Instructions: Please answer the following questions:
What are FHA’s and VA’s roles in the mortgage market?
Explain what is meant by an amortizing mortgage.
Lara is buying a new home with a mortgage loan for $245,000.00 at 4.5 percent annual interest with a term of 30 years. What is the amount of the monthly payment necessary to amortize this debt?
250 word minimum, USE THE ATTACHED REFERENCES AS WELL AS OTHER REFERENCES to answer the questions, cite in APA.
Most borrowers, whether they are purchasing property or refinancing their home, focus on their mortgage rate and loan terms rather than the type of lender they choose.
Yet the landscape of the lending market has shifted dramatically over the past few years from domination by big banks to a market where more loans are made by non-banks — financial institutions that only make loans and do not offer deposit accounts such as a savings account or checking account.
“For consumers, it doesn’t really matter whether you get your loan through a bank or a non-bank, although in some ways non-banks are a little more nimble and can offer more loan products,” says Paul Noring, a managing director of the financial-risk-management practice of Navigant Consulting in Washington. “The impact is bigger on the housing market overall, because without the non-banks we would be even further behind where we should be in terms of the number of transactions.”
In 2011, 50 percent of all new mortgage money was loaned by the three biggest banks in the United States: JPMorgan Chase, Bank of America and Wells Fargo. But by September 2016, the share of loans by these three big banks dropped to 21 percent.
At the same time, six of the top 10 largest lenders by volume were non-banks, such as Quicken Loans, loanDepot and PHH Mortgage, compared with just two of the top 10 in 2011.
Why big banks exited the market
Before the financial crisis, mortgages were the last thing a consumer would default on, Noring says.
“That flipped in 2009, when people started defaulting on their mortgages first,” he says. “That was a tsunami for everyone in the mortgage business, and we’re still seeing the fallout. Lenders were not prepared to deal with it and didn’t do a great job, plus new rules were coming out that they needed to follow.”
The withdrawal of banks from the mortgage business is the result of the fundamental shift in regulations that took place in response to the housing crisis, says Meg Burns, managing director of the Collingwood Group, an adviser for financial services companies in Washington.
“The regulatory atmosphere changed from a risk-management regime to a zero-tolerance and 100-percent-compliance regime,” Burns says. “Not only were new regulations implemented, but new regulators like the Consumer Financial Protection Bureau were created. At the same time, the CFPB and other agencies became more assertive in their enforcement practices.”
Burns says that stepped-up regulations from the CFPB include prescriptive rules that pinpoint exactly how lenders are to make loan decisions.
“The intent should be to broadly make sure borrowers can repay their loans and sustain homeownership instead of this narrow approach,” Burns says. “In the face of stiff penalties and aggressive scrutiny, banks were left with a tremendous uncertainty and risk that made it hard to keep lending.”
Jeffrey Taylor, managing partner of Digital Risk, a provider of mortgage-processing services and risk analytics in Maitland, Fla., says that while the post-crisis regulations were well-intentioned, the result was to make banks more cautious.
“Now banks only approve ‘perfect’ loans, not ‘good-enough’ loans,” Taylor says. “This created an opportunity for non-banks that focus entirely on mortgages and are less regulated than big banks.”
The cost of complying with new regulations and the risk of making mistakes drove many banks to reduce their mortgage business, says Rick Sharga, chief marketing officer of Ten-X, an online real estate marketplace in Irvine, Calif.
“Headline risk is another element of this, because if the media perceives you’re doing something incorrectly, it can really hurt your entire business,” he says.
In the initial aftermath of the housing crisis and the debacle of loan defaults, banks began to add their own overlays, which are loan-approval guidelines and fees that go beyond the requirements of Fannie Mae and Freddie Mac, says Susan Wachter, a professor of real estate and finance at the Wharton School at the University of Pennsylvania in Philadelphia.
Not only have banks reduced their mortgage loan volume, but the entire private market of investors in mortgages disappeared in 2007 and 2008 and, unlike other financial markets, has yet to come back, Wachter says.
“The aftermath of the crisis was lots of litigation and a decline in trust across the board,” Wachter says.
Banks were forced to pay fines and to take back loans that were considered flawed. At the same time, they were required to meet stress tests and have more capital on their books in case they have to handle more defaults, Wachter says.
“Non-banks don’t have to have capital, which could mean that taxpayers are more exposed than in 2009 if numerous defaults take place among loans made by non-banks,” Wachter says.
Noring says that non-banks were more lightly regulated in the initial aftermath of the housing crisis, although in the past two years, regulators have stepped up their scrutiny of these lenders.
Non-banks are regulated in every state where they are licensed to provide loans, says David Norris, chief revenue officer for loanDepot in Foothill Ranch, Calif.
“Prior to the financial meltdown, loan-guarantee fees charged by Fannie Mae and Freddie Mac were substantially lower for banks compared to non-banks, but as part of the financial reform, those fees are now similar for all types of lenders,” Norris says. “Now banks and non-banks are competing on a level playing field, which encouraged more non-banks to increase their business.”
Many large banks have reduced their FHA loan business. Burns says FHA loans were created to serve people with a riskier profile, but she says the recent zero-tolerance policy of the Justice Department has undermined this loan program.
“Lenders were supposed to use good judgment on FHA loan approvals, such as looking at the continuity and stability of the borrower’s income,” Burns says. “The DOJ has used the False Claims Act to target banks in particular to fine them for defects in loan files. But a ‘perfect’ loan is pretty much impossible, particularly for borrowers applying for FHA loans.”
FHA loans appeal to first-time buyers and lower-income borrowers, who are perceived to be more likely to default on a loan, Norris says. He says non-banks are originating more FHA loans to make up for the lack of banks offering the loans.
Consumer impact of market changes
Many banks now limit their loans to conventional 30-year fixed-rate loans for borrowers who neatly fit into the approval box, says Sharga of Ten-X.
“Banks are also approving jumbo loans for high-net-worth individuals that they keep as portfolio loans,” Sharga says. “They are offering these loans so they can sell other banking services to those customers.”
During the last housing boom, many non-bank lenders targeted subprime borrowers, he says.
“This time around, the non-bank lenders are not being reckless,” Sharga says. “Some offer loans to borrowers with lower FICO scores, but they are still not making risky loans. Consumers are benefiting from non-banks because they offer more opportunities to borrowers who are not perfect.”
On the negative side, though, Sharga says that competition from non-banks has contributed to the closing of many community banks, which particularly hurts communities that are geographically underserved.
The entire ecosystem of the mortgage markets is fragile, says Burns, which has a chilling effect on the economy.
“The lack of access to credit not only hurts consumers, but it hurts builders and therefore contributes to the lack of affordable housing,” Burns says. “That, in turn, has an impact on the broader economy, because housing construction impacts a lot of segments such as banking, construction workers, home-improvement businesses and more.”
The pullback in lending from banks contributes to the overall decline in homeownership, says Burns, because people with a slightly risky credit profile are underserved.
“The expansion of non-banks in response is a good thing, but we’re still missing a million or more homeowners, in part because many millennials are still not able to get credit through traditional means,” Wachter says. “For good or bad, consumers with marginal credit scores and unverifiable income are out of the market now.”
Choosing a lender
Rather than decide on a bank or non-bank, many borrowers focus primarily on the price of their loan or opt for a lender that provides them with other financial services or one recommended by a real estate company or builder they are using for a purchase. According to the J.D. Power 2016 U.S. Primary Mortgage Origination Satisfaction Study, 27 percent of first-time buyers regret their choice of a lender and 21 percent of all borrowers regret their choice. The most common reasons for dissatisfaction include lack of communication, unmet promises or feeling pressured to choose a particular loan. But choosing one type of lender over another is no guarantee of satisfaction. The top 10 most highly rated mortgage providers in the survey are evenly split between banks and non-banks.
Digital Risk’s Taylor says banks and non-banks are aware that customers who don’t feel as if they are well-served will find another provider, which is why so many financial institutions are investing heavily in technology.
“It’s a race to improve the customer experience,” he says. “Borrowers realize that there’s not a lot of difference between loan providers on pricing, so they focus on the ease of the loan process and the service they receive.”
Taylor says there are generational differences in the way consumers approach borrowing money.
“Generation Xers and baby boomers have more loyalty to their financial institutions and tend to look first for a credit card, a car loan or a mortgage to their bank,” he says. “Millennials don’t feel the same way and prefer to start with an Internet search for their best mortgage options.”
How the market may shift next
Rising interest rates and anticipated deregulation under the Trump administration could change the mortgage-lending business again and impact the volume of loans.
“We’re likely to see more banks come back into the mortgage market as interest rates rise, because there’s more profit to be made,” Wachter says. “But demand will be down because fewer people will refinance and because affordability issues will mean that first-time buyers are still missing from the market.”
Sharga says that rising rates increase profitability but also reduce refinancing, which forces lenders to compete harder for purchase-loan business, so even borrowers with few minor issues with their loan application may qualify for a loan.
“Higher interest rates will cause funding costs to rise for non-banks, since they have to borrow money from capital markets to make their loans,” says Navigant Consulting’s Noring. “That could mean a rebalancing among lenders because banks fund their loans with deposits.”
Burns, however, thinks addressing regulatory issues will have a bigger impact on the lending atmosphere than rising rates.
“The mortgage industry is overregulated now, so the goal should be to align important safeguards and yet get more investors and lenders back into the market,” Taylor says. “I expect we’ll see some right-setting of regulations so that different products can come into the mortgage market.”
In particular, Taylor anticipates the use of different metrics to evaluate borrowers rather than focusing tightly on FICO scores as lenders do now. “There are already opportunities to make smart decisions based on other data, such as Fannie Mae’s Day 1 Certainty program that uses independent tools to validate a borrower’s income, assets and employment and make it simpler and faster for lenders to approve loans,” Taylor says. “The ultimate winner will be customers, because the more clarity a lender has on what it takes to get a loan, the less risk the lender has to take.”
Both bank and non-bank lenders are impacted by regulations and guidelines from Fannie Mae and Freddie Mac.
“If the Trump administration is successful in relaxing regulations, then the headwinds lenders face could be slowing down,” Sharga says. “That would be good for consumers and for the housing market, as long as it doesn’t lead to the laxity and craziness of the previous housing boom.”
realestate@washpost.com
Word count: 1988
(Copyright The Washington Post Company, Feb 22, 2017)
Chapter 10: Equal Credit Opportunity Act 73
After reading this chapter, you will be able to:
• recognize the protected classes under the Equal Credit Opportunity
Act;
• identify who is subject to the rules of the Equal Credit Opportunity
Act and what activities are prohibited; and
• distinguish the exemptions from anti-
discrimination
rules under
the Equal Credit Opportunity Act.
Learning
Objectives
Equal Credit
Opportunity Act
The federal Equal Credit Opportunity Act prohibits discrimination in
lending based on race, color, religion, national origin, sex, marital status or
age (provided an individual is of legal age).
The anti-discrimination rules apply to institutional lenders, mortgage
brokers, and others who make or arrange mortgages.1
Discriminatory practices take many forms, including:
• treating minority mortgage applicants less favorably than non-
minority applicants;
• placing additional burdens on minority applicants;
• requiring a spouse’s signature on a mortgage application when an
applicant qualifies for a mortgage individually;2
1 15 United States Code §1691a(e)
2 Anderson v. United Finance Company (1982) 666 F2d 1274
Federal fair
lending laws
Equal Credit
Opportunity Act
A 1974 federal
enactment prohibiting
lenders from
discriminating against
borrowers from a
protected class.
credit reporting agency Equal Credit Opportunity Act
Key Terms
Chapter
10
For a further discussion of this topic, see Fair Housing Chapter 8 of
Agency, Fair Housing, Trust Funds, Ethics and Risk Management.
74 Real Estate Principles, Second Edition
• discouraging mortgage applicants based on their race, color, sex, etc.;3
and
• making inquiries into the marital status of mortgage applicants.4
The lender may not make any inquiries into whether an applicant’s income is
derived from alimony or child support. The lender may not inquire whether
the applicant intends to bear children.5
Further, to deny a mortgage based on an applicant’s receipt of income from
a public assistance program, such as welfare or social security, is unlawful
discrimination.6
However, discrimination is rarely practiced overtly. Most lenders are not
transparent enough for the consumer to see the discrimination. Most often,
discrimination takes the form of a lender denying a mortgage to a minority
borrower without a valid reason, or applying different standards to minority
and non-minority borrowers.
Lenders need to be careful not to provide more assistance to non-minority
borrowers than to minority borrowers when preparing applications and
working out problems which arise. The different treatment of minority and
non-minority applicants is another form of unlawful discrimination.
For example, an African-American couple applies for a mortgage to be
insured by the Federal Housing Administration (FHA), which will fund
the purchase of a residence. The home the couple seeks to purchase is 75
miles from their place of work. The couple intends to occupy the home as
their principal residence and commute to work.
The lender suspects the couple wants to purchase the home as an investment,
and not to occupy it themselves. Since the type of FHA insurance sought may
only be used to purchase homes which the buyer will occupy, the lender
denies the mortgage application.
The lender does not discuss with the couple whether they intend to occupy
the home. Also, the lender never suggests the couple can apply for a non-
FHA mortgage. Due to a mortgage contingency, the couple loses their right
to buy the home and incurs expenses in the process.
The couple seeks to recover their money losses from the lender under the
Equal Credit Opportunity Act, claiming the lender’s denial of their mortgage
application was due to unlawful discrimination.
The lender claims the denial of the mortgage application was proper since
it believed the couple did not intend to occupy the home, and thus did not
qualify for an FHA-insured mortgage.
3 12 Code of Federal Regulations §1002.5(b)
4 12 CFR §1002.5(d)
5 12 CFR §1002.5(d)
6 15 USC §1691(a)(2)
Different
treatment is
discrimination
Chapter 10: Equal Credit Opportunity Act 75
Lenders are to provide the same level of assistance to non-minority borrowers
as minority borrowers. Thus, the lender may not unilaterally decide the
couple did not intend to occupy the home without first discussing the
couple’s intentions with them. Also, even if the couple did not qualify for an
FHA-insured mortgage, as a matter of professional practice, the lender needs
to refer them to other forms of financing.
Thus, the lender discriminated against the African-American couple by
denying their mortgage application without a valid reason. Further, there
was a failure to use diligence in assisting the couple to obtain other financing.7
Consider a California-regulated institutional lender who regularly arranges
alternative forms of financing. The lender consistently informs non-minority
applicants of their financing options when they deny a mortgage application.
The lender’s failure to diligently provide the same assistance for minority
applicants subjects the lender to liability for the minority applicant’s money
losses caused by the discrimination. Here, the unlawful discrimination is
based on the lender’s selective release of information based on status.8
Some exceptions to the anti-discrimination rules exist.
For example, a lender may lawfully consider a mortgage applicant’s age
when determining the applicant’s creditworthiness. A lender may also
consider whether the applicant receives income from a public assistance
program, if such an inquiry is for the purpose of determining the amount
and likely continuance of income levels from public assistance.9
Editor’s note — Allowing lenders to consider an applicant’s age or receipt of
income from a public assistance program as an exception in determining
the applicant’s creditworthiness effectively removes these two factors
from the anti-discrimination protection previously discussed.
While a lender may not refuse to accept applications or impose different
mortgage terms based on an applicant’s age or receipt of public assistance
income, the lender can lawfully deny a mortgage based on these factors
simply by stating the applicant is not creditworthy.
Further, lenders may consider an applicant’s immigration status when
considering a mortgage application. Immigration status is used by the lender
to determine whether the applicant is a permanent resident of the United
States.10
7 Barber v. Rancho Mortgage & Investment Corp. (1994) 26 CA4th 1819
8 Barber, supra
9 15 USC §1691(b)(2)
10 12 CFR §1002.6(b)(7)
Differing
levels of
assistance
Discrimination
by age
and public
assistance
76 Real Estate Principles, Second Edition
The Equal Credit Opportunity Act prohibits discrimination
in lending based on race, color, religion, national origin, sex,
marital status or age. The Equal Credit Opportunity Act applies to
institutional lenders, mortgage brokers, and others who regularly
make or arrange mortgages.
Discrimination is rarely practiced overtly. Unlawful discrimination
includes applying different standards to minority and non-
minority borrowers, and providing more assistance to non-minority
borrowers than to minority borrowers.
Exemptions to anti-discrimination rules exist, such as a lender’s
consideration of an applicant’s age, public assistance program
income, or immigration status when determining creditworthiness.
If the lender denies a mortgage application, it is to deliver a
statement to the applicant listing the specific reasons for the denial,
or deliver a notice to the applicant advising them of their right,
upon request, to obtain a statement listing the reasons for denial.
credit reporting agency ……………………………………………… pg. 76
Equal Credit Opportunity Act ……………………………………. pg. 73
Chapter 10
Summary
Chapter 10
Key Terms
Quiz 3 Covering Chapters 8-12 is located on page 608.
After the lender’s receipt of a mortgage application, the lender has 30 days
to notify the applicant as to whether the mortgage is approved or denied.
If the lender denies the mortgage, the lender is to deliver a statement to the
applicant listing the specific reasons for the denial.11 [See RPI Form 219]
Alternatively, if the lender does not give the applicant a statement of the
specific reasons for the denial, the lender is required to deliver a notice to
the applicant stating the applicant has the right, upon request, to obtain a
statement listing the reasons for denial.
In addition to the Equal Credit Opportunity Act, California law controls
credit reporting agencies. Consumers may request a free copy of their
credit report once every year to review it for errors.12
Penalties for discrimination in lending include actual money losses sustained
by a person who has been discriminated against and punitive money awards
of up to $10,000, plus attorney fees.13
11 15 USC §1691(d)
12 Calif. Civil Code §1785.10
13 15 USC §1691e
Denial of
credit and
notification
credit reporting
agency
A private agency
which collects and
reports information
regarding an
individual’s credit
history.
Chapter 11: Home Mortgage Disclosure Act 77
After reading this chapter, you will be able to:
• identify the social goals of the federal Home Mortgage Disclosure
Act (HMDA);
• identify which lenders and mortgage types the HMDA applies to;
and
• find and interpret the data required for HMDA disclosure
statements.
Learning
Objectives
Home Mortgage
Disclosure Act
The federal Home Mortgage Disclosure Act (HMDA) seeks to prevent
lending discrimination and unlawful redlining practices. The HMDA
requires lenders to disclose home mortgage origination information to the
public when the borrower is seeking a residential or home improvement
mortgage.1
State and federally regulated banks and mortgage brokers are required by the
HMDA to compile home mortgage origination data. This data is submitted to
their respective supervisory agencies.2
Home mortgage originations include:
• purchase-assist financing;
• construction for a new home;
1 Department of Housing and Urban Development Mortgagee Letter 94-22
2 12 United States Code §§2802, 2803; Calif. Health and Safety Code §35816
Lenders
release home
mortgage
data
Home Mortgage
Disclosure Act
(HMDA)
A regulatory scheme
requiring lenders to
publically release loan
data.
debt-to-income (DTI) ratio Home Mortgage Disclosure
Act (HMDA)
Key Terms
Chapter
11
For a further discussion of this topic, see Fair Housing Chapter 10 of
Agency, Fair Housing, Trust Funds, Ethics and Risk Management.
78 Real Estate Principles, Second Edition
• improvement of the borrower’s home; or
• the refinance of an existing home mortgage.
Lenders with total assets of more than $28 million, and for-profit mortgage
brokers with total assets of more than $10 million, need to compile origination
data and make it available to the public.
