Real Estate Financing: Notes and Mortgages
Financing can be a very important component of investing in real estate. In general, when investors desire to obtain financing, they usually pledge, or hypothecate, their ownership of real estate as a condition for obtaining loans. In many cases, investors also pledge personal property to obtain loans. What follows is an introduction to notes and mortgages, two legal instruments that are used frequently in real estate financing.
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A promissory note is a document which serves as evidence that debt exists between a borrower and a lender and usually contains the terms under which the loan must be repaid and the rights and responsibilities of both parties. Unless stated otherwise, the borrower is personally liable for payment of all amounts due under the terms of the note. (These loans are said to be made “with recourse” to the borrower.) While many loan provisions may be included, notes usually contain at least the following:
- The amount borrowed—this is generally the face amount of the note, which is usually advanced in total when the loan agreement is executed. However, in cases involving construction loans, amounts could be advanced as a construction progresses, not to exceed a maximum amount.
- The rate of interest—this could be a fixed rate of interest or an adjustable rate. If it is the latter, exactly how the rate may be adjusted (changed) will be specified.
- The dollar amount, due dates, and number of payments to be made by the borrower — (e.g.: $500 per month due on the 1st of each month following the closing date for 300 consecutive months).
- The maturity date, at which time all remaining amounts due under the terms of the loan are to be repaid.
- Reference to the real estate serving as security for the loan as evidenced by a mortgage document (to be discussed).
- Application of payments, which are usually made first to cover any late charges/fees/penalties, then to interest, and then to principal reduction.
- Default—occurs when a borrower fails to perform one or more duties under the terms of the note. Default usually occurs because of nonpayment of amounts due.
- Penalties for late payment and forbearance provisions—the latter specifies any grace periods during which late payments can be made up (usually with penalties) without the lender declaring that the borrower is in default. The lender does not give up the right to declare that the borrower is in default at some future date by allowing a grace, or forbearance, period. Forbearance is used by lenders when they believe that borrowers will make up late payments. They allow time for borrowers to make up such payments when they believe that benefits from this course of action will exceed the time and the expense of declaring the loan in default and embarking on foreclosure proceedings and, perhaps, forcing the sale of the property.
- Provisions, if any, for unscheduled (early) payments or the full or partial prepayment of outstanding balances—when included, this is usually referred to as a “prepayment privilege.” It allows borrowers to make early payments, or to repay the loan, in part or fully before maturity. If allowable, the note will indicate whether future payments will be reduced or whether the loan maturity date will be shortened. This provision is a privilege and not a right because the dollar amount and number of payments to be made by the borrower are specified in (C). A prepayment provision is generally included in residential mortgage loans. However, when financing income-producing properties, it may be highly restricted and require payment of a fee or penalty.
- Notification of default and the acceleration clause—in the event of past due payments, the lender must notify the borrower that he or she is in default. The lender may then accelerate on the note by demanding that all remaining amounts owed under the loan agreement be paid immediately by the borrower.
- Nonrecourse clause—as quoted above, when a borrower executes a note, he is personally liable, or the loan is made “with recourse.” This means that if he defaults on the loan, the lender may bring legal action that may result in the sale of the borrower’s other assets (stocks, bonds, other real estate) in order to satisfy all amounts past due under the terms of the note. In contrast, the “nonrecourse clause” is a provision in the note whereby the lender agrees not to, or specifies conditions under which it will not, hold the borrower personally liable in the event of a default. In this case, the lender may only bring an action to force the sale of the property serving as security for the loan. The borrower is released of personal liability. This clause is very important to real estate investors and developers.
- Loan assumability—this clause indicates under what conditions, if any, a borrower will be allowed to substitute another party in his place, who will then assume responsibility for remaining loan payments. This could occur if the borrower wishes to sell a property to another while allowing the new buyer to retain favorable financing terms that may have been previously negotiated. Lenders who deny borrowers this right can do so by expressly prohibiting it and/or by including a “due on sale” clause which requires that all remaining amounts due be paid upon sale of, or transfer of title to, the property. However, if the note provides that a new owner may assume the loan, the lender usually requires that the credit of the new owner be equivalent to that of the previous owner, or be acceptable to the lender. The note will also specify whether or not the original borrower remains personally liable or is released from liability when the loan is assumed by the new borrower.
- The assignment clause—clause giving the lender the right to sell the note to another party without approval of the borrower.
- Future advances—provision under which the borrower may request additional funds up to some maximum amount or maximum percentage of the current property value under the same terms contained in the original loan agreement. These advances may be subject to an adjustment in the rate of interest.
- Release of lien by lender — lender agrees to release or extinguish its lien on the property when the loan is fully repaid.
Definition of a Mortgage
In its most general sense, the mortgage document is created in a transaction whereby one party pledges real property to another party as security for an obligation owed to that party. A promissory note (discussed previously) is normally executed contemporaneously with the mortgage. This note creates the obligation to repay the loan in accordance with its terms and is secured by the mortgage. The elements essential to the existence of a mortgage are an obligation to pay or perform and a pledge of property as security for that obligation.
