Common Real Estate Finance Methods
Most people take outmortgage loans to help pay for real estate purchases just as people take outother loans to pay for other expenses. However, a mortgage arrangement is muchmore complex and nuanced than more common forms of consumer borrowing, which areoften unsecured loans. These complexities and the originations, processes andoperations of mortgages are the subjects of this course.
This first moduleprovides the basic knowledge, skills, and vocabulary needed to make sense of amortgage loan. The discussion includes an overview of the types of real estateloan products commonly available, including the key features that distinguishthem. However, before diving into the details of real estate finance, we’llbegin with an overview of the proper due diligence that every mortgage borrowershould undertake before even applying for a home loan.
Before Applying for aMortgage
Buying a home is notonly an exciting milestone for many people, it’s also a useful way to buildfinancial stability and wellbeing.[1]However,purchasing real estate involves complex legal and financial issues. Taking outmortgages exposes home buyersto risks of default, foreclosure, and bankruptcy.As a result, everyone should understand the legal and financial liabilitiesassociated with real estate ownership before making the decision to buy a home.
The amount of moneytaken as a loan to finance a real estate purchase is known as leverage. Theamount of leverage allowed by a lender is determined by the bank’sloan-to-value ratio, which determines how much down payment is required. Atypical loan-to-value ratio required by many banks is 80 percent, meaning thata 20 percent down payment is required to take out a mortgage loan.[2]However, there are additional expenses mortgage borrowersmust be ready to pay beyond the down payment. For example, there are closingcosts, attorney’s fees, bank fees, title insurance, inspection fees andhomeowner’s insurance that all must be paid before or at the time of the mortgageclosing.[3]Additionally, if a home buyertakes out aloan with a loan-to-value ratio higher than 80 percent, he will often needprivate mortgage insurance (or “PMI”), which hedges the lender’s risk of givinga loan with a lower down payment by paying for insurance that will indemnifythe bank in case of a default if the bank cannot recover its principal.[4]PMI is terminated automatically when the mortgage principalis paid down to 78 percent of the property’s value on the date it wasmortgaged.[5]
Once a buyer analyzesall direct and indirect costs of a home purchase, he must put to rest anyquestions regarding the title to the property. In most jurisdictions, buyersare responsible for title examinations, which are detailed studies of theproperty’s ownership records. This is necessary to ensure that the buyer isreceiving good and marketable title to the real estate, as defects in title caninterfere with the buyer’s ability to use and occupy the land. The type of deedused to convey the land impacts the seller’s guarantees regarding title, butbuyers are responsible for any defects in title not guaranteed by the deed.[6]Once a title search is completed, a homebuyer secures titleinsurance protecting against any issues impacting title to the land that werenot discovered in the search. While buyers of land are not obligated topurchase title insurance, lenders usually require the purchase of titleinsurance and may dictate its terms.[7]
Once the home buyercalculates the amount he can budget for the down payment, insurance, andinstallment payments for the mortgage, he should review his credit history forany inaccuracies or defects. Mortgage approval depends heavily on creditscores. Credit scores are composite scores that take into account six factors:percentage of available credit that is used, payment history, derogatory marks(such as collections or bankruptcies), average age of credit, total number ofaccounts held and number of recent “hard” credit inquiries.”[8]People seeking mortgages are wise to shore up their credithistories by paying off the debts they can and managing new loans to the bestof their abilities.
Elements of a MortgageLoan
Mortgage loans are themost common real estate financing method in the United States. A mortgage loanis an arrangement that transfers a security interest in land that secures alegal obligation to repay a loan.[9]There are usuallytwo parties to the mortgage loan: the mortgagor, who is the real estate buyerwho transfers the interest as security; and the mortgagee, the lender supplyingthe loan who receives the security interest. Mortgage loans are mainly governedby state law, but they may be subject to federal regulation depending upon howthey are chartered or established.[10]
A mortgage has four distinct characteristics: the amountof the loan (also known as principal), the term of the loan, the schedule forthe loan’s repayment and the interest rate. [11]While there isvariety in types of loans and terms, over time, the legal documents necessary to secure mortgage loanshave become relatively standardized. These documents evidence two legalcommitments: a promise to pay the underlying loan and a security instrumentthat can be used to guarantee payment.