The data includes:
• the type and purpose of the mortgage;
• the owner-occupancy status of the real estate securing the mortgage;
• the amount of the mortgage;
• the action taken by the lender on the application;
• the sex, race and national origin of the mortgage applicant; and
• the income of the mortgage applicant.3
The data is grouped according to census tracts to determine the lender’s
activity within the tract.4
Lenders are exempt from HMDA disclosure requirements if:
• the lender does not have a branch office in a metropolitan statistical
area (MSA);
• the lender’s assets on the preceding December 31 totaled less than $28
million.5
For-profit mortgage brokers are exempt from HMDA disclosure requirements
if on the preceding December 31:
• the mortgage broker did not have a branch office in a MSA; or
• the mortgage broker’s assets totaled less than $10 million and they
originated less than 100 home purchase mortgages in the preceding
year.6
Regardless of exemptions, all lenders approved by the Department of
Housing and Urban Development (HUD) are to report to HUD and disclose
the census tract information on all Federal Housing Administration (FHA)
mortgages they originate. 7
The data is compiled by the Federal Financial Institutions Council into
a disclosure statement sent to the lender.8
3 12 Code of Federal Regulations §1003.4(a)
4 12 USC §2803(j)(2)(C)
5 12 CFR §1003.3(a)(1)
6 12 CFR §1003.3(a)(2)
7 HUD Mortgagee Letter 94-22
8 12 CFR §1003.5(b)
Federal
disclosure
requirements
Lender
exemptions
Chapter 11: Home Mortgage Disclosure Act 79
The disclosure statement is required to be posted in a conspicuous location in
the lender’s office where it is readily accessible to the public. The disclosure is
posted for a minimum of five years.9
On request from any member of the public, the lender is to make available a
copy of the disclosure statement data.10
Lenders who regularly originate residential mortgages who do not report to
a federal or state regulatory agency are to compile data on the number and
dollar amount of mortgage originations for each fiscal year. This includes
both actual originations and completed mortgage applications.11
State regulated lenders who fall into this category include:
• insurers;
• mortgage bankers;
• investment bankers; and
• credit unions that do not make federally related mortgages.
The data is first categorized by geographical area, then by census tract. For
each census tract, mortgage originations are grouped according to:
• FHA and Veterans Administration (VA) mortgage originations on
owner-occupied, one-to-four unit dwellings;
• conventional purchase-assist mortgage originations on owner-
occupied, one-to-four unit dwellings;
• home improvement mortgage originations on owner-occupied, one-
to-four unit dwellings; and
• home improvement mortgage originations on occupied, one-to-four
unit dwellings not occupied by the owner.12
California regulated lenders exempt from mortgage origination disclosures
are:
• lenders whose originations of purchase-assist mortgages totaled less
than 10% of the lender’s mortgage volume during the current reporting
year; and
• licensed real estate brokers who negotiate or arrange purchase-assist
and home improvement mortgages.13
Federally regulated lenders are subject to investigation and penalties by
federal authorities.14
9 12 USC §§2803(a)(2), 2803(c)
10 12 USC §2803(a)(1)
11 21 Calif. Code of Regulations §7118(a)
12 21 CCR §7118(b)(2)
13 21 CCR §7121
14 12 USC §2803(h)
California
state
regulated
lenders
Monitoring
federally
regulated
lenders
80 Real Estate Principles, Second Edition
The federal Home Mortgage Disclosure Act (HMDA) prevents
lending discrimination and unlawful redlining practices on
residential or home improvement mortgages. The HMDA
requires lenders to disclose information on their home mortgage
originations to the public.
State and federally regulated banks are to maintain data on the
type of mortgages they originate, the amount, the occupancy status
of the real estate, the action taken by the lender on the application,
and demographic information about the applicant.
This data is categorized by mortgage type, geographical area and
census tract. It is then compiled into a disclosure statement which
lenders are to post publically. These disclosures help identify
lending patterns and prevent lending discrimination.
debt-to-income (DTI) ratio …………………………………………. pg. 80
Home Mortgage Disclosure Act (HMDA) ………………….. pg. 77
Chapter 11
Summary
Chapter 11
Key Terms
Quiz 3 Covering Chapters 8-12 is located on page 608.
While disclosure of mortgage statistics helps to identify lending patterns,
mortgage statistics alone are not sufficient to determine whether a lender
is unlawfully practicing redlining or other discriminatory practices. [See
Chapter 9]
The mortgage statistic disclosures may be relevant when considered in
conjunction with other evidence. This includes the credit histories of denied
mortgage applicants and their debt-to-income (DTI) ratios.15
15 HUD Mortgagee Letter 94-22
debt-to-income (DTI)
ratio
Percentage of monthly
gross income that goes
towards paying debt.
Chapter 12: HUD advertising guidelines for sales and rentals 81
After reading this chapter, you will be able to:
• recognize the types of advertising considered discriminatory
under the Federal Fair Housing Act (FFHA);
• use the Department of Housing and Urban Development (HUD)
guidelines to avoid discriminatory preferences in advertising; and
• understand the consequences of failing to follow HUD advertising
guidelines.
Learning
Objectives
HUD advertising guidelines
for sales and rentals
The printing or publishing of an advertisement for the sale or rental of
residential property that indicates a wrongful discriminatory preference is
a violation of the Federal Fair Housing Act (FFHA).1 [See Chapter 7]
A property sold or leased for residential occupancy is referred to as a dwelling.
The discriminatory preference rule applies to all brokers, developers and
landlords in the business of selling or renting a dwelling.2
Real estate advertising guidelines are issued by the Department of Housing
and Urban Development (HUD). The guidelines are the criteria by which
1 42 United States Code §3604(c)
2 42 USC §§3603, 3604
Avoiding
discrimination
in advertising
Federal Fair
Housing Act (FFHA)
A collection of policies
designed to prevent
discrimination in
the access to housing
based on an occupant’s
inclusion in a
protected class.
dwelling Federal Fair Housing Act
(FFHA)
Key Terms
Chapter
12
For a further discussion of this topic, see Fair Housing Chapter 11 of
Agency, Fair Housing, Trust Funds, Ethics and Risk Management.
82 Real Estate Principles, Second Edition
HUD determines whether a broker has practiced or will practice wrongful
discriminatory preferences in their advertising and availability of real estate
services.
HUD guidelines also help the broker, developer, and landlord avoid signaling
preferences or limitations for any group of persons when marketing real
estate for sale or rent.
The selective use of words, phrases, symbols, visual aids and media in the
advertising of real estate may indicate a wrongful discriminatory preference
held by the advertiser. When published, the preference can lead to a claim of
discriminatory housing practices by a member of the protected class.
Words in a broker’s real estate advertisement that indicate a particular race,
color, sex, sexual orientation, handicap, familial status or national origin are
considered violations of the FFHA.
To best protect themselves, a broker refuses to use phrases indicating a
wrongful preference, even if requested by a seller or landlord. Words or
phrases indicating a preference in violation of the rights of persons from
protected classes include:
• white private home;
• Jewish (or Christian) home;
• black home;
• Hispanic neighborhood; or
• adult building.
Preferences are often voiced in prejudicial colloquialisms and words such as
restricted, exclusive, private, integrated or membership approval.
Indicating a preference by age is an exclusion from unlawful age
discrimination when marketing qualified 55-or-over residences or
communities. [See Chapter 7]
Selective stereotypical use of media or human models in an advertising
campaign can also lead to discrimination against minority groups.
The HUD issues guidelines that require real estate brokers selling or renting
single family residences to display a fair housing
poster
.3
The fair housing poster is available at any HUD office.4
The broker marketing dwellings for sale or rent is to display the fair housing
poster:
• in the broker’s place of business; and
3 24 CFR §§110.1, 110.10
4 24 CFR §110.20
dwelling
A building occupied
or designed to be
occupied as a residence
by one or more
families.
Marketing
real estate
for sale or
rent
The HUD
fair housing
poster
Chapter 12: HUD advertising guidelines for sales and rentals 83
• at any dwelling offered for sale, other than SFRs.5
Thus, a broker holding an open house at a SFR listed for resale is not required
to display the fair housing poster at the residence.
However, if a dwelling is marketed are part of a residential development, the
fair housing poster is to be displayed by the developer during construction of
the development. Later, the poster is to be displayed in the model dwellings
whether or not the dwellings are sold through a broker.6
The fair housing posters is to be placed where they can be easily seen by any
persons seeking to:
• engage the services of the broker to list or locate a dwelling; or
• purchase a dwelling in a residential development.7
Even though it is required, a broker will not be subject to any penalties for
failing to display the fair housing poster. However, failure to display the
fair housing poster is initially considered sufficient evidence in a lawsuit to
show that a broker practiced discriminatory housing practices.8
Also, a real estate broker and their agents who follow HUD advertisement
guidelines and display the fair housing poster is less likely to practice a
discriminatory activity.
The fair housing poster openly assures potential sellers/landlords and buyers/
tenants the broker does not unlawfully discriminate in the services offered.
Also, the broker following HUD advertising and poster guidelines is in a
better position to defend themselves against a fair housing lawsuit. Use of
the fair housing poster indicates to the public the broker’s invitation to work
with all individuals.
5 24 CFR §110.10(a)
6 24 CFR §§110.10(a)(2)(ii), 110.10(a)(3)
7 24 CFR §110.15
8 24 CFR §110.30
Failure to
follow HUD
guidelines
84 Real Estate Principles, Second Edition
Printing or publishing the sale or rental of a dwelling indicating a
discriminatory preference is a violation of the Federal Fair Housing
Act (FFHA). This includes the selective use of words and phrases in
the advertising of real estate. This rule applies to brokers and agents,
developers and landlords.
The Department of Housing and Urban Development (HUD) provides
guidelines controlling advertisements for dwellings. HUD also
publishes a fair housing poster which is to be displayed, when offering
a dwelling for rent or sale, in the place of business of brokers, agents,
developers and landlords and the dwelling offered, except for single
family homes other than those offered by developers.
Licensees following HUD advertising and poster guidelines are in a
better position to defend themselves against a fair housing lawsuit.
dwelling …………………………………………………………………………. pg. 82
Federal Fair Housing Act (FFHA) …………………………………. pg. 81
Chapter 12
Summary
Chapter 12
Key Terms
Quiz 3 Covering Chapters 8-12 is located on page 608.
Chapter 54: Conventional financing on a sale, and the buyer’s agent 3
59
After reading this chapter, you will be able to:
• undertake the duties of a transaction agent (TA) to police all facets
of their buyer’s
mortgage
process;
• understand the adversarial relationship between a lender and
buyer; and
• advise buyers of the financial advantage gained by submitting
mortgage applications to multiple lenders.
Learning
Objectives
Conventional financing
on a sale, and the
buyer’s agent
Chapter
54
The ability of a
buyer
or an owner to obtain financing is an integral
component of most real estate transactions.
The submission of a mortgage application to a private or institutional
lender is the catalyst which sets the machinery of the mortgage industry in
motion.
The buyer’s agent owes their buyer the duty to ensure their buyer negotiates
the best financial advantage available among mortgage lenders. As viewed
and identified by lenders, the buyer’s agent is called a transaction agent
(TA).
Role of the
transaction
agent (TA)
transaction agent
(TA)
The term lenders
use to identify the
buyer’s agent in a
sales transaction, its
closing contingent on
the buyer obtaining a
mortgage to fund the
purchase price.
Loan Estimate
mortgage shopping
worksheet
transaction agent (TA)
Uniform Residential Loan
Application
For a further study of this discussion, see Chapter 37 of Real Estate
Finance.
Key Terms
360 Real Estate Principles, Second Edition
The TA neither arranges nor makes a mortgage. Further, they are barred from
receiving any compensation for referring the buyer to service providers or
policing lender activity. Events related to the transaction serviced by the TA
are covered solely by the broker fee negotiated on the sales transaction.
The duties imposed by agency law on the TA include:
• helping the buyer locate the most advantageous mortgage terms
available in the market;
• oversight of the mortgage application submission; and
• policing the lender’s mortgage packaging process and funding
conditions.
These TA activities ensure all documents needed to comply with the lender’s
requests and closing instructions are in order. If not, funding cannot take
place and closing the sales escrow is jeopardized.
A lender’s objectives and goals are diametrically opposed to those of the
buyer – a debtor versus creditor relationship.
On the advice from their agents, buyers need to understand that the lender’s
product – money – is always unpriced until the closing has taken place. This
truth exists in spite of the Loan Estimate and interest rate disclosures that
are given to the buyer within three business days following the lender’s
receipt of the mortgage application. [See RPI Form 204-5]
The TA’s
duties
Diametrically
opposed
interests
When applying for a conventional mortgage, a buyer has several types of lenders to
choose from, including:
• portfolio lenders, such as banks, thrifts and credit unions;
• institutional lenders, such as insurance companies and trade association
pensions; and
• warehousing lenders, such as mortgage bankers who resell the mortgage in the
secondary mortgage market.
While portfolio and institutional lenders typically service their own mortgages, they
often originate mortgages for immediate sale in a process called warehousing.
Warehoused mortgages are sold on the secondary mortgage market to investment
pools, such as the Federal National Mortgage Association (Fannie Mae), the Federal
Home Mortgage Corporation (Freddie Mac), the Government National Mortgage
Association (Ginnie Mae) and Wall Street bankers.
The business of servicing mortgages is also bought and sold. This causes the mortgage
to appear to be changing hands. Typically, the originating lender continues to service
the mortgage when they sell the mortgage to an investor.
Sources of
conventional
financing
Chapter 54: Conventional financing on a sale, and the buyer’s agent 3
61
The buyer needs to understand the Loan Estimate is not a commitment to
lend and is not a guarantee a mortgage on substantially the same terms will
be funded. A lender at any time may change the mortgage terms then simply
provide another, refreshed Loan Estimate. [See RPI Form 204-5]
Editor’s note — The new Loan Estimate and Closing Disclosure forms
published by the Consumer Financial Protection Bureau (CFPB), which
apply to all consumer mortgages, went into effect October 3, 2015. The new
forms significantly simplify and streamline the mortgage lending process
for homebuyers. [See RPI Form 204-5 and 402]
The Loan Estimate replaces both the initial Truth-in-Lending statement and
the good faith estimate of costs (GFE). The Loan Estimate is provided within
three business days of the lender’s receipt of the application, and provides
the mortgage terms and details quoted by the lender. [See RPI Form 204-5]
The Closing Disclosure replaces both the old final Truth-in-Lending
statement and the HUD-1 Settlement Statement. This form is provided
within three business days of mortgage closing. It summarizes the “final”
mortgage terms and details.1 [See RPI Form 402]
After their buyer’s offer has been accepted, it’s time for the buyer’s agent
to assist their buyer with submitting a Uniform Residential Loan
Application to multiple lenders. [See Chapter 55; see RPI Form 202 (FNMA
1003)]
Editor’s note – Instructions for the accurate completion of the Uniform
Residential Loan Application are provided in Chapter 55.
As part of the TA’s advice and guidance in the mortgage application process,
the TA instructs the buyer regarding:
• the expectations held and the role of each servicer or affiliate
involved in the mortgage transaction, such as the lender’s mortgage
representative, an appraiser, any mortgage broker involved, credit
agencies, creditors of the buyer, etc.;
• what is going to take place during the application process, such as
lender disclosures, payment of lender costs, funding requirements, etc.;
and
• what to guard against, such as excuses and claims usually made by the
lender to justify an increase in rates at the time of closing.
Documents the buyer needs to gather and submit to the lender to process the
mortgage include:
• W-2s or other tax documents for the self-employed;
• recent bank statements; and
1 12 Code of Federal Regulations §§1026.19 et seq.
Loan Estimate
An estimate of a
buyer’s settlement
charges and mortgage
terms handed to the
buyer on a standard
form within three
business days
following the lender’s
receipt of the mortgage
application. [See RPI
Form 204-5]
Before
meeting with
a lender
Uniform Residential
Loan Application
A standardized
mortgage application
completed by the
buyer with the
assistance of the
transaction agent and
the mortgage lender’s
representative. [See
RPI Form 202]
362 Real Estate Principles, Second Edition
A variety of state and federal loan programs exist, offering down payment assistance
for low- to moderate-income buyers and first-time buyers, mortgage refinance or
modification programs to distressed owners, and special programs for veterans.
Federal programs:
Federal Housing Administration (FHA)-insured mortgage: The FHA insures lenders
against loss for the full amount of a mortgage. FHA-insured mortgages permit small
cash down payments and higher loan-to-value ratio (LTV) requirements than
mortgages
originated by conventional lenders. [See Chapter 56]
U.S. Department of Veterans Affairs (VA) mortgage guarantee: The VA mortgage
guarantee program assists qualified veterans or their surviving spouses to buy a home
with zero down payment.
Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage
Corporation (Freddie Mac) and Government National Mortgage Association (Ginnie
Mae): Fannie Mae, Freddie Mac and Ginnie Mae are government-sponsored enterprises
(GSEs) designed to help facilitate home purchases for low- to moderate-income buyers.
Fannie Mae and Freddie Mac do not provide home mortgages directly. Instead, they
purchase and package pools (tranches) of qualifying single family residence (SFR)
mortgages originated by mortgage bankers, known as conforming mortgages, as
mortgage-backed bonds (MBBs). They then sell the MBBs to Wall Street Bankers on the
secondary mortgage market.
State programs:
California Housing Finance Agency (CalHFA): CalHFA administers several first-time
homebuyer assistance programs, offering 30-year fixed rate mortgages with interest
rates and fees typically lower than conventional financing.
California Department of Veterans Affairs (CalVet): CalVet provides a veteran with an
ARM mortgage at a rate generally below market, low monthly payments and flexible
credit
standards
, as compared to conventional financing or mortgages insured by the
FHA or guaranteed by the VA.
California Department of Housing and Community Development (HCD): HCD
programs fund local public agencies and private entities which produce affordable
housing for rental or ownership.
Government
financing
programs at a
glance
• recent pay-stubs to evidence the employment information represented
by the buyer in section four of the mortgage application. [See Chapter
55; see RPI Form 202 (FNMA 1003)]
Lenders also verify other information in the application by requesting and
reviewing:
• an appraisal report to establish the value of the property serving as
security;
• verification of deposit or tax returns to establish the buyer’s income
and assets; and
• a credit report to establish the buyer’s liabilities and propensity to
repay the mortgage. [See Chapter 55; see RPI Form 202 (FNMA 1003)]
Chapter 54: Conventional financing on a sale, and the buyer’s agent 3
63
To best protect the buyer, applications are to be submitted to at least two
lenders. The second application is insurance against lenders’ last minute
changes to the rates and terms at the time of closing.
Without a backup application processed by another lender, the buyer is left
with no opportunity to reject the lender’s changes.
Multiple government agencies promote the practice of submitting multiple
applications. To assist the buyer with the task of comparing the products of two
Government
supports
multiple
applications
Form 312
Mortgage
Shopping
Worksheet
364 Real Estate Principles, Second Edition
or more lenders, entities such as the California Department of Corporations,
Freddie Mac, the Federal Reserve, and the Federal Trade Commission publish
Mortgage Shopping Worksheets.
The Mortgage Shopping Worksheet published by Realty Publications,
Inc. (RPI) is designed to be completed by the buyer with the assistance of
the TA. The worksheet contains a list of all the mortgage variables commonly
occurring on origination and during the life of the mortgage. [See Form 312
accompanying this chapter]
After submitting mortgage applications to two lenders and receiving the
corresponding Loan Estimates, the buyer will possess all the information
needed to fill out a Mortgage Shopping Worksheet for each lender. Once
complete, the buyer and TA can clearly compare the terms offered by the
competing lenders and if that lender remains competitive, close with that
lender. [See Form 312]
Mortgage Shopping
Worksheet
A worksheet designed
for use by buyers
when submitting
applications for a
consumer mortgage
to compare mortgages
offered by different
lenders based on a list
of all the variables
commonly occurring
as costs at the time
of origination and
over the life of the
mortgage. [See RPI
Form 312]
It is the duty of the buyer’s transaction agent (TA) to ensure their buyer
negotiates the best financial advantage available to them. Further, the
TA ensures all documents needed to comply with the lender’s closing
instructions are timely delivered and in order. The TA neither arranges
nor makes a mortgage, but polices all facets of the mortgage process.