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In general, when a loan is made by a borrower to purchase real estate consisting of an existing property and improvement, it is referred to as a purchase-money mortgage (discussed in more detail later in this chapter). This is in contrast to construction loans, loans made to refinance existing loans, and so on.
The obligation secured by a mortgage need not be monetary. It may be, for example, an agreement to perform some service or to perform some other specified actions. An obligation which is not itself an explicitly monetary one must be reducible to monetary terms. In other words, a dollar value must be placed on it.
Relationship of Note to Mortgage
Normally, the underlying obligation secured by a mortgage is evidenced by a separate promissory note. As pointed out in the discussion of notes, unless the note contains a nonrecourse clause, it provides evidence of the debt and generally makes the borrower (mortgagor) personally liable for the obligation. The mortgage is usually a separate document that pledges the designated property as security for the debt. Therefore, the lender (mortgagee) has two sources from which amounts borrowed can be repaid: (1) the borrower, who is personally liable, and (2) the property that serves as security for the note.
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In case of default, the mortgagee may elect to disregard the mortgage and sue on the note. The judgment awarded the mortgagee as a result of a suit on the note may be attached to other property of the mortgagor which, when sold to satisfy the judgment lien, may enable the mortgagee to recover the amount of the claim more readily than if he or she foreclosed on the mortgage. In practice, the mortgagee will normally elect to sue on the note and foreclose on the mortgage simultaneously. Mortgages typically include clauses containing important covenants for both the mortgagor and mortgagee. These covenants are promises, duties, and responsibilities of the borrower, in addition to payments required under the terms of the note. These are frequently repeated in the promissory note, or the note may incorporate these covenants by reference to the mortgage.
Interests That Can Be Mortgaged
Most people are accustomed to thinking of a mortgage in relation to full, or fee simple, ownership. But any interest in real estate that is subject to sale, grant, or assignment—that is, any interest that can be transferred—can be mortgaged. Thus, such diverse interests as fee simple estates, life estates, estates for years, remainders, reversions, leasehold interests, and options to purchase real estate, among others, are all mortgageable interests as far as legal theory is concerned. Whether, as a matter of sound business judgment, mortgagees would be willing to lend money against some of the lesser interests in land is quite another question.
Minimum Mortgage Requirements
A mortgage involves a transfer of an interest in real estate from the property owner to the lender. Accordingly, the statute of frauds requires that it must be in writing. The vast volume of mortgage lending today is institutional lending, and institutional mortgages are standardized, formal documents. There is, however, no specific form required for a valid mortgage. Indeed, although most mortgages are formal documents, a valid mortgage could be handwritten. The requirements of a valid mortgage document are (1) wording that appropriately expresses the intent of the parties to create a security interest in real property for the benefit of the mortgage and (2) other items required by state law.
In the United States, mortgage law has traditionally been within the jurisdiction of state law; by and large, mortgages continue to be governed primarily by state law. Thus, to be enforceable, a mortgage must meet requirements imposed by the law of the state in which the property offered as security is located. Whether a printed form of mortgage instrument is used or an attorney draws up a special form, the following subjects should always be included:
- Appropriate identification of mortgagor and mortgagee.
- Proper description of the property serving as security for the loan.
- Covenants of seisin and warranty. A covenant is a promise or binding assurance. Seisin is the state of owning the quantum of title being conveyed.
- Provision for release of dower rights.
- Any other desired covenants and contractual agreements.
All of the terms and contractual agreements included in the note can be included in the mortgage as well by making reference to the note in the mortgage document. Although the bulk of mortgage law remains within the jurisdiction of state law, a wide range of federal regulations also are operative in the area of mortgage law. Moreover, in recent years the federal government has acted to directly preempt state law in a number of areas (e.g., overturning state usury laws, overturning state restrictions on the operation of due-on-sale clauses, and establishing conditions for allowing prepayment of the mortgage debt and for setting prepayment penalties). This has been particularly true in legislation affecting residential mortgages. Commercial property lending and mortgages have generally been exempted from such federal legislation.
In addition, the federal government has exerted a strong but indirect influence on mortgage transactions by means of its sponsorship of the agencies and quasi-private institutions that support and, for all practical purposes, constitute the secondary market for residential mortgages. The Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC) have adopted joint standardized mortgage forms for the purpose of facilitating secondary-market transactions on a nationwide basis. The joint FNMA-FHLMC uniform mortgage form has been so widely adopted by residential mortgage lenders that it has largely replaced the use of mortgage forms used by individual institutions. One reason for the popularity of this form with residential lenders is that it is readily acceptable by the major secondary market institutions, should the lender desire to sell the mortgage after it has been originated.
Important Mortgage Clauses
It is beyond the scope of this chapter to discuss all the clauses and covenants that might be found in a mortgage document. We will mention some of the more important clauses, however, so that the reader gains an appreciation of the effect these clauses may have on the position of the borrower and lender.