A Promissory Note is acontract that formalizes the buyer’s promise to repay the loan made by thelender. The Promissory Note includes all the terms and conditions of theloan, including the interest rate, payment due dates, the location and methodof payment, and what may occur if the payments are not made.[12]The promissory note must be accompanied by a securityinstrument to create a mortgage interest. The mortgage itself is the securityinstrument that entitles a lender to foreclose on the real estate in the eventof a default on the terms of the promissory note.[13]A mortgage mustinclude certain elements to be legally enforceable, including: the namedparties to the agreement, words of conveyance, a valid description of thesubject property, a valid execution, attestation and effective delivery.[14]
A mortgage creates anencumbrance on the subject property, meaning that it represents a third-partyclaim on real estate that runs with the land.[15]This encumbrancecannot be discharged until the mortgage loan is paid in full or discharged byother legal means. The mortgage interests can be transferred by the interestholders, and it is common for banks to sell their mortgage interests to otherfinancial institutions.
Mortgage Payments
The most common mortgage type utilized in the UnitedStates is that of a fixed-rate mortgage with a 15 or 30-year term, in whichevery payment is the same amount and each payment has a component of interestin a component of principal.[16]However, there are several variations ontraditional mortgage loans.
Fixed-Rate andAdjustable-Rate Mortgages
Mortgage loans aredivided into two broad categories: fixed rate loans and adjustable rate loans.Fixed rate mortgage loans are valued for their stability. Under thesearrangements, the interest rate on the loan does not change, so monthlypayments remain constant throughout the term of the agreement.[17]In contrast, an adjustable rate mortgage (sometimes calledan “ARM”) has an interest rate that changes during the term of the agreement.Typically, the interest rate on an ARM is tied to the interest rate set by the“prime” rate, which is the interest rate the commercial banks charge their mostcreditworthy customers.[18]They can be set up in any number of ways.For example, ARM loans often start with lower interest rates, which arecommonly known as “teasers” because they incentivize buyers with lowintroductory payments. These loans carry a heavy risk of default since theirpayments invariably increase dramatically later in the lives of the loans.
“Convertible” ARM loansinclude options to convert the loan’s adjustable interest rate to a fixed one,typically for a fee. Combination Fixed Rate/ARM loans typically begin as afixed-rate loan that converts to an adjustable rate after a set period.Interest-only ARMs require borrowers to pay interest on the loan, but notprincipal, for a fixed time, meaning that installment payments will increaseonce principal payments kick in. Payment-option ARMs are arrangements in whichthe interest rates are adjusted over time, but the minimum payments remainfixed. These types of loans are very risky, as the mortgage balance mayincrease over time if the minimum monthly payments are not sufficient to coverthe interest of the loan.[19]
Amortization and BalloonPayments
Mortgage loans are madeup of the principal, which is the amount borrowed to purchase the property, andinterest, which is what the bank charges for lending out the money. Loans areusually repaid according to an amortization schedule, which sets forth theinstallment payments. Fixed rate mortgages have level amortization schedulesand monthly payments are made in the same amount each month. Under this arrangement,a loan is “fully amortized,” meaning that the balance is paid off when the lastinstallment payment is made.[20]
Payments made pursuantto a fixed-rate mortgage start as mostly interest payments because theprincipal balance is highest at the outset of the loan. Over time, while theamounts of the monthly payments remain the same, the principal contingent ofeach payment becomes higher and the interest contingent becomes lower, as theprincipal balance decreases. The last few mortgage payments on an amortizedlong-term loan are virtually all principal.
Rather than fullyamortizing their loans, some home buyersprefer an amortization schedule with aballoon payment. Under this arrangement, installment payments made on themortgage do not cover the entire principal and interest accrued. As a result,homeowners must make a large payment, or a “balloon payment,” at the end of theloan to repay the remaining balance.[21]Mortgages withballoon payments may come with certain tax benefits and they are oftenwell-suited for people who plan to sell their homes within a few years ofbuying them. However, homeowners who are unable to make the large balloonpayment due at the end of the term face increased risk of default andforeclosure.