A buyer’s first step toward obtaining a mortgage is the submission of
a standardized Uniform Residential Loan Application to a lender as a
prospective borrower. The Uniform Residential Loan Application is
designed to be completed by the buyer with the assistance of the TA and
the lender’s mortgage representative.
To ensure competitive mortgage rates and terms, the TA needs to advise
their buyer to submit separate mortgage applications to multiple
lenders. By having mortgage applications with two or more lenders, the
TA is able to direct the buyer to the lender who offers the superior set of
mortgage costs, terms for payment and interest rates, and keep it that
way through closing.
Loan Estimate ……………………………………………………………………. pg. 361
mortgage shopping worksheet ………………………………………… pg. 3
64
transaction agent (TA) ………………………………………………………. pg. 359
Uniform Residential Loan Application ………………………….. pg. 361
Chapter 54
Summary
Chapter 54
Key Terms
Quiz 10 Covering Chapters 49-54 is located on page 615.
Chapter 55: The Uniform Residential Loan Application and post-submission activities 3
65
After reading this chapter, you will be able to:
• understand the components of the Uniform Residential Loan
Application;
• guide your buyer on how to prepare the mortgage application;
and
• advise on the lender disclosures required under the Real Estate
Settlement Procedures Act (RESPA).
Learning
Objectives
The Uniform Residential
Loan Application and
post-submission activities
Chapter
55
The Uniform Residential Loan Application prepared by the buyer with
the assistance of their transaction agent (TA) provides the lender with
necessary information about the buyer and the property which will secure
the mortgage. It also gives the lender authorization to start the mortgage
packaging process. [See Figure 1, RPI Form 202 (FNMA 1003)]
Fundamentals
of the
Uniform
Residential Loan
Application
balance sheet
buyer mortgage capacity
creditworthiness
debt-to-income ratio (DTI)
loan-to-value ratio (LTV)
mortgage package
Real Estate Settlement
Procedures Act (RESPA)
transaction agent (TA)
Uniform Residential Loan
Application
For a further study of this discussion, see Chapter 38 of Real Estate
Finance.
Key Terms
366 Real Estate Principles, Second Edition
Generally, a mortgage is sought in a home sales transaction which is
contingent on the buyer obtaining a mortgage to fund the purchase of the
property, known as purchase-assist financing. However, a mortgage may
also be needed for funding by:
• an owner of vacant land to construct a dwelling;
• a property owner to improve or renovate a property they currently
own;
• a property owner to refinance an existing mortgage; or
• a tenant on a long-term lease who has agreed to make tenant
improvements (TIs) to the property they rent.
As implied by its title, the Uniform Residential Loan Application is intended
primarily for use on mortgages secured by residential properties.
However, as a generic mortgage application, it is used by mortgage
brokers
as an application for a mortgage funding any purpose and secured by any
type of property. The Uniform Residential Loan Application contains all
the information required for arranging all types of real estate mortgages.
In practice, the type of property intended to be purchased by use of the
mortgage funds is provided by the description of the property in the mortgage
application.
The first section of the Uniform Residential Loan Application calls for the
type of mortgage sought, such as conventional, VA or FHA-insured. The
buyer also indicates:
• the total dollar amount of the mortgage requested;
• the anticipated interest rate, and whether it is to be fixed or adjustable;
• the periodic payment schedule (constant or graduated); and
• the amortization period (positive or negative). [See Figure 1, RPI Form
202 (FNMA 1003)]
The property under contract to secure the mortgage is identified and its
intended use set forth in section two. Section two also states the purpose to be
funded by the mortgage, such as purchase-assist or refinance. Also disclosed
is the source of down payment funds and closing costs. [See Figure 1, RPI
Form 202 (FNMA 1003)]
Information identifying the buyer, such as their name and social security
number, is entered in section three. Space is left to insert any co-borrower
information if the income, assets and liabilities of a co-borrower are to be
considered for mortgage qualification purposes.
A separate form is used to disclose to the lender the applicant’s assets and
liabilities if:
• the assets and liabilities result from separate property owned by a co-
borrower;
transaction agent
(TA)
The term lenders
use to identify the
buyer’s agent in a
sales transaction, its
closing contingent on
the buyer obtaining a
mortgage to fund the
purchase price.
Components
of the Uniform
Residential
Loan
Application
Buyer
information
Uniform Residential
Loan Application
A standardized
mortgage application
completed by the
buyer with the
assistance of the
transaction agent and
the mortgage lender’s
representative. [See
RPI Form 202]
Chapter 55: The Uniform Residential Loan Application and post-submission activities 3
67
• the co-borrower is a necessary party to the transaction as the property
encumbered is considered community property; or
• the co-borrower is a co-signer of the note as a primary borrower. [See
Figure 2, RPI Form 209-3]
The buyer and co-borrower need to prepare a balance sheet if their assets
and liabilities are sufficiently joined to make one combined statement viable.
If not, each co-borrower is to prepare a separate asset and liabilities statement
for individual consideration by the lender. [See Figure 2, RPI Form 209-3]
balance sheet
An itemized, dollar-
value presentation
for setting an
individual’s net worth
by subtracting debt
obligations (liabilities)
from asset values. [See
RPI Form 209-3]
Figure 1
Form 202
Uniform
Residential Loan
Application
For a full-size, fillable copy of this or
any other form in this book that may be
used in your professional practice, go to
realtypublications.com/forms
368 Real Estate Principles, Second Edition
The buyer’s (and co-borrower’s) employment information necessary to
identify their source of income is entered in section four of the Uniform
Residential Loan Application.
Employment information includes:
• the employment currently held by the buyer;
• the buyer’s job title; and
Employment
information
Figure 1
Form 202 Cont’d
Uniform
Residential Loan
Application
For a full-size, fillable copy of this or any
other form in this book that may be used
in your professional practice, go to
realtypublications.com/forms
Chapter 55: The Uniform Residential Loan Application and post-submission activities 3
69
• years spent at that specific job and within that profession. [See Figure 1,
RPI Form 202 (FNMA 1003)]
If the buyer is self-employed, they indicate this by checking the self-employed
box. [See Figure 1, RPI Form 202 (FNMA 1003)]
Next, the buyer reports their monthly income and housing expenses in
section five. [See Figure 1, RPI Form 202 (FNMA 1003)]
The buyer’s assets and liabilities are entered into section six. This discloses
the buyer’s net worth. The information is pertinent since the buyer’s
liabilities affect their ability to repay the mortgage. However, the buyer
may not want to disclose all their assets. Thus, a balance needs to be struck
between maintaining financial privacy and disclosing enough assets to get
creditworthiness clearance so the mortgage will be funded. [See Figure 1,
RPI Form 202 (FNMA 1003)]
Since the mortgage funds the acquisition of property, the buyer enters
pricing details about the transaction in section seven, including the cost
of repairs, alterations and improvements made to the property. [See Figure 1,
RPI Form 202 (FNMA 1003)]
The buyer (and any co-borrower) declares any relevant miscellaneous
creditworthiness issues in section eight of the mortgage application. This
includes debt enforcement or debt avoidance the buyer has experienced. [See
Figure 1, RPI Form 202 (FNMA 1003)]
The buyer signs the application (with any co-borrower) to acknowledge and
agree to the numerous conditions, some of which are:
• the property will be occupied as represented in the application;
• the buyer will amend the application and resubmit it to the lender if
the facts originally stated substantially change;
• the lender may sell/assign the mortgage to others, though the buyer
will not be able to sell the property and delegate the mortgage
responsibility to another person who acquires the property; and
• the lender is authorized to verify all aspects of the mortgage application
as represented by the buyer. [See Figure 1, RPI Form 202 (FNMA 1003)]
A lender evaluating a mortgage package considers a buyer’s willingness and
capacity to pay. To comply, borrowers applying for a consumer mortgage are
evaluated by the lender for their ability-to-repay (ATR), part of Regulation
Z (Reg Z), which implements TILA.1
Generally, the debt-to-income ratio (DTI) for conventional mortgages, also
called the debt-to-income standard, limits the buyer’s:
• monthly payments for the maximum purchase-assist mortgage,
including impounds for hazard insurance premiums and property
taxes, to approximately 31% of the buyer’s monthly gross income; and
1 12 CFR 1026.43 et seq.
Additional
components of
the application
“Willing and
able” to pay
debt-to-income ratio
(DTI)
Percentage of monthly
gross income that goes
towards paying debt.
370 Real Estate Principles, Second Edition
• long-term debt, plus the monthly payments, to approximately 41% of
the buyer’s gross monthly income. [See RPI Form 229-1, 229-2 and 230]
Lenders use the DTI ratio to evaluate the buyer’s ability to make timely
mortgage payments. This is referred to as buyer mortgage capacity. [See
RPI Form 230]
The buyer’s willingness to make mortgage payments is evidenced by the
credit report. The credit history demonstrates to the lender whether or not
the buyer has a propensity to pay, called creditworthiness.
The DTIs can be adjusted depending on one or more compensating factors,
such as if the buyer has:
• ample cash reserves;
• a low LTV; and
• spent more than five years at the same place of employment.
The Real Estate Settlement Procedures Act (RESPA) mandates lenders
active in the secondary mortgage market to disclose all mortgage related
charges on mortgages used to purchase, refinance or improve one-to-four
unit residential properties.
buyer mortgage
capacity
A buyer’s ability
to make mortgage
payments based on
their debt-to-income
ratios (DTI).
creditworthiness
An individual’s ability
to borrow money,
determined by their
present income,
wealth and previous
debt payment history.
RESPA
disclosures
Real Estate
Settlement
Procedures Act
(RESPA)
Legislation prohibiting
brokers from giving
or accepting referral
fees if thebroker or
their agent is already
acting as a transaction
agent in the sale of
a one-to-four unit
residential property
which is being funded
by a purchase-assist,
federally-related
consumer mortgage.
The typical conventional mortgage is a 30-year amortized mortgage with a fixed rate
of interest.
The buyer’s monthly payment remains the same during the life of the fixed-rate
mortgage. Fixed-rate mortgages offer greater long-term stability for the buyer than
adjustable rate mortgages (ARMs) with their varying interest rates and payment
schedules.
Financing options include:
• ARMs where the interest rate changes periodically based on an index for short-
term consumer rates, plus a profit margin. ARMs cause the buyer’s monthly
payment to periodically adjust;
• rate buy-downs where the buyer receives an initial interest rate which is
periodically increased, along with the monthly payment, to a fixed rate within a
few years, called a graduated payment mortgage (GPM);
• the length of the mortgage, which is typically 15 or 30 years, although some
lenders offer mortgages with irregular terms;
• assumable mortgages allowing resale to a creditworthy buyer, with or without
a rate adjustment [See Chapter 57];
• bi-weekly mortgages with payments made every two weeks to reduce the total
amount of interest paid on the mortgage; and
• private mortgage insurance (PMI) where a qualifying buyer obtains a mortgage
with less than a 20% down payment while paying a premium for insurance
to cover the lender’s risk of loss created by the smaller down payment. [See
Chapter 60]
Types of
mortgages
Chapter 55: The Uniform Residential Loan Application and post-submission activities 3
71
Mortgage related charges include:
• origination fees;
• credit report fees;
• insurance costs; and
• prepaid interest.
RESPA is now administered and enforced by the Consumer Financial
Protection Bureau (CFPB) — not the U.S. Department of Housing and
Urban Development (HUD).
A RESPA-controlled lender provides the buyer with:
• a Loan Estimate of all mortgage terms quoted by the lender within
three business days of the lender’s receipt of the buyer’s mortgage
application [See RPI Form 204-5; see Chapter 54];2
• a special information booklet published by the CFPB to help the
buyer understand the nature and scope of real estate settlement costs
within three business days after the lender’s receipt of the buyer’s
application;3
• a Closing Disclosure, which summarizes the “final” mortgage terms
and details, provided by the lender at least three days before the
consumer closes on the mortgage [See RPI Form 402];4 and
• a list of homeownership counseling organizations.
Editor’s note: A list of homeownership counseling organizations approved
by HUD can be found at the CFPB’s website.
If the buyer is arranging financing through a mortgage broker, the broker, not
the lender, provides a copy of the special information booklet to the buyer.5
However, the booklet does not need to be given to the buyer if the mortgage
funds:
• the refinance of an existing mortgage;
• a closed-end mortgage in which the lender takes a subordinate lien;
• a reverse mortgage; and
• any federally related mortgage used to fund the purchase of other than
a one-to-four unit residential property.6
Also, on ARMs, the lender informs the buyer not only of the interest rate, but
also the index, margin and payment and interest rate floors and caps. [See
RPI Form 320-1]
On the lender’s receipt of a mortgage application, the property is appraised.
[See RPI Form 223-2 and 207; see Chapter 29]
2 12 CFR §1026.37
3 12 CFR §1026.19(g)
4 12 CFR §1026.19(f)(ii)
5 12 CFR §1024.6(a)(1)
6 12 CFR §1024.6(a)(3)
Property
appraisal
• long-term debt, plus the monthly payments, to approximately 41% of
the buyer’s gross monthly income. [See RPI Form 229-1, 229-2 and 230]
Lenders use the DTI ratio to evaluate the buyer’s ability to make timely
mortgage payments. This is referred to as buyer mortgage capacity. [See
RPI Form 230]
The buyer’s willingness to make mortgage payments is evidenced by the
credit report. The credit history demonstrates to the lender whether or not
the buyer has a propensity to pay, called creditworthiness.
The DTIs can be adjusted depending on one or more compensating factors,
such as if the buyer has:
• ample cash reserves;
• a low LTV; and
• spent more than five years at the same place of employment.
The Real Estate Settlement Procedures Act (RESPA) mandates lenders
active in the secondary mortgage market to disclose all mortgage related
charges on mortgages used to purchase, refinance or improve one-to-four
unit residential properties.
buyer mortgage
capacity
A buyer’s ability
to make mortgage
payments based on
their debt-to-income
ratios (DTI).
creditworthiness
An individual’s ability
to borrow money,
determined by their
present income,
wealth and previous
debt payment history.
RESPA
disclosures
Real Estate
Settlement
Procedures Act
(RESPA)
Legislation prohibiting
brokers from giving
or accepting referral
fees if thebroker or
their agent is already
acting as a transaction
agent in the sale of
a one-to-four unit
residential property
which is being funded
by a purchase-assist,
federally-related
consumer mortgage.
372 Real Estate Principles, Second Edition
The appraisal determines whether the property is of sufficient value to
support the amount of financing the buyer requests. Essentially, the lender
uses the appraisal to gauge whether the loan-to-value ratio (LTV) meets
the lender’s standards. [See Chapter 29]
Generally, an acceptable LTV for conventional mortgages is 80% of the
property’s value, requiring the buyer to make a minimum 20% down
payment. A greater LTV compels the lender to require the buyer to obtain
private mortgage insurance (PMI).
loan-to-value ratio
(LTV)
A ratio stating
the outstanding
mortgage balance as
a percentage of the
mortgaged property’s
fair market value. The
degree of leverage.
Figure 2
Form 209-3
Balance Sheet
Financial
Statement
For a full-size, fillable copy of this or
any other form in this book that may be
used in your professional practice, go to
realtypublications.com/forms
Chapter 55: The Uniform Residential Loan Application and post-submission activities 373
Once a lender approves property based on an appraisal, a mortgage package
is assembled and sent to a mortgage underwriter for review.
A mortgage approval issued by a lender is often conditioned on a buyer
providing more information or taking corrective actions. For example:
• the physical condition of the property may need correction;
• title may need to be cleared of defects;
• derogatory entries on the buyer’s credit report may need to be
eliminated; or
• the buyer’s long- or short-term debt is to be reduced.
Once conditions for funding are met and verified, the mortgage is classified as
approved. Escrow calls for mortgage documents and funds, and on funding,
the sales transaction is closed.
Agents need to remind themselves that the degree of risk each lender finds
acceptable is different. More often than not, a lender exists who will make a
mortgage of some amount and under some conditions to nearly any buyer. It
is the business of lenders to do so.
mortgage package
A collection of
documents required
to process a mortgage
application and
sent to a mortgage
underwriting officer
for review after receipt
of the appraisal on the
property offered as
security.
Mortgage
approval
The Uniform Residential Loan Application prepared by the buyer
with the transaction agent (TA) supplies the lender with necessary
information about the buyer and the property securing the mortgage.
It also gives the lender authorization to start the mortgage packaging
process.
The Uniform Residential Loan Application calls for the buyer, with the
assistance of the mortgage representative and TA, to enter information
such as:
• the type of mortgage sought;
• the identity of the property used to secure the mortgage;
• the buyer’s name and employment information;
• the buyer’s monthly income and housing expenses;
Chapter 55
Summary
374 Real Estate Principles, Second Edition
• the buyer’s assets and liabilities; and
• relevant miscellaneous creditworthiness issues to be disclosed to
the lender.
A Real Estate Settlement Procedures Act (RESPA)-controlled lender
needs to provide the buyer with a Loan Estimate of all mortgage related
charges, a copy of the HUD-published special information booklet, a
Closing Disclosure detailing all charges actually incurred and a list of
homeownership counseling organizations.
Once a lender receives a mortgage application and any processing fee,
the property is appraised to determine if it qualifies as security for the
mortgage. If a lender approves the property based on an appraisal, a
mortgage package is assembled and sent to an underwriter for review.
Once mortgage conditions are met and verified, the mortgage is
classified as approved. Escrow calls for mortgage documents and funds.
On funding, the sales transaction is closed.
balance sheet …………………………………………………………………….. pg. 367
buyer mortgage capacity …………………………………………………. pg. 3
70
creditworthiness ……………………………………………………………….. pg. 370
debt-to-income ratio (DTI) ………………………………………………… pg. 369
loan-to-value ratio (LTV) ………………………………………………….. pg. 3
72
mortgage package ……………………………………………………………… pg. 373
Real Estate Settlement Procedures Act (RESPA) …………….. pg. 371
transaction agent (TA) ………………………………………………………. pg. 3
66
Uniform Residential Loan Application ………………………….. pg. 366
Chapter 55
Key Terms
Quiz 11 Covering Chapters 55-61 is located on page 616.
Chapter 56: The FHA-insured home mortgage 375
After reading this chapter, you will be able to:
• understand how purchase-assist mortgages insured by the Federal
Housing Administration (FHA) enable buyers to become owners;
• explain the minimum down payment and loan-to-value ratio
(LTV) for FHA-insured financing;
• determine whether a buyer and property qualify for an FHA
insured mortgage; and
• advise buyers on the use of an FHA Energy Efficient Mortgage to
finance energy efficient improvements.
The FHA-insured home
mortgage
Chapter
56
Consider a residential tenant who is solicited by a real estate agent to buy
a home. The financial and tax aspects together with the social benefits of
home ownership are compared to the corresponding benefits and mobility
provided by renting their shelter.
The tenant indicates they are ready and willing to be owners of a home for
their shelter. However, they have not accumulated enough cash reserves for
the down payment needed to qualify for a mortgage they need to fund the
purchase of a home.
Enabling tenants
to become
homeowners
Energy Efficient Mortgage
(EEM)
Federal Housing
Administration (FHA)-
insured mortgage
fixed payment ratio
loan-to-value (LTV) ratio
mortgage insurance
premium (MIP)
mortgage payment ratio
Real Estate Settlement
Procedures Act (RESPA)
Key Terms
Learning
Objectives
For a further study of this discussion, see Chapter 41 of Real Estate
Finance.