Funds for Taxes and Insurance
This clause requires the mortgagor to pay amounts needed to cover property taxes and property fire and casualty insurance, plus mortgage insurance premiums, if required by the lender, in monthly installments in advance of when they are due unless such payments are prohibited by state law. The purpose of this clause is to enable the mortgagee to pay these charges out of money provided by the mortgagor when they become due instead of relying on the mortgagor to make timely payments on his own. The mortgagee is thereby better able to protect his or her security interest against liens for taxes, which normally have priority over the first mortgage, and against lapses in insurance coverage. Such funds may be held in an escrow or trust account for the mortgagor.
Charges and Liens
This clause requires the mortgagor to pay all taxes, assessments, charges, and claims assessed against the property that have priority over the mortgage and to pay all leasehold payments, if applicable. The reason for this clause is that the mortgagee’s security interest can be wiped out if these claims, or liens, are not paid or discharged, since they generally can attain priority over the interests of the mortgagee. For example, if taxes and assessments are not paid, a first mortgage on the property can be wiped out at a sale to satisfy the tax lien, unless the mortgagee is either the successful bidder at the tax sale or pays the tax due to keep the property from being sold at the tax sale.
Hazard Insurance
This clause requires the mortgagor to obtain and maintain insurance against loss or damage to the property caused by fire and other hazards, such as windstorms, hail, explosion, and smoke. In effect, this clause acknowledges that the mortgagee as well as the mortgagor has an insurable interest in the mortgaged property. The mortgagee’s insurable interest is the amount of the mortgage debt.
Preservation and Maintenance of the Property
This clause obligates the mortgagor to maintain the property in good condition and to not engage in or permit acts of waste.Waste is the abuse or destructive use of property which reduces the value and, therefore, the security for the loan.
This clause recognizes that the mortgagee has a valid interest in preventing the mortgaged property from deteriorating to the extent that the collateral value of the property is impaired. Transfer of Property or a Beneficial Interest in Borrower This clause, known as the due-on-sale clause, allows the mortgagee to accelerate the debt (i.e., to take action to make the outstanding loan balance plus accrued interest immediately due and payable) when the property, or some interest in the property, is transferred without the written consent of the mortgagee. The purpose of the due-on-sale clause is to enable the mortgagee to protect his or her security interest by approving any new owner. The clause may also permit the mortgagee to increase the interest rate on the loan to current market rates. This, of course, reduces the possibility of the new owner assuming a loan with an attractive interest rate.
Borrower’s Rights to Reinstate
This clause deals with the mortgagor’s right to reinstate the original repayment terms in the note after the mortgagee has caused an acceleration of the debt. It gives the mortgagor the right to have foreclosure proceedings discontinued at any time before a judgment is entered enforcing the mortgage (i.e., before a decree for the sale of the property is given) if the mortgagor does the following:
- Pays to the mortgagee all sums which would then be due had no acceleration occurred.
- Cures any default of any other covenants or agreements.
- Pays all expenses incurred by the lender in enforcing its mortgage.
- Takes such action as the mortgagee may reasonably require to ensure that the mortgagee’s rights in the property and the mortgagor’s obligations to pay are unchanged.
Right of Entry: Lender in Possession
This clause provides that upon acceleration or abandonment of the property, the mortgagee (or a judicially appointed receiver) may enter the property to protect the security. The lender may collect rents until the mortgage is foreclosed. Rents collected must be applied first to the costs of managing and operating the property, and then to the mortgage debt, real estate taxes, insurances, and other obligations of the mortgagor as specified in the mortgage.
Future Advances
While it is expected that a mortgage will always state the total amount of the debt it is expected to secure, this amount may be in the nature of a forecast of the total debt to be incurred in installments. In other words, a mortgage may cover future advances as well as current advances. For example, a mortgage may be so written that it will protect several successive loans under a general line of credit extended by the mortgagee to the mortgagor. In case the total amount cannot be forecasted with accuracy, at least the general nature of the advances or loans must be apparent from the wording of the mortgage.
As an illustration of a mortgage for future advances, sometimes called an open-end mortgage, consider the form of construction loans. Here the borrower arranges in advance with a mortgagee for a total amount, usually definitely stated in the mortgage, that will be advanced, in stages, under the mortgage to meet the part of the costs of construction as it progresses. As the structure progresses, the mortgagor has the right to call upon the mortgagee for successive advances on the loan. All improvements become security under the terms of the mortgage as they are constructed.
Subordination Clause
By means of this clause, a first mortgage holder agrees to make its mortgage junior in priority to the mortgage of another lender. A subordination clause might be used in situations where the seller provides financing by taking back a mortgage from the buyer, and the buyer also intends to obtain a mortgage from a bank or other financial institution, usually to develop or construct an improvement. Financial institutions will generally require that their loans have first mortgage priority. Consequently, the seller must agree to include a subordination clause in the mortgage whereby the seller agrees to subordinate the priority of the mortgage to the bank loan. This ensures that even if the seller’s mortgage is recorded before the bank loan, it will be subordinate to the bank loan.
Source: Real estate finance and investments / William B. Brueggeman, Jeffrey D. Fisher.—14th ed. p. cm.—(The McGraw-Hill/Irwin series in finance, insurance, and real estate) ISBN-13: 978-0-07-37733-9
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