Second Mortgages andHome Equity Loans
In most cases, borrowerscan take out multiple mortgages on real estate. However, real estate lenderstake on increased risk when issuing second mortgages, as mortgage superiorityis based on which agreement was first in time. In other words, if the realestate owner defaults on a first mortgage and the property is foreclosed, thesecond mortgage is terminated. As a result, it can be very difficult to takeout second or third mortgages. When lenders do agree to issue a secondmortgage, they commonly require an estoppel certificate from the first mortgagelender. An estoppel certificate requires the first mortgage lender to notifythe second mortgage lender if a default occurs. This gives the second mortgageholder an opportunity to recover before its rights are terminated byforeclosure.[22]Second mortgage lenders may also onlyprovide loans to the extent that the total amount owed on the house is limitedto a percentage of the home’s value. For example, a second mortgage lender mayrequire that the homeowner maintain at least 20% equity in the house. If ahouse is worth $500,000, for example, and the homeowner already owes $340,000on a first mortgage, the second mortgage lender may limit the amount of thesecond mortgage to $60,000 or less to ensure that the total value of themortgages does not exceed 80% of the home’s value, or in this case, $400,000.
Second mortgages areoften referred to as “home equity loans” because they require building up ofequity before the banks will issue them. Some home equity loans are“revolving,” which means that the buyer may withdraw up to a maximum amount andwill make monthly interest payments to cover the interest on the balance. Theborrower may repay the principal at will, though many such loans require thatthe buyer commence paying principal after a given number of years.[23]Because these home equity loans behave like a line ofcredit, they are often called “home equity lines of credit” or HELOCs.
While in the process ofmaking amortized payments on a loan, a buyer may choose to refinance, usuallyto take out more money or to take advantage of lower available interest rates.The refinancing process requires payment in full of the first mortgage and thesimultaneous receipt of the new mortgage loan.
Homeowners often chooseto borrow money against the equity in their homes (either through refinancingof a bigger loan or opening a home equity line of credit) to improve theproperty or consolidate more expensive debt.[24]Keep in mind thatunsecured loans such as credit card debt usually charge much higher interestrates than mortgage loans. So, paying off high interest loans through moneyobtained from mortgages is often an excellent way to save money.
Reverse Mortgages
A reverse mortgageis a specialized loan available to those age 62 and over. Under a reversemortgage, a homeowner accepts a line of credit or receives regular installmentpayments that are repaid when the home is sold, or the homeowner passes away.Reverse mortgages are repaid from the proceeds of the sale of the property orthe property owner’s estate, but only up to the amount of the property’s value.While reverse mortgages can be excellent opportunities for seniors to gainaccess to needed income, because interest accrues until repayment, there isoften surprisingly little equity remaining in the house when it is sold. Reversemortgages raise issues regarding estate planning and insurance coverage beyondthe financial and legal liabilities typically incurred when someone takes out aloan. As such, counseling is usually required before taking out a reversemortgage.[25]
Conclusion
Mortgage agreements arethe most common ways people finance their homes. Despite being so common, thesetransactions are very complex. They are subject to several consumer protectionlaws and financial regulations that are discussed throughout the remainder ofthis course. However, at the end of this preliminary discussion, you shouldhave a basic grasp of the vocabulary and concepts relevant to mortgages.
[1]Mark W. Olson, Governor, Fed. Reserve Bd., Speechat the Community Development Policy Summit, Cleveland, Ohio: Exploring theBenefits and Challenges of an Ownership Society (June 23, 2005) (transcriptavailable athttp://www.federalreserve.gov/boarddocs/speeches/2005/20050623/default.htm);Liz Pulliam Weston, Why It’s Smarter toBuy than Rent, MSN MONEY, Jan. 15, 2006,http://moneycentral.msn.com/content/Banking/Homebuyingguide/P72655.asp.
[13]In some jurisdictions, the mortgage security instrument is a “deed of trust,”but these documents serve the same function as a mortgage in otherjurisdictions. Definition “Mortgage” Id.