376 Real Estate Principles, Second Edition
The agent assures the tenant that first-time homebuyers with little cash
available for a down payment can buy a home by qualifying for a purchase-
assist mortgage insured by the Federal Housing Administration (FHA).
By insuring mortgages made with less demanding cash down payment
requirements, and with high loan-to-value (LTV) ratios of up to 96.5%, the
FHA enables prospective buyers to become homeowners.
The FHA does not lend money to buyers. Rather, the FHA insures mortgages
originated by approved direct endorsement lenders to qualified buyers who
will occupy the property as their principal residence. For issuing insurance
to the lender covering losses on a default, the buyer will pay premiums to
FHA for the coverage.
To qualify for an FHA-insured fixed-rate mortgage, a first-time homebuyer is
required to make a down payment of at least 3.5% of the purchase price. The
interest rate on the underlying mortgage is negotiated between the buyer
and the lender.1
If a buyer defaults on an FHA-insured mortgage, the FHA covers the lender
against loss on the entire remaining balance of the mortgage. This is unlike
private mortgage insurance (PMI) and insurance from the Veterans
Administration (VA) which only insures a portion of the total mortgage
amount.
After the lender acquires the property through
foreclosure
and conveys the
property to the FHA, the FHA pays the lender the amount of the unpaid
principal balance remaining on the mortgage.2
Before accepting a conveyance from the lender, the FHA requires the lender
to confirm the property is in a marketable condition and has not suffered any
waste. The FHA then sells the property to recoup the amount it paid to the
lender.
Unlike conventional home mortgages where only a lender is involved, a
buyer who takes out an FHA-insured mortgage with a lender is personally
liable to the FHA for any loss the FHA suffers as a result of the homebuyer’s
default.
When the FHA suffers a loss, the FHA can obtain a money judgment against
the homebuyer for the difference between:
• the amount the FHA paid the lender; and
• the price received from the sale of the property.
California anti-deficiency mortgage laws do not apply to FHA-insurance
coverage for lender claims on insured mortgages.3
1 24 Code of Federal Regulations §203.20
2 24 CFR §203.401
3 24 CFR §203.369
Federal Housing
Administration
(FHA)-insured
mortgage
A mortgage originated
by a lender and
insured by the FHA,
characterized by a
small down payment
requirement, high
loan-to-value (LTV)
ratio and high
mortgage insurance
premiums (MIPs),
typically made to first-
time homebuyers.
Buyer liability
on a default
Chapter 56: The FHA-insured home mortgage 377
The most commonly used FHA-insurance program is the Owner-occupied,
One-to-Four Family Home Mortgage Insurance Program, Section 203(b).
Buyers obtaining a Section 203(b) mortgage need to occupy the property as
their primary residence.
For the privilege of making a small down payment, the buyer needs to
pay a mortgage insurance premium (MIP) to the FHA. This essentially
increases the annual cost of borrowing as the annual rate charged for MIP is
added to interest payments. Together, the MIP and interest are the annual
cost incurred to borrow FHA-insured funds for the purchase of a home.
FHA guidelines include:
• manual underwriting for homebuyers whose debt-to-income ratio
(DTI) exceeds 43% and whose credit scores are below 620;
• 5% minimum down payments on FHA mortgages greater than
$625,000; and
• MIP to continue through the life of the mortgage (previously it was
cancelled once the homeowner reached a 78% LTV).
Further, an upfront premium, paid once at the time the mortgage is
originated, is calculated as 1.75% of the funded mortgage amount.
The public policy rationale behind the FHA Section 203(b) program is
based on the proposition homeowners are less of a financial burden on the
government in their later years than life-time tenants.
The maximum FHA-insured mortgage available to assist a buyer in the
purchase of one-to-four unit residential property is determined by:
• the type of residential property; and
• the county in which the property is located.
A list of counties and their specific mortgage ceilings is available from FHA
or an FHA direct endorsement lender, or online from the Department of
Housing and Urban Development (HUD) at http://www.hud.gov.
The FHA sets limitations on the amount of a mortgage it will insure. The
limit is a ceiling set as a percentage of the appraised value of the property,
called the loan-to-value ratio (LTV) .
The LTV ratio on an FHA-insurable mortgage is capped at a ceiling of 96.5% of
the property’s fair market value. Thus, the minimum down payment is 3.5%.4
Additionally, even after including buyer-paid closing costs in the LTV
calculations, the insurable mortgage amount cannot exceed the ceiling of
96.5% of the property’s appraised value.
4 HUD Mortgagee Handbook 4155.1 Rev-5 Ch-2 §A.2.b
One-to-four
unit mortgage
default
insurance
mortgage insurance
premium (MIP)
The cost for default
insurance incurred
by a borrower on an
FHA-insured mortgage
set as a percent of the
mortgage amount paid
up front and an annual
rate on the principal
balance paid with
monthly principal and
interest for the life of
the mortgage.
FHA-insured
dollar limits by
regions
Loan-to-value
(LTV) ceilings
and costs
loan-to-value ratio
(LTV)
A ratio stating
the outstanding
mortgage balance as
a percentage of the
mortgaged property’s
fair market value. The
degree of leverage.
378 Real Estate Principles, Second Edition
The maximum mortgage amount the FHA will insure is the LTV ratio’s
percentage amount of the lesser of:
• the property’s sales price; or
• the appraised value of the property.5
Closing costs may not be used to help meet the 3.5% minimum down
payment requirement. Also, closing costs are not deducted from the sales
price before setting the maximum mortgage amount.6
The lender’s origination fee
included
as a closing cost is limited to 1% of the
mortgage amount, excluding any competitive discount points and the 1.75%
upfront MIP.
Either the buyer or seller may pay the buyer’s closing costs, called non-
recurring closing costs. The lender may also advance closing costs on
behalf of the buyer.
For a buyer to be creditworthy for an FHA-insured mortgage, the following
debt-to-income (DTI) ratios need to be met:
• the buyer’s mortgage payment may not exceed 31% of the buyer’s gross
effective income, called the mortgage payment ratio; and
• the buyer’s total fixed payments may not exceed 43% of the buyer’s
gross effective income, called the fixed payment ratio.7
A buyer’s income consists of salary and wages. Social security, alimony, child
support, and government assistance are factored into the buyer’s income
to determine effective income. The buyer’s effective income before any
reduction for the payment of taxes is referred to as gross effective income.
The maximum mortgage payment ratio of 31% of the gross effective income
determines the maximum amount of principal, interest, taxes and insurance
(fire and MIP) the buyer is able to pay on the mortgage. Collectively, this is
called PITI.
Lenders use the maximum fixed payment ratio of 43% of the gross effective
income. Applying this ratio, they determine whether a buyer can afford to
incur the long-term debt of an FHA-insured mortgage in addition to all other
long-term payments the buyer is obligated to pay.
When computing the fixed-payment ratio, the lender adds the buyer’s total
mortgage payment to all the buyer’s recurring monthly obligations. This
includes debts extending ten months or more, such as all installment loans,
alimony and child support payments.8
5 HUD Mortgagee Handbook 4155.1 Rev-5 Ch-2 §A.2.a
6 HUD Mortgagee Handbook 4155.1 Rev-5 Ch-2 §A.2.d
7 HUD Handbook 4155.1 Rev-5 Ch-4 §F.2
8 HUD Handbook 4155.1 Rev-5 Ch-4 §C.4
Credit
approval
mortgage payment
ratio
A debt-to-income
ratio (DTI) used to
determine eligibility
for an FHA-insured
mortgage limiting
the buyer’s mortgage
payment to 31% of the
buyer’s gross effective
income.
fixed payment ratio
A debt-to-income
ratio (DTI) used to
determine eligibility
for an FHA-insured
mortgage limiting
the buyer’s total fixed
payment on all debts
to 43% of the buyer’s
gross income, also
called the DTI back-
end ratio.
Chapter 56: The FHA-insured home mortgage 379
However, even if the buyer’s ratios exceed FHA requirements, the mortgage
may be approved if the buyer:
• makes a large down payment;
• has a good credit history;
• has substantial cash reserves; and
• demonstrates potential for increased earnings due to job training or
education.
Taken together, these are referred to as compensating factors.9
The Real Estate Settlement Procedures Act (RESPA) requires any lender
making an FHA-insured mortgage to deliver to the mortgage applicant a
Loan Estimate published by the Consumer Financial Protection Bureau
(CFPB) of costs paid to providers of services on the sale of a one-to-four unit
residential property. [See RPI Form 204-5; see Chapter 54]
9 HUD Handbook 4155.1 Rev-5 Ch-4 §F.3
RESPA
and TILA
disclosures
Acceptable sources of cash down payment include:
• Savings and checking accounts: Lenders need to verify the account balance
is consistent with the buyer’s typical recent balance and no large increase
occurred just prior to the mortgage application. [See RPI Form 211]
• Gift funds: The donor of the gift needs to have a clearly defined interest in the
buyer and be approved by the lender. Relatives or employer unions typically are
acceptable donors. Gift funds from the seller or broker are kickbacks considered
an inducement to buy and result in a reduction in the mortgage amount.
• Collateralized mortgages: Any money borrowed to make the down payment
needs to be fully secured by the buyer’s marketable assets (i.e., cash value of
stocks, bonds, or insurance policies), which may not include the home being
financed. Cash advances on a credit card, for example, are not acceptable
sources for down payment funds.
• Broker fees: If the buyer is also a real estate agent involved in the sales
transaction, the fee received on the sale may be part of the buyer’s down
payment.
• Exchange of equities: The buyer may trade property they own to the seller as
the down payment. The buyer needs to produce evidence of value and ownership
before the exchange will be approved.
• Sale of personal property: Proceeds from the sale of the buyer’s personal
property may be part of the down payment if the buyer provides reliable
estimates of the value of the property sold.
• Undeposited cash is an acceptable source of down payment funds if the buyer
can explain and verify the accumulation of the funds. [HUD Handbook 4155.1
Rev-5 Ch-5 §B.1]
Acceptable
source of cash
down payment
380 Real Estate Principles, Second Edition
Lenders also deliver a Housing and Urban Development (HUD) information
booklet. Both need to be delivered within three days after receiving the
buyer’s application. [See Chapter 54]
Upon closing a sale, the lender delivers a Closing Disclosure published by
the CFPB detailing all mortgage related charges incurred by the buyer and
seller.10 [See RPI Form 402; see Chapter 54]
Mortgages insured by the FHA under Section 203(b) are subject to both
disclosure requirements since they fund personal use mortgages and are
federally related (RESPA).11
When a home is sold with the buyer taking title subject to an existing FHA-
insured mortgage under some arrangement to pay for the seller’s equity, the
seller is released from personal liability, if:
• they request a release from personal liability;
• the prospective buyer of the property is creditworthy;
• the prospective buyer assumes the mortgage; and
• the lender releases the seller from personal liability by use of an FHA-
approved form.12
If the conditions for release from personal liability are not satisfied, the seller
remains liable for any FHA loss on their insurance coverage for five years
after the sale.13
However, if five years pass from the time the property is resold, the seller is
then released from personal liability if:
• the mortgage is not in default by the end of the five-year period;
• the buyer assumes the mortgage with the lender; and
• the seller requests the release of liability from the lender.14
Homebuyers and homeowners have a way to finance energy efficient
improvements under the FHA’s Energy Efficient Mortgage (EEM)
program.
The underlying idea behind the EEM program is this: reduced utility charges
allow applicants to make higher monthly mortgage payment to fund the
cost of the energy efficient improvements.
Financeable energy efficient improvements funded under FHA’s program
include:
• purchasing energy efficient appliances or heating and cooling systems;
• installing solar panels;
10 24 CFR §3500 et seq.
11 12 CFR §226.19
12 HUD Form 92210; 24 CFR §203.510(a); HUD Handbook 4155.1 Rev-5 Ch-7
13 12 USC §1709(r)
14 24 CFR §203.510(b)
Real Estate
Settlement
Procedures Act
(RESPA)
Legislation prohibiting
brokers from giving
or accepting referral
fees if thebroker or
their agent is already
acting as a transaction
agent in the sale of
a one-to-four unit
residential property
which is being funded
by a purchase-assist,
federally-related
consumer mortgage.
Personal
liability of the
seller
Energy
efficiency
Energy Efficient
Mortgage (EEM)
An FHA-insured
purchase-assist or
refinance mortgage
which includes the
additional amount
to cover the costs of
constructing energy
improvements on the
mortgaged property.
Chapter 56: The FHA-insured home mortgage 381
• installing energy efficient windows;
• installing wall or ceiling installation; and
• completing repairs of existing systems to improve energy efficiency.
Under the EEM program, the costs of fundable energy improvements
are added to the base FHA maximum mortgage amount on a purchase or
refinance.15
Like most FHA mortgage programs, the EEM is not funded by the FHA. It is
funded by a lender, and insured to guarantee repayment by the FHA.
An EEM may be used in connection with either an FHA-insured purchase or
refinance mortgage (including streamline refinances), under the:
• “standard” 203(b) program for one-to-four unit residential properties;
• 203(k) rehabilitation program;
• 234(c) program for condominium projects; and
• 203(h) program for mortgages made to victims of presidentially
declared disasters.16
Eligible property types include new and existing:
• one-to-four unit residential properties for the 203(b) and 203(k)
programs;
• one-unit condominiums; and
• manufactured housing.17
15 HUD Mortgagee Letter 2009-18
16 HUD Handbook 4155.1 Chapter 6.D.2.a
17 HUD Handbook 4155.1 Chapter 6.D.2.a
The Federal Housing Administration (FHA) insures mortgages
originated by approved direct endorsement lenders to qualified buyers
to fund the purchase of their principle residence.
FHA-insured mortgages provide for a down payment as low as 3.5% and
a higher loan-to-value (LTV) ratio than conventional mortgages. For the
privilege of making a small down payment, the buyer pays a mortgage
insurance premium (MIP) to the FHA, effectively increasing the annual
cost of borrowing as an addition to interest.
If a buyer defaults on an FHA-insured mortgage, the FHA covers the
lender against loss on the entire remaining balance of the mortgage.
The most commonly used FHA-insurance program is the Owner-
occupied, One-to-Four Family Home Mortgage Insurance Program,
Section 203(b).
Chapter 56
Summary
382 Real Estate Principles, Second Edition
Before the FHA will insure a mortgage, the lender needs to determine
the buyer’s creditworthiness. For a buyer to be creditworthy for FHA
mortgage insurance, the following debt-to-income ratios (DTI) need to
be met:
• the buyer’s mortgage payment ratio may not exceed 31% of their
gross effective income; and
• the buyer’s fixed payment ratio for all installment debts may not
exceed 43% gross effective income.
Homebuyers and homeowners may finance energy efficient
improvements under the FHA’s Energy Efficient Mortgage (EEM)
program. With reduced utility charges, buyers and owners may make
higher monthly mortgage payment to fund the cost of the energy
efficient property improvements.
Energy Efficient Mortgage (EEM) …………………………………….. pg. 380
Federal Housing Administration (FHA)-insured
mortgage ……………………………………………………………………………. pg. 376
fixed payment ratio…………………………………………………………… pg. 378
loan-to-value (LTV) ratio …………………………………………………… pg. 377
mortgage insurance premium (MIP) ……………………………….. pg. 377
mortgage payment ratio …………………………………………………… pg. 378
Real Estate Settlement Procedures Act (RESPA) …………….. pg. 380
Chapter 56
Key Terms
Quiz 11 Covering Chapters 55-61 is located on page 616.
Chapter 57: Carryback financing in lieu of cash 383
After reading this chapter, you will be able to:
• comprehend the financial benefits afforded to a seller and a buyer
under seller carryback finance arrangements;
• identify the seller’s risks involved in carryback financing; and
• explain the tax advantages available to a seller for carrying back a
portion of the sales price.
For a further discussion of this topic, see Chapter 26 of Real Estate
Finance.
Carryback financing in
lieu of cash
Chapter
57
When the availability of real estate mortgages tightens, a seller hoping to
locate a buyer amenable to the seller’s asking price needs to consider seller
financing.
Seller financing is also known as:
• an installment sale;
• a credit sale;
• carryback financing; or
• an owner-will-carry (OWC) sale.
Seller
financing
supports the
price
all-inclusive trust deed
(AITD)
nonrecourse
portfolio category income
private mortgage
insurance (PMI)
seller financing
Learning
Objectives
Key Terms
384 Real Estate Principles, Second Edition
Seller financing occurs when a seller carries back a note executed by the buyer
to evidence a debt owed for purchase of the seller’s property. The amount of
the debt is the remainder of the price due after deducting:
• the down payment; and
• the amount of any existing or new mortgage financing used by the
buyer to pay part of the price.
On closing, the rights and obligations of real estate ownership held by the
seller are shifted to the buyer. Concurrently, the seller carries back a note and
trust deed taking on the rights and obligations of a secured creditor.
Editor’s note —California brokers and agents who make, offer or negotiate
residential mortgages for compensation are required to obtain a Mortgage
Loan Originator (MLO) license endorsement on their California Bureau of
Real Estate (CalBRE) license. A residential mortgage is a consumer purpose
loan secured by a one-to-four unit residential property.
Thus, offering or negotiating carryback financing triggers the MLO license
endorsement only if the broker or agent receives additional compensation
for the act of offering or negotiating the carryback, beyond the fee collected
for their role as seller’s agent or buyer’s agent.
The seller who offers a convenient and flexible financing package to
prospective buyers makes their property more marketable and defers the
tax bite on their profits.
Qualified buyers who are rational are willing to pay a higher price for real
estate when attractive financing is available. This holds regardless of whether
financing is provided by the seller or a mortgage lender. For most buyers, the
primary factors when considering their purchase of a property is the amount
of the down payment and the monthly mortgage payments.
Buyer willingness is especially apparent when the rate of interest on the
carryback financing is in line with or below the rates lenders are charging on
their purchase-assist mortgages. The lower the interest rate, the higher the
price may be.
For buyers, seller carryback financing generally offers:
• a moderate down payment;
• competitive interest rates;
• less stringent terms for qualification and documentation than imposed
by lenders; and
• no origination (hassle) costs.
In a carryback sale, the amount of the down payment is negotiable between
the buyer and seller without the outside influences a traditional mortgage
broker and borrower has to contend with.
seller financing
A note and trust deed
executed by a buyer
of real estate in favor
of the seller for the
unpaid portion of
the sales price on
closing. Also known
as an installment sale,
credit sale or carryback
financing.
Marketing
property: the
seller will
carry
Flexible sales
terms for the
buyer
Chapter 57: Carryback financing in lieu of cash 385
Additionally, a price-to-interest rate tradeoff often takes place in the
carryback environment. The buyer is usually able to negotiate a lower-than-
market interest rate in exchange for agreeing to the seller’s higher-than-
market asking price.
Taxwise, it is preferable for a seller to carry back a portion of the sales price,
rather than be cashed out when taking a significant taxable profit.
The seller, with a reportable profit on a sale, is able to defer payment of a
substantial portion of their profit taxes until the years in which principal
is received. When the seller avoids the entire profit tax bite in the year of
the sale, the seller earns interest on the amount of the note principal that
represents taxes not yet due and payable.
If the seller does not carry a note payable in future years, they will be cashed
out and pay profit taxes in the year of the sale (unless exempt or excluded).
What funds they have left after taxes are reinvested in some manner. These
after-tax sales proceeds will be smaller in amount than the principal on
the carryback note. Thus, the seller earns interest on the net proceeds of the
carryback sale before they pay taxes on the profit allocated to that principal.
