intentions to service the loan or transfer it to another lender.
3. Equal Credit Opportunity Act (ECOA)
a. This is a federal law enacted to prevent discrimination in making credit available to consumers.
b. The lender cannot discriminate based on race, color, religion, national origin, sex, marital status, age, or the applicant’s receipt of income from public assistance.
c. When evaluating an applicant’s qualifications, lenders must consider
1) reliable public assistance income,
2) reliable income from part-time employment, Social Security, pensions, and annuities,
3) reliable alimony, child support, or separate maintenance payments, and
4) income regardless of sex or marital status.
4. Fair Credit Reporting Act
a. This is a federal law enacted to give individuals the right to examine their own credit history.
b. It enabled consumers to contact credit bureaus and find out what credit information is being provided by the bureaus.
c. It allows consumers to dispute the wrongful use or interpretation of their information.
d. It was amended in 2003 by the Fair and Accurate Credit Transaction Act (FACT), which
1) provides for more accurate credit reporting, measures to prevent identity theft, and restrictions on the marketing of financial products using sensitive information, and also gives consumers the right to one free credit report per year from each credit bureau;
2) provides that both the credit reporting bureau and the information provider must correct any inaccurate or incomplete information in a credit report;
3) entitles consumers to obtain a list of everyone who has requested a report within the past year (or past 2 years for employment-related requests).
5. Homeowner’s Protection Act
a. This federal law establishes rules for homeowners who wish to cancel their PMI.
b. Under the act, borrowers can cancel their PMI after they have paid off 20% of their home’s cost, as long as they
1) request cancellation in writing,
2) have a good payment history, and
3) have not allowed the property to devalue below its original price.
c. Automatic cancellation takes place when 22% of the home’s value has been paid off.
6. Gramm-Leach-Bliley Act
a. This is a federal law requiring financial institutions to establish safeguards to ensure the confidentiality of customer records and nonpublic personal information.
b. Financial institutions must have a privacy policy and disclose it to its customers at the commencement of the customer relationship and at least once a year thereafter. Customers also must be given the option to “opt-out” before any nonpublic information is disclosed to an unaffiliated third party.
c. The act provided that the Federal Trade Commission (FTC) enforce the privacy provisions on non-bank affiliated mortgage brokers and lenders. In accordance with this, the FTC promulgated the Financial Privacy Rule and the Safeguards Rule, which must be followed by these brokers and lenders.
Preparation of Financing Instruments
R. Promissory note: should include
1. date,
2. city and state in which the note is made,
3. parties,
4. amount of loan,
5. interest rate, fixed or adjustable,
6. total amount of payments,
7. maturity date,
8. amount of each payment and what is included in each payment,
9. when payments are to be made,
10. where payments are to be made,
11. late charges, if any,
12. security for note
13. prepayment privileges or penalties,
14. parties’ rights in event of default,
15. waiver of homestead or other debtor’s rights, and
16. signature(s) of maker and guarantor.
S. Mortgages and deeds of trust: should include
1. date,
2. parties,
3. social security number of trustor/mortgagor,
4. legal description of the property,
5. description of all personal property serving as additional collateral,
6. description of the loan debt terms,
7. agreement by trustor/mortgagor to pay debt on above terms,
8. tax clause,
9. maintenance clause,
10. inspection clause,
11. assignment of rents clause, if applicable,
12. receivership clause, if applicable,
13. duties of trustor/mortgagor,
14. due-on-sale clause, if applicable,
15. rights of parties in event of default,
16. signature of trustor/mortgagor,
17. signatures of witnesses,
18. notarization, and
19. name and address of preparer of instrument.
Secondary Market
T. Definition: a market for the purchase and sale of existing mortgages.
U. Federal National Mortgage Association (FNMA): a governmentally regulated corporation that buys and services conventional, FHA, and VA residential loans that meet its specific guidelines.
V. Government National Mortgage Association (GNMA): a division of HUD that works in tandem with the FNMA in the secondary market, assisting lending institutions with low-income housing projects.
W. Federal Home Loan Mortgage Corporation (FHLMC): a corporation established to provide a secondary market, primarily for conventional loans.
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