The tax impact the seller receives on their carryback financing is classified as
portfolio category income.
On closing the sale, the seller financing may be documented in a variety of
ways. Common arrangements include:
• land sales contracts;
• lease-option sales;
• sale-leasebacks; and
• trust deed notes, standard and all-inclusive.
Legally, the note and trust deed provides the most certainty. Further,
they are the most universally understood of the various documents used to
structure seller financing. In this arrangement, carryback documentation
consists of:
• a promissory note executed by the buyer in favor of the seller as
evidence of the portion of the price remaining to be paid for the real
estate before the seller is cashed-out [See RPI Form 421]; and
• a trust deed lien on the property sold to secure the debt owed by the
buyer as evidenced by the note. [See RPI Form 450]
The note and trust deed are legally coupled, inseparable and function in
tandem. The note provides evidence of the debt owed but is not filed with the
County Recorder. The trust deed creates a lien on property as the source for
repayment of the debt in the event of a default.
Tax benefits
and flexible
sales terms
portfolio category
income
Unearned income
from interest on
investments in bonds,
savings, income
property, stocks and
trust deed notes.
The closing
documents
needed for
the carryback
386 Real Estate Principles, Second Edition
Form 303
Foreclosure Cost
Sheet
In addition, when the seller carries back a note executed by the buyer as part
of the sales price for property containing four-or-fewer residential units, a
financial disclosure statement is to be prepared. This statement is prepared
by the broker who represents the person who first offers or counteroffers on
terms calling for a carryback note.1 [See RPI Form 300]
1 Calif. Civil Code §2956
Chapter 57: Carryback financing in lieu of cash 387
A carryback seller assumes the role of a lender at the close of the sales
escrow. This includes all the risks and obligations of a lender holding a
secured position in real estate – a mortgage. The secured property described
in the trust deed serves as collateral, the seller’s sole source of recovery to
mitigate the risk of loss on a default by the buyer on the note or trust deed.
Another implicit risk of loss for secured creditors arises when the property’s
value declines due to deflationary future market conditions or the buyer
committing waste. The risk of waste, also called impairment of the security,
is often overlooked during boom times.
However, a decline in property value during recessionary periods due to
the buyer’s lack of funds poses serious consequences for the seller when the
buyer defaults on the payment of taxes, assessments, insurance premiums or
maintenance of the property.
Also, the seller needs to understand a carryback note secured solely by a trust
deed lien on the property sold is nonrecourse paper. Thus, the seller will
be barred from obtaining a money judgment against the buyer for any part
of the carryback debt not satisfied by the value of the property at the time of
foreclosure – the unpaid and uncollectible deficiency.2
However, as with any mortgage lender, if the risk premium built into the
price, down payment, interest rate and due date on the carryback note is
sufficient, the benefits of carryback financing level out or outweigh the risks
of loss. [See RPI Form 303]
2 Calif. Code of Civil Procedure §580b
Carryback
risks for the
seller
nonrecourse
A debt secured by real
estate, the creditor’s
source of recovery on
default limited solely
to the value
of their security
interest in the secured
property.
Seller financing, also known as carryback financing, occurs when the
seller carries back a note for the unpaid portion of the price remaining
after deducting the down payment and the amount of the mortgage the
buyer is assuming.
Carryback financing offers considerable financial and tax advantages
for both buyers and sellers when properly structured. A carryback seller
is able to defer a meaningful amount of profit taxes, spreading the
payment over a period of years. Further, a seller who offers a convenient
and flexible financing package makes their property more marketable.
For buyers, seller carryback financing generally offers a moderate down
payment, competitive interest rates, less stringent terms for qualification
than those imposed by lenders and no origination costs.
A carryback seller takes on the role of a lender in a carryback sale, with
all the risks and obligations of a lender holding the seller’s secured
Chapter 57
Summary
388 Real Estate Principles, Second Edition
position on title. As with any creditor, if the risk premium built into
the rate and terms of the carryback note is sufficient, the benefits of
carryback financing outweigh the risks of loss.
all-inclusive trust deed (AITD) ……………………………………….. pg. 467
nonrecourse ……………………………………………………………………… pg. 387
portfolio category income ………………………………………………. pg. 385
private mortgage insurance (PMI) …………………………………. pg. 465
seller financing ……………………………………………………………….. pg. 384
Chapter 57
Key Terms
Quiz 11 Covering Chapters 55-61 is located on page 616.
Chapter 58: Usury and the private lender 389
After reading this chapter, you will be able to:
• determine which lending arrangements are subject to or exempt
from usury restrictions on interest rates;
• identify extensions of credit on property sales as excluded from
usury restrictions;
• discern when the usury threshold rate applies; and
• explain the penalties imposed on a non-exempt private lender on
violations of usury law.
Usury and the private
lender
Chapter
58
When a mortgage is made, the lender charges the borrower interest for use
of the money during the period lent.
However, the amount of interest a private, non-exempt lender can charge is
regulated by statute and the California Constitution. Collectively, these are
referred to as usury laws.1
Today, the remaining goal of usury laws is the prevention of loan-sharking
by private lenders. Loan-sharking involves charging interest at a higher rate
than the ceiling-rate established by the usury laws. These mortgages are
categorized as usurious.2
1 Calif. Constitution, Article XV; Calif. Civil Code §§1916-1 through 1916-5
2 CC §1916-3(b)
Broker
arranged
mortgages
avoid
usury
usury
A limit on the lender’s
interest rate yield on
nonexempt real estate
mortgages.
exempt debt
excluded debt
restricted real estate loans
treble damages
usury
Key Terms
Learning
Objectives
For a further study of this discussion, see Chapter 43 of Real Estate
Finance.
390 Real Estate Principles, Second Edition
Adopted in 1918 as a consumer protection referendum, the first California
usury laws set the maximum interest rate at 12% for all lenders — no
exceptions.
During the Great Depression, California legislation exempted certain types
of lenders from usury restrictions. The exemptions were implemented with
the intent to open up the mortgage market.3
These exemptions to usury laws remain in place today and more have been
added. For example, in 1979, mortgages made or arranged in California by
real estate brokers were exempted from usury restrictions.
Other types of lenders exempted from usury law restrictions include:
• savings and loan associations (S&Ls);
• state and national banks;
• industrial mortgage companies;
• credit unions and pawnbrokers;
• agricultural cooperatives;
• corporate insurance companies; and
• personal property brokers.4
Exemptions successfully opened the market by increasing the availability
of funds. In turn, interest rates were soon driven lower due to increased
competition.
When a borrower pays interest on a mortgage, they are paying rent to the
lender for use of its money for a period of time. The money lent is fully repaid
during or at the end of the period.
Normally, the amount of interest charged is a fixed or adjustable percentage
of the amount of money loaned.
Though interest is commonly paid with money, interest may also be paid
by the borrower by providing the lender with personal property, goods or
services. The many types of consideration given by the borrower for
the lender making a mortgage become part of the lender’s yield on the
mortgage—interest.5
Thus, interest includes the value of all compensation a lender receives for
lending money, whatever its form, excluding reimbursement or payment for
mortgage origination costs incurred and services rendered by the lender.6
If the use of the proceeds of a mortgage is earmarked primarily for personal,
family, or household use by the borrower, the maximum annual interest
rate is 10% per annum.7
3 Cal. Const. Art. XV
4 Cal. Const. Art. XV
5 CC §1916-2
6 CC §1915
7 Calif. Const. Art. XV §1(1)
Usury
exemptions
spur
competition
Interest paid
with goods
and services
Setting the
interest rate
Chapter 58: Usury and the private lender 391
Mortgages made to fund the improvement, construction, or purchase of
real estate when originated by a non-exempt private lender are subject to a
different usury threshold rate, which is the greater of:
• 10% per annum; or
• the applicable discount rate of the Federal Reserve Bank of San
Francisco (FRBSF), plus 5%.
Two basic classifications of private mortgage transactions exist relating to
interest rates private lenders may charge on real estate mortgages:
• brokered real estate mortgages; and
• restricted or non-brokered real estate mortgages.
Brokered real estate mortgages are exempt from usury restrictions and fall
into one of two categories:
• mortgages made by a licensed real estate broker acting as a principal
for their own account as the private lender who funds the mortgage; or
• mortgages arranged with private lenders by a licensed real estate broker
acting as an agent in the mortgage transaction for compensation.
Restricted real estate mortgages are all mortgages made by private party
lenders which are neither made nor arranged by a broker.
Editor’s note — Private lenders include corporations, limited liability
companies, partnerships and individuals. These entities are not exempt
from usury limitations unless operating under an exempt classification,
such as a personal property broker or real estate broker.
The most common restricted mortgage involves private party lenders,
unlicensed and unassisted by brokers, who make secured or unsecured
mortgages.
Private party transactions involving the creation of a debt which avoid usury
laws break down into two categories:
• exempt debts, being debts which involve a mortgage or a forbearance
on a mortgage and are broker-made or arranged; and
• excluded debts, being debts which do not involve a mortgage.
The most familiar of the excluded “non-mortgage” type debts is seller
carryback financing. [See Chapter 57]
Carryback notes executed by the buyer in favor of the seller are not loans of
money. They are credit sales, also called installment sales. A seller may
carry back a note at an interest rate in excess of the usury threshold rate. The
rate exceeding the usury law threshold is enforceable since the debt is not a
mortgage. Thus, carryback notes are not subject to usury laws.
Usury law and
real estate
mortgages
restricted real estate
loans
All mortgages made by
private party lenders
which are neither
made nor arranged by
a real estate broker.
Exceptions
for private
parties
exempt debt
Private party
transactions exempt
from usury laws
involving the
origination of a
mortgage secured by
real estate and made
or arranged by a real
estate broker.
excluded debt
Extensions of credit
by sellers of real
estate creating a debt
obligation in sales
transactions which
avoid usury laws.
392 Real Estate Principles, Second Edition
The most common penalty imposed on a non-exempt private lender in
violation of usury law is the forfeiture of all interest on the mortgage.
Thus, the lender is only entitled to a return of the principal advanced on
the mortgage. All payments made by the borrower are applied entirely to
principal reduction, with nothing applied to interest.8
The lender may also have to pay a usury penalty of treble damages.9
Treble damages are computed at three times the total interest paid by the
borrower during the one year period immediately preceding their filing of a
suit and during the period of litigation until the judgment is awarded.
An award of treble damages is typically reserved for a lender the court
believes took grossly unfair advantage of an unwary borrower.10
A borrower who knew at all times a loan interest rate was usurious is not
likely to be awarded treble damages. Also, a lender who sets a usurious rate
in complete ignorance of the illegality of usury would not be additionally
penalized with treble damages.
8 Bayne v. Jolley (1964) 227 CA2d 630
9 CC §1916-3
10 White v. Seitzman (1964) 230 CA2d 756
Penalties for
usury
treble damages
A usury penalty
computed at three
times the total interest
paid by the borrower
during the one year
period immediately
preceding their filing
of an action on a non-
exempt private lender
mortgage.
The amount of interest a private, non-exempt lender can charge a
borrower is regulated by the California Constitution and statutes,
collectively called usury laws.
Mortgages made or arranged by a California real estate broker are
exempt from usury restrictions. Further, sales transactions involving
the extension of credit by a seller are not subject to usury laws.
Non-exempt mortgages made to fund the improvement, construction,
or purchase of real estate are subject to an interest restriction of 10%
annually or the current discount rate of the Federal Reserve Bank of San
Francisco plus 5%, whichever is greater.
Penalties for violating usury law include the forfeiture of all interest
on a usurious mortgage. Lenders who are found to have taken grossly
unfair advantage can also be penalized with treble damages.
exempt debt ……………………………………………………………………….. pg. 391
excluded debt …………………………………………………………………….. pg. 391
restricted real estate loans ……………………………………………….. pg. 473
treble damages ………………………………………………………………….. pg. 392
usury ………………………………………………………………………………….. pg. 389
Chapter 58
Summary
Chapter 58
Key Terms
Quiz 11 Covering Chapters 55-61 is located on page 616.
Chapter 59: A lender’s oral promises as commitments 393
After reading this chapter, you will be able to:
• identify the unenforceability of a lender’s oral or unsigned mortgage
commitment; and
• better your buyer’s chance of closing with the best rates and terms
possible by submitting mortgage applications to at least two
lenders.
Learning
Objectives
For a further study of this discussion, see Chapter 39 of Real Estate Finance.
A lender’s oral promises
as commitments
Chapter
59
Consider an owner planning to make improvements to their industrial
property. The owner applies for a mortgage to upgrade the facilities, add
equipment and construct additional improvements. The owner has a long-
standing business relationship with a lender, having borrowed from it in the
past.
The mortgage officer processing the mortgage orally assures the owner
it will provide permanent long-term financing to refinance the short-term
financing the owner will use to fund the improvements. Nothing is put to
writing or signed. Relying on the lender’s oral assurances, the owner enters
into a series of short-term mortgages and credit sales arrangements to acquire
equipment and improvements.
The mortgage officer visits the owner’s facilities while improvements are
being installed and constructed. The lender orally assures the owner they
will provide long-term financing again.
mortgage commitment Key Terms
No
responsibility
for oral or
conditional
promises
394 Real Estate Principles, Second Edition
On completion of the improvements, the owner makes a demand on the
lender to fund the permanent financing. However, the lender refuses. The
owner is informed the lender no longer considers the owner’s business to
have sufficient value as security to justify the financing.
The owner is unable to obtain permanent financing with another lender.
Without amortized long-term financing, the business fails for lack of capital.
The business and property are eventually lost through foreclosure to the
holders of the short-term financing. The owner seeks to recover money losses
from the lender, claiming the lender breached its commitment to provide
financing.
Can the owner recover for the loss of their business and property from the
lender?
No! The lender never entered into an enforceable mortgage commitment.
Nothing was placed in writing or signed by the lender which unconditionally
committed the lender to specific terms of a mortgage.
Even though the lender orally assured the owner multiple times a mortgage
will be funded, and despite the owner’s reliance on their pre-existing
business relationship with the lender, the owner cannot rely on the lender’s
oral commitment.1
The only other course of action the buyer may take is to purchase a written
mortgage commitment, paying for the assurance funds will be provided on
request.
However, these commitments are always conditional, never absolute.
The lender is allowed to deny a mortgage even after delivering a written
mortgage commitment in exchange for a commitment fee without liability
if they refuse to fund.
Once a lender signs a written agreement, it is bound to follow it. The preceding
scenario is an example of the reason lenders rarely enter into signed written
promises regarding a mortgage application. When they do, they need to do
nothing more than the limited federally mandated nonbinding disclosures
on single family residence (SFR) mortgages under Regulation Z (Reg Z),
also known as the Truth-in-Lending Act (TILA). [See Chapter 54]
Lenders customarily process applications and prepare mortgage documents.
However, these documents are at all points only signed by the buyer. The
lender orally advises the buyer whether the mortgage has been approved,
but signs nothing that binds it.
The first and only act committing the lender is its actual funding of the
mortgage — at the time of closing.
Thus, the lender-borrower relationship is one of power, not one of an open
market arrangement. Lending is an asymmetrical power relationship.
1 Kruse v. Bank of America (1988) 202 CA3d 38
mortgage
commitment
A lender’s
commitment to make a
mortgage, enforceable
only when written,
unconditional and
signed by the lender
for consideration.
Escape
from an oral
commitment
Chapter 59: A lender’s oral promises as commitments 395
Until the lender delivers funds and a closing has occurred, the lender can
back out of its oral or unsigned written commitment at any time without
liability.
When a lender breaches its oral commitment to lend, the buyer’s reliance on
anything less than an unconditional written mortgage commitment is
not legally justified — even though the buyer had no realistic choice other
than to rely on the lender’s oral promises.
In order to prepare a buyer for the mortgage application process, agents
need to advise their buyer of the likely scenarios they will encounter. Thus,
the informed buyer is best able to anticipate and defend themselves when
confronted with unscrupulous eleventh-hour changes.
Always advise buyers seeking a purchase-assist mortgage to “double app”;
that is, submit mortgage applications to a minimum of two lenders as
recommended by the U.S. Department of Housing and Urban Development
(HUD) and the California Bureau of Real Estate (CalBRE). [See RPI Form 312]
Multiple competitive applications keep lenders vying for your buyer’s
business up to the very last minute – the ultimate moment of funding, when
commitments truly are commitments. [See Chapter 54]
Agents
provide
protection for
their buyers
A lender’s oral or unsigned mortgage commitment is unenforceable by
a buyer. A mortgage commitment is only enforceable when it is placed
in writing and signed by the lender, unconditionally committing the
lender to the specific terms of a mortgage for consideration.
Lenders customarily process applications and prepare mortgage
documents. However, these documents are signed only by the buyer.
The first and only act committing the lender is its actual funding of the
mortgage which occurs at the time of closing. Thus, until the lender
delivers funds and a closing has occurred, the lender can back out of its
oral commitment at any time without liability.
To better your buyer’s chance of closing with the best rate and terms
possible, counsel them to submit applications for a mortgage to at least
two institutional lenders. A second application with another institution
gives the buyer additional leverage in mortgage negotiations needed at
closing.
mortgage commitment ……………………………………………………. pg. 394
Chapter 59
Summary
Chapter 59
Key Terms
Quiz 11 Covering Chapters 55-61 is located on page 616.
Notes:
Chapter 60: Private mortgage insurance 397
After reading this chapter, you will be able to:
• advise your buyers who have a down payment less than 20%
about the availability of private mortgage insurance (PMI)
on conventional mortgages with loan-to-value ratios (LTVs)
exceeding 80%; and
• review the qualification and approval process for obtaining PMI
with buyers.
Private mortgage
insurance
Chapter
60
Private mortgage insurance (PMI) indemnifies a lender against losses on
a mortgage when a borrower defaults.1
The lender’s recoverable losses include:
• principal on the debt;
• any deficiency in the value of the secured property; and
• foreclosure costs.
PMI insurers are unrelated to government-created insurance agencies, such as
the Federal Housing Administration (FHA) and the Veterans Administration
(VA), which also insure or guarantee mortgages made to qualified borrowers.
[See Chapter 56]
1 Calif. Insurance Code §12640.02
private mortgage
insurance (PMI)
Default mortgage
insurance coverage
provided by
private insurers for
conventional loans
with loan-to-value
ratios higher than 80%.
Protecting
the lender
from loss
lender-paid mortgage
insurance (LPMI)
loan-to-value ratio (LTV)
private mortgage
insurance (PMI)
Key Terms
Learning
Objectives
For a further study of this discussion, see Chapter 42 of Real Estate
Finance.
398 Real Estate Principles, Second Edition
PMI is not mortgage life insurance, which pays off the insured mortgage in
the event a borrower dies, becomes disabled, or loses their health or income.
PMI insures the lender for losses incurred up to a percentage of the mortgage
amount. In turn, the mortgage amount represents a percentage of the
property’s value, called the loan-to-value ratio (LTV).
Typically, mortgages insured by PMI are covered for losses on amounts
exceeding 67% of the property’s value at the time the mortgage is originated.
The buyer usually pays the PMI premiums, not the lender (although the
lender is the insured and holder of the policy).
However, some lenders and PMI insurers offer a lender-paid mortgage
insurance (LPMI) program. If issued by the PMI insurer, the lender pays
the mortgage insurance premium and charges the borrower a higher interest
rate on their principal payments.
Premium rates are set as a percentage of the mortgage balance and are
calculated in the same manner as interest.
If the buyer is current on PMI payments and has not taken out other mortgages
on their property, the buyer may terminate their PMI coverage when the
equity in their property reaches 20% of its value at the time the mortgage
was originated. Once the buyer reaches 22% equity, PMI is automatically
cancelled (unless the mortgage is a piggyback 80-10-10).
Furthermore, the buyer may cancel PMI two years after the mortgage is
recorded if the LTV for the mortgage balance is 75%. The lender may agree to
a higher LTV for cancellation.
When PMI may be cancelled as agreed, the lender may not charge advance
PMI payments unless the borrower has:
• incurred more than one late penalty in the past 12 months; or
• been more than 30 days late on one or more payments on the note.2
Premiums charged by PMI insurers do not include an up-front fee on
origination like FHA, only an annual fee calculated as a percentage of
the mortgage balance and payable monthly with principal and interest
payments.
Depending on the policies of the insurer, the buyer needs to meet PMI
qualification standards such as:
• a minimum credit score of upwards of 680;
• a debt-to-income ratio between 41% and 45%;
2 Calif. Civil Code §2954.12(a)(3)
Private
mortgage
insurance
coverage
loan-to-value ratio
(LTV)
A ratio stating
the outstanding
mortgage balance as
a percentage of the
mortgaged property’s
fair market value. The
degree of leverage.
Who pays for
PMI?
lender-paid
mortgage insurance
(LPMI)
Default mortgage
insurance provided
by private insurers
in which the lender
pays the mortgage
insurance premium
and recovers the cost
through a higher
interest rate.
Buyer and
property
standards
Chapter 60: Private mortgage insurance 399
• two months principal, interest, taxes and insurance (PITI) payments in
cash reserves;
• employment full time during the past two years, a current pay
stub, written verification by employer (VOE form), and telephone
confirmation of employment at closing, unless self-employed;
• if self-employed, financial statements for the two prior years and year-
to-date, plus IRS tax returns;
• all documents and title vestings to be in the name of the buyer as an
individual;
• limit to three mortgages under PMI coverage in the name of the buyer;
• completion of a homeowners’ course of education on mortgage debt
obligations;
• no bankruptcy within four years, unless excused by extenuating
circumstances; and
• no prior foreclosure under a mortgage.
The PMI investigation and documentation takes place after submission of a
mortgage application. It is generally limited to verification of all the buyer’s
representations on the application. The availability of PMI coverage for
different types of California real estate is limited. Only properties classified as
single family residences (SFRs) may receive PMI.
Most PMI contracts do not authorize the insurer to seek indemnity from the
borrower for claims made on the policy by the lender. This is distinct from
FHA or VA insurance programs which place homeowners at a risk of loss for
a greater amount than their down payment.
Most insured mortgages are purchase-money mortgages made to buyer-
occupants to acquire their principal residence. Purchase money mortgages
are nonrecourse obligations, with recovery on the mortgage limited to
the value of the real estate.3
However, if the mortgage is recourse, as is the case of a refinance, the lender’s
right to seek a deficiency judgment may be assigned to the PMI insurer.
Pursuing a money judgment to collect from the borrower for a deficiency in
the value of the property requires a judicial foreclosure action. [See Chapter
70]
In the case of fraud on recourse or nonrecourse mortgages, the PMI insurer is
not barred by anti-deficiency statutes from recovering losses. Thus, they may
enforce collection of their losses against the borrower for misrepresentations,
such as the property’s value, job status, etc.
To qualify for PMI, the buyer needs to be a natural person and take title as the
vested owner of the property.
3 Calif. Code of Civil Procedure §580b
Defaulting
borrower and
PMI recourse
The PMI
credit check
400 Real Estate Principles, Second Edition
The lender, when qualifying the buyer for a mortgage to be covered by PMI,
relies on the more restrictive PMI insurer’s requirements regarding the
buyer’s:
• liquid assets after closing;
• debt-to-asset ratio;
• debt-to-income ratio; and
• regard for financial obligations.
A buyer required to qualify for PMI before a lender funds a mortgage
undergoes an in-depth risk analysis based on the PMI insurer’s eligibility
requirements.
At a minimum, the buyer is required to submit documents for review by the
PMI insurer, including:
• a copy of the mortgage application;
• a credit report current within 90 days and covering a minimum of two
years; and
• an appraisal of the real estate to be purchased.
However, the PMI carrier may also require additional documentation
to verify the mortgage transaction fulfills the insurer’s underwriting
requirements, such as verification the buyer will occupy the property and a
copy of the signed purchase agreement.
The buyer’s credit rating and disposable income need to clearly support their
ability to make the monthly payments on the low down payment mortgage.
Private mortgage insurance (PMI) indemnifies a lender for loss on a
mortgage secured by an interest in real estate when a borrower whose
down payment is less than 20% defaults.
If the buyer is current on PMI payments and has taken out no other
mortgages on their property, the buyer may terminate their PMI
coverage when the equity in their property reaches 20% of its value
at the time the mortgage was originated. Once the buyer reaches 22%
equity, PMI is automatically cancelled.
The lender making a conventional mortgage to fund the purchase of a
principal residence when the mortgage will exceed 80% of the property
value requires the buyer to meet the qualifications for PMI coverage,
not just the lender’s qualifications.
lender-paid mortgage insurance (LPMI) …………………………. pg. 398
loan-to-value ratio (LTV) …………………………………………………… pg. 398
private mortgage insurance (PMI) …………………………………… pg. 397
Chapter 60
Summary
Chapter 60
Key Terms
Quiz 11 Covering Chapters 55-61 is located on page 616.
Chapter 61: The promissory note 401
After reading this chapter, you will be able to:
• understand a signed promissory note is evidence of the existence
of an underlying debt, not the debt itself;
• recognize the linkage between a promissory note and a trust deed;
and
• identify the different types of promissory notes and debt
repayment arrangements they are used to evidence.
Learning
Objectives
The promissory
note
Chapter
61
Most real estate sales hinge on financing some portion of the purchase price.
A buyer promises to pay a sum of money, in installments or a single payment
at a future time, to a lender who funds the sales transaction. Alternately,
the buyer may make payments to the seller under a carryback financing
arrangement.
Given in exchange for property or a loan of money, the promise to pay
evidences a debt owed by the buyer and payable to the seller or lender to
whom the promise is made.
Evidence of
the debt
adjustable rate mortgage
(ARM)
all-inclusive trust deed
(AITD)
applicable federal rate
(AFR)
balloon payment
graduated payment
mortgage (GPM)
installment note
promissory note
reconveyance
straight note
usury
For a further discussion of this topic, see Chapter 5 of Real Estate Finance.
Key Terms
402 Real Estate Principles, Second Edition
The promise to pay is set out in a written document called a promissory
note. A promissory note represents an underlying debt owed by one person
to another.
The signed promissory note is not the debt itself, but evidence the debt exists.
The buyer, called the debtor or payor, signs the note and delivers it to the
lender or carryback seller, called the creditor.
The note can be either secured or unsecured. If the note is secured by real
estate, the security device used is a trust deed. When secured, the debt
becomes a voluntary lien on the real estate described in the trust deed.
Notes are categorized by the method for repayment of the debt as either:
• installment notes; or
• straight notes.
The installment note is used for debt obligations with constant periodic
repayments in any amount and frequency negotiated.
Variations of the installment note include:
• interest-included; and
• interest-extra.
Finally, notes are further distinguished based on interest rate calculations,
such as:
• fixed interest rate notes, commonly called fixed rate mortgages (FRMs);
and
• variable interest rate notes, commonly called adjustable rate mortgages
(ARMs).
An interest-included installment note with constant periodic payments
produces a schedule of payments. The schedule contains diametrically
varying amounts of principal and interest from payment to payment.
Principal reduction on the mortgage increases and interest paid decreases
with each payment made on the mortgage. [See Form 420 accompanying
this chapter]
Each payment is applied first to the interest accrued on the remaining
principal balance during the period between payments, typically monthly.
The remainder of the payment is applied to reduce the principal balance of
the debt for accrual of interest during the following period before the next
payment is due.
Interest-included installment notes may either:
• be fully amortized through constant periodic payments, meaning the
mortgage is fully paid at the end of the term; or
promissory note
A document given
as evidence of a debt
owed by one person
to another. [See RPI
Form 421 and 424]
The
promissory
note
installment note
A note calling for
periodic payments of
principal and interest,
or interest only, until
the principal is paid in
full by amortization
or a final balloon
payment. [See RPI
Form 420, 421 and 422]
straight note
A note calling for the
entire amount of its
principal to be paid
together with accrued
interest in a single
lump sum when the
principal is due. [See
RPI Form 423]
Installment
note, interest
included
Chapter 61: The promissory note 403
• include a final/balloon payment after a period of installment
payments, called a due date.
Interest-extra installment notes call for a constant periodic payment of
principal on the debt. In addition to the payment of principal, accrued
interest is paid concurrently with the principal installment.
balloon payment
Any final payment
on a note which is
greater than twice the
amount of any one
of the six regularly
scheduled payments
immediately preceding
the date of the final/
balloon payment. [See
RPI Form 418-3 and
419]
Installment
note, interest
extra
Form 420
Note Secured by
Deed of Trust
Installment
— Interest
included
404 Real Estate Principles, Second Edition
The principal payments remain constant until the principal amount is fully
paid or a due date calls for a final balloon payment. Accordingly, the interest
payment decreases with each payment of principal since the interest is paid
on the remaining balance. [See RPI Form 422]
Thus, unlike an interest-included note, the amount of each scheduled
payment of principal and interest on an interest-extra note is a declining
amount from payment to payment.
A straight note calls for the entire amount of its principal to be paid in a
single lump sum due at the end of a period of time. No periodic payments
of principal are scheduled, as with an installment note. [See RPI Form 423]
Interest usually accrues unpaid and is due with the lump sum principal
installment. Thus, this form of real estate financing is sometimes referred to
as a sleeper trust deed. Occasionally, the interest accruing is paid periodically
during the term of the straight note, such as monthly payments of interest
only with the principal all due at the end of a fixed period of time.
The straight note is typically used by bankers for short-term mortgages since
a banker’s short-term note is not usually secured by real estate. In real estate
transactions, the note evidences what is generally called a bridge loan, a
short term obligation.
While the installment note and the straight note are common, variations
on the interest rate and repayment schedules contained in the installment
and straight notes are available to meet the specific needs of the lender and
borrower.
The variations include the:
• adjustable rate mortgage (ARM);
• graduated payment mortgage (GPM);
• all-inclusive trust deed (AITD); and
• shared appreciation mortgage (SAM).
The ARM, as opposed to an FRM, calls for periodic adjustments to the interest
rate. Thus, the amount of scheduled payments fluctuates from time to time.
The interest rate varies based on movement in an agreed-to index, such as
Cost-of-Funds index for the 11th District Federal Home Loan Bank.
The ARM provides the lender with periodic increases in its yield on the
principal balance during periods of rising and high short-term interest rates.
When an upward interest adjustment occurs, the note’s repayment schedule
calls for an increase in the monthly payment to maintain the original
Straight
notes
Payment
variations
adjustable rate
mortgage (ARM)
A variable interest rate
note, often starting out
with an introductory
teaser rate, only to
reset at a much higher
rate in a few months
or years based on a
particular index. [See
RPI Form 320-1]
Adjustable
rate
mortgage
Chapter 61: The promissory note 405
amortization period. If the amount of the original monthly payment is
retained without an increase to reflect an increase in the interest rate, the
mortgage term is extended or negative amortization occurs.
GPM provisions, in which the payment increases gradually from an initial
low base level, are in demand when interest rates or home prices rise too
quickly and ARM mortgages are disfavored. A graduated payment schedule
allows buyers time to adjust their income and expenses in the future. A GPM
often has a variable interest rate.
For example, the GPM provision allows low monthly payments on
origination. The payments are gradually increased over the first three- to
five-year period of the mortgage, until the payment amortizes the mortgage
over the desired number of remaining years.
However, any accrued monthly interest remaining unpaid each month
is added to the principal balance resulting in negative amortization. The
negative amortization causes the unpaid interest to bear interest as though it
were principal, called compounding.
The AITD variation of a note is used more often in carryback transactions
than money lending. AITDs become popular in times of recession, increasing
long-term rates and tight credit. The property is subject to one or more trust
deed mortgages with lower than current mortgage rates, though the opposite
can be the case.
The AITD “wraparound” note typically calls for the buyer to pay the carryback
seller constant monthly installments of principal and interest. The carryback
seller then pays the installments due on the underlying (senior) trust deed
note from the payments received on the AITD note.
The SAM repayment schedule variation is designed to help sellers attract
buyers during times of tightening mortgage money. Usually, the real estate
sales volume is in a general decline, followed in a year by a drop in prices.
The SAM is an example of a split-rate note. [See Figure 1, RPI Form 430]
Under a SAM note, the buyer pays an initial fixed interest rate, called a
“floor” or “minimum” rate. The floor rate charged is typically two-thirds to
three-fourths of the prevailing market rate, but not less than the applicable
federal rate (AFR) for reporting imputed interest.
In return, the carryback seller receives part of the property’s appreciated
value as additional interest, called contingent interest, when the property
is sold or the carryback SAM is due.
graduated payment
mortgage (GPM)
A mortgage providing
for installment
payments to be
periodically increased
by predetermined
amounts to accelerate
the payoff of principal.
Graduated
payment
mortgage
All-inclusive
trust deed
note
Shared
appreciation
mortgage
applicable federal
rate (AFR)
Rates set by the
Internal Revenue
Service for carryback
sellers to impute and
report income at the
minimum interest
when the note rate on
the carryback debt is a
lesser rate.
406 Real Estate Principles, Second Edition
Figure 1
Form 430
Shared
Appreciation
Note
Installment
— Contingent
Interest Extra
A note documents the terms for repayment of a mortgage or the unpaid
portion of the sales price carried back after a down payment, including:
• the amount of the debt;
• the interest rate;
• the periodic payment schedule; and
• any due date.
The dollar amount of the note carried back by a seller on an installment
sale as evidence of the portion of the price remaining to be paid is directly
influenced by whether the carryback is:
• an AITD note; or
• a regular note.
The face amount of an AITD note carried back by a seller will always be greater
than had a regular note been negotiated in any given sales transaction. The
AITD note is for the difference remaining after deducting the down payment
from the purchase price. Thus, the AITD note includes the principal amount
of the wrapped mortgages. However, a regular note is only for the amount
of the seller’s equity remaining after deducting from the purchase price the
down payment and the principal balance due on the existing trust deed
notes taken over by the buyer.
Financial
aspects
all-inclusive trust
deed (AITD)
A note entered into by
the buyer in favor of
the seller to evidence
the amount remaining
due on the purchase
price after deducting
the down payment, an
amount inclusive of
any specified mortgage
debts remaining
of record with the
seller retaining
responsibility for their
payment. Also referred
to as a wraparound
mortgage or overriding
mortgage. [See RPI
Form 421]
Chapter 61: The promissory note 407
California’s usury law limits the interest rate on non-exempt real estate
mortgages to the greater of:
• 10%; or
• the discount rate charged by the Federal Reserve Bank of San Francisco,
plus 5%.1 [See Chapter 58]
In most carryback transactions, the buyer gives the seller a trust deed lien on
the real estate sold as security for payment of the portion of the price left to
be paid.
The trust deed is recorded to give notice and establish priority of the seller’s
security interest in the property.2
A trust deed alone, without a monetary obligation for it to attach to the
described property, is a worthless trust deed for there is nothing to be secured.
Although the note and trust deed executed by a buyer in favor of the seller are
separate documents, a trust deed is only effective as a lien when it provides
security for an existing promise to pay or perform any lawful act that has a
monetary value.3
Even though they are separate documents, the note and trust deed are for the
same transaction and are considered one contract to be read together.4
The promissory note, once signed by the borrower and delivered to the
lender, represents the existence of a debt.5
When a secured debt has been fully paid, the trust deed securing the debt is
removed from title to the secured property, a process called reconveyance.6
1 Calif. Constitution, Article XV
2 Monterey S.P. Partnership v. W.L. Bangham, Inc. (1989) 49 C3d 454
3 Domarad v. Fisher & Burke, Inc. (1969) 270 CA2d 543
4 Calif. Civil Code §1642
5 Calif. Code of Civil Procedure §1933
6 CC §2941
Interest rate
limitations on
mortgages
usury
A limit on the lender’s
interest rate yield on
nonexempt real estate
loans.
The trust
deed
Satisfaction
of the debt
reconveyance
A document executed
by a trustee named in
a trust deed to release
the trust deed lien
from title to real estate,
used when the secured
debt is fully paid. [See
RPI Form 472]
408 Real Estate Principles, Second Edition
A promissory note is a document given as evidence of a debt owed by
one person to another. To be enforceable, the promissory note needs to
be signed by the payor and delivered to the lender or carryback seller on
closing the sale.
A note may be secured or unsecured. If the note is secured by real estate,
the security device used is a trust deed, commonly called a mortgage.
When secured, the debt evidenced by the note becomes a voluntary lien
on the real estate described in the trust deed that references the note.
Even though they are separate documents, the note and trust deed are
for the same transaction and are considered one contract to be read
together.
Notes are categorized by the method for repayment of the debt as either
installment notes or straight notes. The installment note is used for debts
paid periodically in negotiated amounts and at negotiated frequencies.
A straight note calls for the entire amount of its principal to be paid
together with accrued interest in a single lump sum when the principal
is due.
An interest-included installment note produces a schedule of constant
periodic payments which amortize the mortgage principal. Interest-
extra installment notes call for a constant periodic payment of principal
on the debt. In addition to the payment of principal, accrued interest
is paid separately, typically concurrent with payment of the principal
installment.
Variations exist on the interest rate and repayment schedules contained
in installment and straight notes.
When a debt secured by a trust deed lien on real estate has been fully
paid, the lien is removed from title, a process called reconveyance.
adjustable rate mortgage (ARM) ……………………………………… pg. 404
all-inclusive trust deed (AITD) ……………………………………….. pg. 406
applicable federal rate (AFR) …………………………………………… pg. 405
balloon payment …………………………………………………………….. pg. 403
graduated payment mortgage (GPM) ……………………………… pg. 405
installment note ………………………………………………………………. pg. 402
promissory note ……………………………………………………………….. pg. 402
reconveyance …………………………………………………………………… pg. 407
straight note …………………………………………………………………….. pg. 402
usury …………………………………………………………………………………. pg. 407
Chapter 61
Key Terms
Chapter 61
Summary
Quiz 11 Covering Chapters 55-61 is located on page 616.
Chapter 62: Late charges and grace periods 409
After reading this chapter, you will be able to:
• determine the provisions and conduct needed for a lender or
carryback seller to establish their right to collect a late charge;
• differentiate late charge arrangements based on the type of
property securing repayment, and whether the loan was arranged
by a broker; and
• understand how late charges are enforced and calculated.
Learning
Objectives
Late charges and
grace periods
Chapter
62
Promissory notes contain a late charge provision. The late charge provision
imposes an additional charge if payment is not received by the lender when
due or within a grace period.
To establish the right to enforce collection of a late charge, the following
conditions need to be met by the lender or carryback seller:
• a late charge provision exists in the note [See Form 418-1 accompanying
this chapter];
• a scheduled payment is delinquent;
• a notice of amounts due is delivered to the lender or carryback seller
assessing the late charge and demanding its payment;
Elements of a
late charge
late charge
A fee imposed as an
additional charge
under a provision in a
promissory note, lease
or rental agreement
when payments are
not received by their
due date or during a
grace period.
balloon payment
brokered loan
grace
period
late charge
Key Terms
For a further discussion of this topic, see Chapter 12 of Real Estate
Finance.
410 Real Estate Principles, Second Edition
• the dollar amount of the late charge is within the limits set by
applicable statutes and reasonableness standards; and
• accounting requirements for semi-annual and annual reports have
been complied with.
The failure of an owner to pay a late charge is a non-material breach of the
note and trust deed. As a non-material breach, the failure to pay late charges
cannot be the sole monetary basis for initiating a foreclosure by recording a
notice of default (NOD).
grace period
The time period
following the due date
for a payment during
which payment
received by the lender
or landlord is not
delinquent and a late
charge is not due. [See
RPI Form 550 §4.3 and
552 §4.7]
Form 418-1
Late Payment
Provisions
Chapter 62: Late charges and grace periods 411
Distinctions exist in the treatment of late charges permitted for private lender
loans as compared to charges permitted for seller carryback paper.
For private lenders, late charges on loans secured by single family residences
(SFRs) are treated differently than when they are secured by other types of
property. Also, the amount of the late charge a private lender may impose
is further controlled by whether or not the loan was made or arranged by a
broker.
Late charge provisions included in notes used by institutional lenders are
generally non-negotiable. This non-negotiable status is due primarily to
lender adherence to established uniformities, such as ceilings set by statute
or pooling arrangements in the secondary mortgage money market.
However, the inclusion of late charge provisions in notes carried back by
sellers or originated by private lenders are not automatic as boilerplate
language but are left to negotiations.
Before a late charge provision is included in a note, the charge needs to be
agreed to. When a late charge is referenced in a carryback note provision
agreed to in a purchase agreement, escrow is instructed to include the
applicable late charge provision in the note prepared for signatures. [See RPI
Form 150 §8.1]
For a late charge provision to be complete, it needs to include:
• the amount of the late charge;
• the duration of any grace period following the due date before a
payment received by the lender is delinquent; and
• a requirement for notice from the lender to impose the late charge and
demand its payment. [See Form 418-1]
The reasonable amount of monetary losses collectible as a late charge include:
• the actual out-of-pocket expenses incurred in a reasonable collection
effort; and
• the lost use of the principal and interest (PI) portion of the delinquent
payment.
To collect a late charge for the delinquent payment on a note secured by any
type of real estate, the carryback seller or private lender is to notify the
owner of the charge and make a demand for its payment.
The
negotiation of
late charge
provisions
The provision
and the
late charge
amount
Collectable
losses
Late charge
notice
412 Real Estate Principles, Second Edition
Private lenders are to give notice and make a demand for the late charge in a
timely manner by use of either:
• a billing statement or notice sent for each payment prior to its due
date stating the late charge amount and the date on which it will be
incurred; or
• a written statement or notice of the late charge amount due concurrent
with or within ten days after mailing a notice to cure a delinquency.1
The notice of amounts due or the billing statement is to include the exact
amount of the late charge or the formula used to calculate the charge.2
If the private lender fails to initiate collection of the late charge, the lender
waives its right to collect a late charge on that payment. However, failure to
comply with the late charge notice requirements on a delinquency does not
waive the private lender’s right to enforce the late charge provision on future
delinquencies.3
In regards to carryback notes, if, on receipt of a delinquent payment, the
carryback seller fails to make a demand for payment of the late charge, they
waive their right to collect a late charge on that installment.4
Ten days is the minimum grace period allowed for a private lender secured
by an owner-occupied SRF, even if the homeowner agrees to a shorter grace
period, or no grace period is agreed to.5
The late charge amount on a private lender loan which is not made or
arranged by a broker and is secured by an owner-occupied SFR is limited to
the greater of:
• 6% of the delinquent PI installment; or
• $5.6
Mailing the installment within the grace period does not qualify the
payment as timely paid. The payment needs to be actually received by the
carryback seller, lender or collection agent no later than the last day of the
grace period.7
When a licensed real estate broker makes or arranges a loan as or for a private
lender, the 6% limit for late charges established for loans secured by owner-
occupied SFRs does not apply. Further, reasonableness standards do not
apply as well. Instead, statutes control.8
1 CC §2954.5(a)
2 CC §2954.5(a)
3 CC §2954.5(e)
4 Calif. Code of Civil Procedure §2076; CC §1501
5 CC §2954.4(a), (b)
6 CC §2954.4(a), (e)
7 Cornwell v. Bank of America National Trust and Savings Association (1990) 224 CA3d 995
8 CC §2954.4(e)
Late charge
grace periods
on private
lender
mortgages
Made or
arranged by
brokers
Chapter 62: Late charges and grace periods 413
For private lender loans made or arranged by a real estate broker, called
a brokered loan, and secured by any type of real estate, the late charge is
limited to the greater of:
• 10% of the delinquent principal and interest payment; or
• $5.9 [See Form 418-1 §2.2]
Also, if the private lender loan made or arranged by a broker contains a
due date for a final/balloon payment, a late charge may be assessed on
the final/balloon payment if it is not received within ten days after its due
date. [See Form 418-1 §2.4]
Like an owner-occupied SFR loan, an installment on a private lender loan
made or arranged by a broker on any type of property is not late if it is received
by the lender within ten days after the installment is due.10
For a private lender loan secured by an owner-occupied SFR, or one made or
arranged by a broker and secured by any type of property, the private lender
cannot charge more than one late charge per delinquent monthly installment,
no matter how many months the payment remains delinquent.11
Refusal or failure of an owner to pay a late charge when demanded does not
justify a call of the loan or initiation of foreclosure by itself.12
No lender or carryback seller is entitled to foreclose on an owner who has
tendered all installments which are due, but has failed to pay outstanding
late charges. Collection of late charges when no other monetary breach exists
needs to be enforced by means other than foreclosure.
Additionally, a private lender making a loan on any type of real estate is
required to furnish the owner with a semi-annual accounting for the total
amount of late charges due and unpaid during the accounting period.13
For late charges on a carryback note secured by property improved with only
a one-to-four unit residence, the carryback seller needs to also provide the
owner with an annual accounting statement detailing any late charges
due and unpaid during the entire year.14
9 Calif. Business and Professions Code 10242.5(a)
10 Bus & P C §10242.5(b)
11 CC §2954.4(a); Bus & P C §10242.5(b)
12 Baypoint Mortgage Corporation v. Crest Premium Real Estate Investments Retirement Trust (1985) 168 CA3d 818
13 CC §2954.5(b)
14 CC §2954.2(a)
brokered loan
A private lender loan
made or arranged by a
real estate broker.
balloon payment
Any final payment
on a note which is
greater than twice the
amount of any one
of the six regularly
scheduled payments
immediately preceding
the date of the final/
balloon payment. [See
RPI Form 418-3 and
419]
One
charge per
delinquency
Enforcement
of the late
charge
414 Real Estate Principles, Second Edition
To establish the right to enforce collection of a late charge:
• a late charge provision needs to exist in the note;
• a scheduled payment needs to be delinquent;
• a notice of amounts due has been delivered to the owner;
• the dollar amount of the late charge is within the limits set by
applicable statues and reasonableness standards; and
• accounting requirements for semi-annual and annual reports
have been complied with.
For a late charge provision to be complete, it needs to include:
• the amount of the late charge;
• the duration of any grace period; and
• a requirement for notice from the trust deed holder to impose the
late charge and make a demand for its payment.
The late charge amount on a private lender loan which is not made or
arranged by a broker and is secured by an owner-occupied SFR is limited
to the greater of 6% of the delinquent principal and interest payment or
$5.
For private lender loans made or arranged by a real estate broker and
secured by any type of real estate, the late charge is limited to the greater
of 10% of the delinquent principal and interest payment or $5.
balloon payment ……………………………………………………………… pg. 413
brokered loan ……………………………………………………………………. pg. 413
grace period ………………………………………………………………………. pg. 410
late charge ………………………………………………………………………… pg. 409
Chapter 62
Summary
Chapter 62
Key Terms
Quiz 12 Covering Chapters 62-67 is located on page 617.
Chapter 63: Prepayment penalties 415
After reading this chapter, you will be able to:
• understand how prepayment penalties were historically used by
lenders to prevent the loss of interest;
• determine whether a prepayment penalty is prohibited under
the Dodd-Frank Wall Street Reform and Consumer Protection Act;
and
• advise on the enforceability of a prepayment penalty provision in
a note secured by a trust deed containing a due-on clause.
Learning
Objectives
Prepayment penalties
Chapter
63
Consider an owner of real estate who wants to pay off some or the entire
principal on a mortgage before it is due by its terms. However, the owner has
previously agreed to an additional charge the lender may levy to reduce or
pay off the debt, called a prepayment penalty.
The prepayment penalty agreement is included in the promissory note. It
is not a provision in the trust deed, since it relates to the payment of the debt,
not the care and maintenance of the real estate.
The unscheduled prepayment of any principal on a debt before it is due is
ironically considered a privilege, since the borrower wants to deleverage
and is now able to pay off their lender. If a prepayment penalty provision is
agreed to in the note, a lender can charge the owner on each exercise of the
Debt
reduction
— a costly
privilege
prepayment penalty
A provision in a note
giving a lender the
right to levy a charge
against a borrower
who pays off the
outstanding principal
balance on a loan prior
to expiration of the
prepayment provision.
[See RPI Form 418-2]
Dodd-Frank Wall Street
Reform and Consumer
Protection Act
due-on clause
prepayment penalty Key Terms
For a further discussion of this topic, see Chapter 10 of Real Estate
Finance.
416 Real Estate Principles, Second Edition
Form 418-2
Prepayment
of Principal
Provisions
privilege. The owner may be charged whether the reduction is a portion or
all of the principal remaining on the debt. [See Form 418-2 accompanying
this chapter]
Historically, prepayment penalties were used by lenders to prevent the loss
of interest until the funds were re-lent to another borrower.
Prepayment penalties became regulated in 2010 under the Dodd-Frank
Wall Street Reform and Consumer Protection Act.
Enforceable
penalties
Dodd-Frank Wall
Street Reform
and Consumer
Protection Act
A 2010 enactment of
significant changes
to U.S. financial
regulation in response
to the 2007 financial
crisis.
Chapter 63: Prepayment penalties 417
Prepayment penalties are prohibited on mortgage loans which are not
qualified mortgages.
A qualified mortgage is any consumer loan secured by an owner- or non-
owner-occupied one-to-four unit residential property.
Further, prepayment provisions are also prohibited on qualified mortgages
which have:
• an adjustable rate of interest; or
• an annual percentage rate (APR) exceeding the average prime offer
rate in a comparable residential mortgage loan by set quotas.
Prepayment penalties on qualified mortgages cannot exceed:
• 3% of the outstanding balance on the mortgage during the 1st year of
payment following the recording of the mortgage;
• 2% of the outstanding balance on the mortgage during the 2nd year of
payment;
• 1% of the outstanding balance on the mortgage during the 3rd year of
payment; and
• 0% after the first three years following the recording of the mortgage.
Further, a SFR secured lender on the payoff of a consumer mortgage may
only charge a prepayment penalty if:
• the prepayment penalty does not extend beyond three years after the
date of the mortgage’s closing;
• the prepayment penalty provision is not included in the terms of any
refinancing by the same lender of the mortgage paid off;
• at closing, the borrower’s total monthly payments on installment debts
are less than 50% of their verified gross income; and
• the monthly payments do not change or adjust during the first four-
year period after closing. [12 Code of Federal Regulations §§1026.32(d)
(6)-(7)]
Prepayment penalty provisions in all notes secured by a trust deed containing
a due-on clause and encumbering an owner-occupied, one-to-four unit
residential property are unenforceable if the lender or carryback seller:
• calls the mortgage due for a transfer in violation of the due-on clause;
• starts foreclosure to enforce a call under the due-on clause; or
• fails during the pendency of the sale of property subject to the
mortgage to approve, within 30 days of receipt of the completed credit
application from a qualified buyer, the assumption of the mortgage or
carryback note.1
However, a seller carrying back a note secured by a one-to-four unit
residential property can bar prepayment only for the calendar year of sale,
if they have not already carried back more than four notes in the same year.2
1 12 Code of Federal Regulations §591.5(b)(2), (3)
2 CC §2954.9(a)(3)
Due-on
clause and
prepayment
penalties
due-on clause
A trust deed provision
used by lenders to call
the loan immediately
due and payable, a
right triggered by the
owner’s transfer of
any interest in the real
estate, with exceptions
for intra-family
transfers of their home.
privilege. The owner may be charged whether the reduction is a portion or
all of the principal remaining on the debt. [See Form 418-2 accompanying
this chapter]
Historically, prepayment penalties were used by lenders to prevent the loss
of interest until the funds were re-lent to another borrower.
Prepayment penalties became regulated in 2010 under the Dodd-Frank
Wall Street Reform and Consumer Protection Act.
Enforceable
penalties
Dodd-Frank Wall
Street Reform
and Consumer
Protection Act
A 2010 enactment of
significant changes
to U.S. financial
regulation in response
to the 2007 financial
crisis.
418 Real Estate Principles, Second Edition
Prepayment penalties were historically used by lenders in an effort
to prevent the loss of interest until the funds were re-lent to another
borrower.
A property owner’s right to prepay principal to reduce their debt or
payoff and release the trust deed lien on their property is established
by the terms of the promissory note. Further, prepayment penalties
are regulated by the Dodd-Frank Wall Street Reform and Consumer
Protection Act.
Dodd-Frank Wall Street Reform and Consumer Protection
Act …………………………………………………………………………………….. pg. 417
due-on clause ……………………………………………………………………. pg. 417
prepayment penalty ………………………………………………………… pg. 415
Chapter 63
Summary
Chapter 63
Key Terms
Quiz 12 Covering Chapters 62-67 is located on page 617.
Chapter 64: Balloon payment notices 419
After reading this chapter, you will be able to:
• understand what constitutes a final/balloon payment on a note;
• calculate the amount of a final/balloon payment; and
• advise on the requirements for the contents and delivery of a
final/balloon payment notice.
Balloon payment
notices
Chapter
64
A final/balloon payment is any final payment on a note in an amount
greater than twice the amount of any of the six regularly scheduled payments
immediately preceding the balloon payment date.1
Final/balloon payment notes contain due date provisions calling for an
accelerated final payoff of the principal in a lump sum amount before the
note balance has been fully amortized through periodic payments. Further,
a note has a balloon payment if it contains a call provision giving the
carryback seller or lender the right to demand final payment at any time or
after a specified time.2
Consumer mortgages are contrasted with business mortgages based on
the purpose for which the funds are intended to be used.
A consumer mortgage both:
• funds a personal, family or household purpose; and
1 CC §§2924i(d)(1), 2957(b)
2 CC §§2924i(d)(2), 2957(c)
Notes
containing
a balloon
payment
Limitations on
final/balloon
payments in
consumer
mortgages
balloon payment call provision
Learning
Objectives
Key Terms
For a further discussion of this topic, see Chapter 13 of Real Estate
Finance.
420 Real Estate Principles, Second Edition
• is secured by a one-to-four unit residential property, whether or not
occupied by the borrower or their family.3
Final/balloon payments in consumer mortgages have become rare due to
Regulation Z (Reg Z) rules. Mortgage lenders making consumer mortgages
are mandated by Reg Z to qualify the borrower under ability-to-repay rules
(ATR).
If the mortgage complies with Reg Z qualified mortgage (QM) standards
the mortgage is presumed compliant with ATR rules.
However, to be classified as a QM, the mortgage needs to be fully amortized
in substantially equal regular installments, a rule eliminating the inclusion
of a final/balloon payment provision.
Some mortgages with due dates require a final/balloon payment notice.
A 90/150-day due date notice provision is required in notes containing a
final/balloon payment provision with a term exceeding one year if:
• the note is carried back by a seller and secured by a trust deed on one-
to-four residential units; or
• the note evidences a loan secured by a trust deed on an owner-occupied,
one-to-four unit residential property.
A due date notice is not required, unless agreed to by both parties, on
transactions including:
• carryback mortgages secured by any type of real estate other than a
one-to-four unit residential property, whether or not owner-occupied;
• lender mortgages secured by any type of real estate other than owner-
occupied, one-to-four residential units;
• open-ended credit secured by any type of real estate, such as a home
equity line of credit (HELOC); and
• construction loans for any type of improvements.4
The due date notice is used to remind the owner of the secured property of a
note’s final/balloon payment. The notice, while a reminder, gives the owner
an opportunity to refinance or pay off the note.
Carryback sellers and lenders need to deliver the notice to the buyer or owner
of the property:
• personally; or
• by first-class certified mail to the property owner’s last known address.
The notice needs to be given at least 90 days, but not more than 150 days,
before the due date.5
3 12 Code of Federal Regulations §1026.2(a)(19)
4 CC §2924i(b)(1), (3)
5 CC §§2924i(c), 2966(a)
Final/balloon
payment
notice and
due dates
Delivery and
contents of
the notice
balloon payment
Any final payment
on a note which is
greater than twice the
amount of any one
of the six regularly
scheduled payments
immediately preceding
the date of the final/
balloon payment. [See
RPI Form 418-3 and
419]
call provision
A provision in a note
giving the mortgage
holder the right to
demand full payment
at any time or after
a specified time or
event, also called an
acceleration clause.
[See RPI From 418-3]
Chapter 64: Balloon payment notices 421
If the notice is not timely delivered, the final due date is extended until 90
days after proper notice is given. No other terms of the note are affected. Thus,
the accrual of interest and the schedule of periodic payments remain the
same during the extended due date period.6
The failure to deliver the notice does not invalidate the note or lessen
the property owner’s obligation to continue making the regular periodic
payments. Non-delivery of the notice merely extends the date by which the
owner is obligated to pay off the note.
If the owner defaults on a payment during the due-date extension period,
the noteholder may initiate foreclosure.
6 CC §§2924i(e), 2966(b)
Form 419
Notice of
Balloon
Payment Date
422 Real Estate Principles, Second Edition
The dollar amount of the final/balloon payment in a carryback transaction
needs to be computed and disclosed to the buyer:
• first in a Seller Carryback Disclosure Statement handed to both the
buyer and seller as an attachment to the purchase agreement, or for
further approval before the close of escrow subject to cancellation on
reasonable disapproval [See RPI Form 300];7 and
• again in a written due date notice delivered at least 90 days, but not
more than 150 days, before the final/balloon payment is enforced by
the carryback seller. [See Form 419 accompanying this chapter]
Additionally, the carryback note prepared by escrow includes a statutory
provision calling for the final/balloon payment due date notice.8 [See RPI
Form 418-3 §2.1]
7 2924i (e)
8 2966
A final/balloon payment is any payment on a note which is an amount
greater than twice the amount of any of the six regularly scheduled
payments immediately preceding the date of the final/balloon payment.
Final/balloon payments in consumer mortgages have become rare due
to Regulation Z (Reg Z) rules, as they are prohibited in most qualified
mortgages (QMs).
A 90/150-day due date notice provision is required in certain mortgages
with terms exceeding one year and containing a final/balloon payment
provision. Carryback sellers and lenders need to deliver the final/balloon
payment notice to the buyer or owner of the property personally or by
first-class certified mail to the property owner’s last known address. The
notice needs to be given at least 90 days, but not more than 150 days,
before the due date.
A lender or carryback seller may not foreclose if the buyer fails to make
a final/balloon payment unless timely notice of the upcoming payoff
was given. If the notice is not delivered on time, the final due date of the
loan is extended until 90 days after proper notice is given. Non-delivery
of the notice extends the date by which the owner is obligated to pay off
the note but does not affect any other terms of the note.
balloon payment ……………………………………………………………… pg. 420
call provision ……………………………………………………………………. pg. 420
Chapter 64
Summary
Chapter 64
Key Terms
Quiz 12 Covering Chapters 62-67 is located on page 617.
Chapter 65: Trust deed characteristics 423
After reading this chapter, you will be able to:
• understand how a trust deed voluntarily imposes a lien for a debt
on an ownership interest real estate;
• identify the three parties and their roles under a trust deed; and
• take steps to have a trust deed removed from title to a property.
Learning
Objectives
For a further discussion of this topic, see Chapter 14 of Real Estate
Finance.
Trust deed
characteristics
Chapter
65
Financing involves a borrower who signs and delivers a
promissory note
to a lender or seller as evidence of the debt owed for money lent or credit
extended. However, the promissory note itself is only a promise to pay as
agreed. It is not a guarantee or other assurance the debt evidenced by the
note will actually be repaid.
A guarantee is an agreement entered into by a person who is not the borrower
under the note, known as a guarantor. The guarantee agreement obligates
the guarantor to be responsible for the borrower’s performance. In essence,
the guarantor agrees to buy the note in the event the borrower defaults.
[See RPI Form 439]
In real estate loan transactions, lenders want assurance the debt owed by the
borrower will be repaid. Thus, lenders who fund real estate transactions or
provide refinancing require borrowers to provide the real estate involved as
collateral to secure the performance of the borrower’s promise to pay if they
default on repayment.
A security device
and a lien
promissory note
A document given
as evidence of a debt
owed by one person
to another. [See RPI
Form 421 and 424]
guarantee
An assurance that
events and conditions
will occur as presented
by the agent.
beneficiary
deed-in-lieu of foreclosure
guarantee
promissory note
reconveyance
trustee
Key Terms
424 Real Estate Principles, Second Edition
To secure payment of the debt by a parcel of real estate, the security device
used is a trust deed agreement. The trust deed is always the preferential
method used to impose a lien on real estate. [See Figure 1, RPI Form 450]
The lien gives the lender or carryback seller the right to foreclose on the real
estate when the borrower defaults. The trust deed, by its words, purports to
convey legal title to a neutral person, called a trustee. In law, the title is
not transferred. Instead, a lien is created to encumber the owner’s title and
establish the property as security for the debt.
By the use of the trust artifice, title to the property is theoretically held by a
trustee as a middleman. In other words, title is held in trust on behalf of the
owner and for the benefit of the lender or carryback seller.
If the borrower or owner defaults on the note, the trustee is instructed by the
lender to sell the property at a public auction to satisfy the debt.
A trust deed lien arrangement consists of:
• an identification of the parties;
• a description of the real estate liened as security;
• an identification of the primary money obligation, usually evidenced
by a note, which brought about the need for security;
• the terms of the lender’s security interest which is the encumbrance
on the property, limited to setting out the rights and obligations of the
borrower and the lender solely in regard to the real estate; and
• the borrower’s signature and notary acknowledgments. [See Form 450]
The trust deed identifies three parties, each of whom has distinctly separate
roles in the secured transaction:
• the borrower/owner (trustor) who voluntarily imposes the trust deed
lien on their property;
• the middleman (trustee) who holds the power of sale over the property;
and
• the lender or carryback seller (beneficiary) who benefits from the trust
deed lien encumbering the property.
The trustor who signs and delivers a trust deed to a lender or carryback seller
is the owner of the real estate interest encumbered. Delivery is accomplished
by recording the trust deed with the county recorder, which perfects its
priority on title.
The owner creating a trust deed encumbrance on real estate usually is the
borrower of money or buyer of the property in a seller financed credit sale.
The owner’s real estate interest which is encumbered can be less than the
entire fee interest, such as:
• a fractional co-ownership;
• leasehold interest;
trustee
One who holds title to
real estate in trust for
another.
Parties to the
trust deed
Chapter 65: Trust deed characteristics 425
• life estate in the property;
• beneficial interests of creditors in existing trust deeds;
• equitable ownership rights under land sales contracts; and
• purchase rights under options to buy.
For example, a condominium owner can encumber their long-term leasehold
interest, even though some other person is the fee owner of the real estate.1
1 Calif. Civil Code §§783, 1091, 2947
Figure 1
Form 450
Deed of Trust
and Assignment
of Rents
For a full-size, fillable copy of this or any
other form in this book that may be used
in your professional practice, go to
realtypublications.com/forms
426 Real Estate Principles, Second Edition
The trust deed lien created by the owner of a fractional interest in the real
estate attaches only to the owner’s interest in the property. It does not attach
to the interests of any co-owners.2
If community property is encumbered, both spouses need to consent to the
encumbrance of the community real estate interest, with the exception of
attorney fees agreements in divorce proceedings.3
Despite the wording in the trust deed stating the trustor “hereby grants and
conveys to trustee…the following real property…”, the trustee receives no
ownership or security interest in the real estate. Further, the trustee holds no
legal right to any interest in the property.
The trustee merely receives the authority to carry out the activities vested in
the trustee by the power-of-sale provision in the trust deed lien held by
the beneficiary (lender).4
Under the trust deed, the trustee’s sole responsibilities concerning the prop-
erty are to:
• auction the property at a public sale on notice from the beneficiary;
and
• reconvey title to the trustor (owner) and release the beneficiary’s lien
on instructions from the beneficiary or the trustor.
Thus, the owner’s possessory right to the property is never transferred to the
trustee under a trust deed. The trustor, as the owner of the real estate, remains
free to occupy, sell, lease or further encumber their property, subject to the
existing trust deed lien. Any person other than the owner of the real estate
may serve as trustee. This includes the beneficiary of the trust deed, be they
the lender or carryback seller.5
Some private lenders name their attorney or broker as the trustee. Frequently,
title and escrow companies unknowingly play the role of trustee in a
particular transaction by virtue of the lender’s use of general trust deed forms
distributed by title companies.
Under a trust deed lien, the trustee is non-existent until the beneficiary
elects to foreclose or release its security interest in the property. The trustee’s
conduct is in nearly all aspects completely controlled by statutes.6
When the trustee is called on by the beneficiary to carry out its duty to
foreclose or reconvey, the trustee is required to act impartially. A trust deed
lien does not create a trust relationship between the parties to the trust deed.
The trustee is regarded as a common agent and bears a responsibility to
both the beneficiary and the trustor to absolutely follow the strict statutory
foreclosure scheme.7
2 Caito v. United California Bank (1978) 20 C3d 694
3 Calif. Family Code §1102
4 Lupertino v. Carbahal (1973) 35 CA3d 742
5 More v. Calkins (1892) 95 C 435
6 Garfinkle v. Superior Court of Contra Costa County (1978) 21 C3d 268; CC §2924 et seq.
7 Kerivan v. Title Insurance and Trust Company (1983) 147 CA3d 225
The trustee’s
authority
No
possessory
right
transferred
Chapter 65: Trust deed characteristics 427
The beneficiary, such as a lender or carryback seller, is the entity entitled to
the performance of the promised activity referenced in the trust deed as the
purpose for obtaining the security. This is generally the repayment of debt
evidenced by a note.
The beneficiary, like the trustee, receives no ownership interest in the
property. But unlike the trustee, the beneficiary holds an interest in the
property in the form of a lien.
Thus, the beneficiary has the power to instruct the trustee (who may be the
beneficiary) to sell the secured property on behalf of the beneficiary. In turn,
the trustee has authority from both the trustor and the beneficiary under the
power-of-sale provision in the trust deed to sell the property in conformance
with the statutory scheme at the direction of the beneficiary.8
A trust deed ceases to exist when its purpose as security for a debt ends. Thus,
once the beneficiary (lender or carryback seller) receives the full amount of
money they are entitled to under the note and trust deed, any later claim of
a security interest by the beneficiary is invalid.
Removing the trust deed from the title to the property on ending the debt
relationship between the owner and the creditor is accomplished in one of
three ways:
• foreclosure by issuance of a trustee’s deed or sheriff’s deed [See RPI
Form 475];
• full repayment by reconveyance [See RPI Form 472]; or
• mutual agreement by a deed-in-lieu of foreclosure. [See RPI
Form 406]
Foreclosure of the trust deed lien is accomplished by a public auction at a
trustee’s sale or sheriff’s sale, the proceeds of which are applied to the debt.
If the price bid at the foreclosure sale is insufficient to fully satisfy the note,
the foreclosure sale terminates the trust deed lien on the property. The
foreclosure sale cancels the trust deed’s effect on the title on issuance of the
trustee’s or sheriff’s deed.
Full repayment of the debt requires the beneficiary to cause the trust deed to
be reconveyed. Once the debt is fully repaid by the trustor, the beneficiary
delivers the original note to the trustee, together with a request for a
reconveyance of title. In turn, the trustee records a reconveyance of the trust
deed. [See RPI Form 472]
On a request for reconveyance, the trustee will demand identification of the
beneficiary and require the original note be marked as paid. After recording
the reconveyance, the trustee will deliver the note to the owner at the
owner’s request.
Unless the recorded trust deed lien expires earlier, the lien expires and is no
8 Prob C §§16000, 16420(a)(1)
The
beneficiary is
the lienholder
beneficiary
One entitled to the
benefits of properties
held in a trust or estate,
with title vested in a
trustee or executor.
Extinguishing
the
relationship
deed-in-lieu of
foreclosure
A deed to real property
accepted by a lender
from a defaulting
borrower to avoid the
necessity of foreclosure
proceedings by the
lender. [See RPI Form
406]
reconveyance
A document executed
by a trustee named in
a trust deed to release
the trust deed lien
from title to real estate,
used when the secured
debt is fully paid. [See
RPI Form 472]
Request for
reconveyence
428 Real Estate Principles, Second Edition
The trust deed agreement is the preferential method used to impose a
lien on real estate. The trust deed identifies three parties:
• the owner, called the trustor;
• the middleman, called the trustee; and
• the lender or carryback seller, called the beneficiary.
The trustee holds no legal right to any interest in the property. The
trustee has the limited authority to carry out the activities vested in the
trustee by the power-of-sale provision in the trust deed lien held by the
beneficiary.
On the instruction from the beneficiary, the trustee’s sole responsibilities
concerning the property are to:
• auction the property at a public sale; or
• reconvey title to the trustor and release the beneficiary’s lien.
The beneficiary, such as a lender or carryback seller, is the entity entitled
to the performance of the promised activity referenced in the trust deed,
such as the repayment of debt evidenced by a note. The beneficiary
holds an interest in the property in the form of a lien.
The trust deed ceases to exist when its purpose as security for a debt ends.
Removing the trust deed from the title to the property on ending the
debt relationship is accomplished in one of three ways:
• foreclosure by issuance of a trustee’s deed or sheriff’s deed;
• full repayment by reconveyance; or
• mutual agreement by a deed-in-lieu of foreclosure.
beneficiary ……………………………………………………………………….. pg. 427
deed-in-lieu of foreclosure ………………………………………………. pg. 427
guarantee ………………………………………………………………………….. pg. 423
promissory note ……………………………………………………………….. pg. 423
reconveyance …………………………………………………………………… pg. 427
trustee ……………………………………………………………………………….. pg. 424
Chapter 65
Summary
Chapter 65
Key Terms
longer enforceable by any means after the later of:
• ten years after the final maturity date contained in the recorded trust
deed; or
• 60 years after the recording of the trust deed if the final maturity date
cannot be ascertained from the recorded trust deed.9
9 CC §882.020
Quiz 12 Covering Chapters 62-67 is located on page 617.
Chapter 66: Assumptions: formal and subject-to 429
After reading this chapter, you will be able to:
• identify four procedures for a buyer to take over mortgage
financing which encumbers a seller’s property;
• understand the use of a beneficiary statement to confirm the
amount and terms of an existing mortgage;
• determine the nonrecourse nature of a purchase-money mortgage;
and
• advise a seller on the steps to be taken to reduce their risk of loss
on a buyer’s takeover of a recourse mortgage.
Learning
Objectives
Assumptions: formal
and subject-to
Chapter
66
assumption agreement
beneficiary statement
due-on clause
nonrecourse
novation
purchase-money mortgage
recourse mortgage
subject-to transaction
Key Terms
On the sale of real estate, financing the seller has in place as an existing
encumbrance on the property may be taken over by a buyer when acquiring
ownership under one of four procedures:
• a formal assumption agreement between the lender and the buyer;
• a subject-to assumption agreement between the seller and the
buyer;
• a subject-to transfer of ownership to a buyer without an assumption
agreement of any type; and
• a novation agreement between the lender, seller and buyer.
Mortgage
takeover by
a buyer
For a further study of this discussion, see Chapter 23 of Real Estate
Finance.
430 Real Estate Principles, Second Edition
A subject-to transaction is initially structured by use of a financing
provision in a purchase agreement. The provision calls for the amount of an
existing mortgage to be part of the purchase price the buyer is to pay for the
property. The financing provision further states the buyer is to take title to
the property subject to the existing mortgage. [See RPI Form 150 §§5 and 6]
The seller’s representation of the terms and condition of the mortgage is
confirmed by the buyer during escrow on escrow’s demand and receipt of
the lender’s beneficiary statement. [See RPI Form 415]
The buyer relies on the beneficiary statement for future payment schedules,
interest rates and the principal balance on the mortgage they are taking over
from the seller.
Some buyers acquire their ownership rights under unrecorded sales
documents, such as lease-option agreements or land sales contracts. This is
done in an effort to avoid detection of a change in ownership by the lender.
Thus, the seller and buyer avoid conveyances, escrow, title insurance, and
other customary transfer activities until the buyer originates new financing
or negotiates an assumption of the existing mortgage. These unrecorded sales
transactions do, however, trigger due-on clauses and reassessments. [See
Chapter 67]
On a subject-to transaction when mortgage rates charged are comparable to
or lower than the note rate on the seller’s existing mortgage:
• a beneficiary statement is ordered to confirm the mortgage amount
and its terms;
• the change of ownership conveyance is recorded and insured; and
• the conveyance is promptly brought to the lender’s attention so they
cannot accept payments and then later call the mortgage when rates
rise, claiming the transfer went undisclosed.
Conversely, when interest rates are rising or high compared to the note rate
on an existing mortgage, the lender is often not notified of a subject-to sales
transaction.
However, the lender can enforce its due-on clause and call the mortgage on
its future discovery of any sale, regardless of how the sale was structured.
The concern of the seller on either a subject-to or an assumption of the seller’s
mortgage is whether personal liability exists on the mortgage. Mortgage
liability depends on whether the mortgage is:
• a recourse mortgage, meaning the lender may pursue the seller for a
loss due to a deficiency in the value of the secured property, but only if
the lender forecloses judicially; or
• a nonrecourse mortgage, meaning the lender may not pursue the
seller for a loss on the mortgage when the property has insufficient
value to satisfy the outstanding debt.
The
subject-to
transaction
beneficiary
statement
A document issued
by a mortgage holder
on request noting
future payment
schedules, interest
rates and balances on
a mortgage assumed
by an equity purchase
(EP) investor. [See RPI
Form 415]
Unrecorded
sales
documents
due-on clause
A trust deed provision
used by lenders to call
the loan immediately
due and payable, a
right triggered by the
owner’s transfer of
any interest in the real
estate, with exceptions
for intra-family
transfers of their home.
subject-to
transaction
A sale of mortgaged
property calling for
the buyer to take
title subject to the
mortgage, the principal
balance being
credited toward the
purchase price paid.
Compare with formal
assumption. [See RPI
Form 156 §5]
Nonrecourse
mortgage debt
nonrecourse
A debt secured by real
estate, the creditor’s
source of recovery on
default limited solely
to the value
of their security
interest in the secured
property.
Chapter 66: Assumptions: formal and subject-to 431
A seller has no liability for the lender’s losses on a purchase-money
mortgage taken over by a buyer under any procedure.
Purchase-money mortgages include:
• seller carryback financing on the sale of any type of real estate which
becomes the sole security for the carryback note;
• a mortgage which funded the purchase of an owner-occupied, one-to-
four unit residential property;1 and
• a mortgage made for the construction of an owner-occupied, single
family residence (SFR).
A lender as the holder of a purchase-money mortgage has no recourse to the
borrower on a default, and is limited to foreclosing and selling the secured
property as the sole source of recovery for any amounts remaining unpaid
on the mortgage.2
On the take-over of a purchase-money mortgage by a buyer, the mortgage
retains its original nonrecourse purchase-money characteristic, regardless of
whether the buyer takes title subject-to or assumes the mortgage.3
Thus, a non-occupying buyer who takes over a purchase-money mortgage
under any procedure is entitled to anti-deficiency protection. In contrast,
purchase-assist mortgage financing originated by a non-occupying buyer
of any type of residential property, including one-to-four unit residential
property, is a recourse mortgage.
Recourse mortgages are all mortgages not classified as purchase-money
mortgages, as reviewed above. When property is sold and title is conveyed
to a buyer subject-to an existing recourse mortgage, the seller remains liable
for any deficiency on the recourse mortgage if the buyer fails to pay and the
lender forecloses.4
Further, unless the buyer enters into an assumption agreement with either
the seller or the lender, a subject-to buyer is not liable to either the seller or
the lender for a drop in the property’s value below the mortgage balance,
unless the buyer commits waste.5
However, when the buyer and lender enter into an assumption agreement
which significantly modifies the terms of the recourse mortgage without the
seller’s consent, the seller is not liable for the mortgage.6
A seller can take steps to reduce their risk of loss on a buyer’s takeover of a
recourse mortgage. To do so, the seller includes a provision in the purchase
agreement requiring the buyer to enter into an assumption agreement
with the seller.
1 Calif. Code of Civil Procedure §580b
2 CCP §580b
3 Jackson v. Taylor (1969) 272 CA2d 1
4 Braun v. Crew (1920) 183 C 728
5 Cornelison v. Kornbluth (1975) 15 C3d 590; CC §2929
6 Braun, supra; CC §2819
purchase-money
mortgage
Nonrecourse mortgage
financing provided by
a lender as purchase-
assist funding for the
purchase of a one-to-
four unit residential
property the buyer is
going to occupy, or a
seller carryback note
and trust deed as an
extension of credit to
a buyer of any type
of real estate which is
secured solely by the
property sold. Anti-
deficiency mortgage.
recourse mortgage
A mortgage debt in
which a lender may
pursue collection from
a property owner for a
loss due to a deficiency
in the value of the
secured property to
fully satisfy the debt if
the lender forecloses
judicially.
Recourse
real estate
mortgages
Buyer-seller
assumption
432 Real Estate Principles, Second Edition
The buyer-seller assumption agreement is a promise given by the buyer to
the seller to perform all the terms of the mortgage taken over by the buyer
on the sale. It is agreed to in the purchase agreement and prepared in escrow.
[See Form 431 accompanying this chapter]
The assumption agreement gives the seller the right to collect from the buyer
the amount of any deficiency judgment a recourse lender might be awarded
against the seller in a judicial foreclosure. To be enforceable, the assumption
agreement is required to be in writing.7
Although the buyer’s promise to pay the mortgage under a buyer-seller
assumption agreement is given to the seller, the buyer also becomes liable
under the agreement to the recourse lender under the legal doctrine of
equitable subrogation.8 [See Form 431 §6]
Even though the buyer takes over the primary responsibility for the recourse
mortgage, the seller remains secondarily liable to the lender. The seller’s risk
of loss arises when the buyer fails to pay the recourse mortgage and there
is a lack of market value remaining in the property to cover the mortgage
amount.9
Unlike the subject-to seller, the seller under the buyer-seller assumption
agreement is entitled to be indemnified, meaning held harmless by the
buyer for any losses the seller later incurs due to their continued liability on
the mortgage taken over by the buyer.
Sales negotiations calling for the buyer to enter into an assumption
agreement with the seller may also call for the buyer to secure the assumption
agreement by a performance trust deed carried back by the seller as a lien
on the property sold. [See RPI Form 432 and 451]
With a recorded trust deed held by the seller to secure the buyer’s promise to
pay the lender as agreed in the assumption agreement, any default by the
buyer allows the seller to:
• demand the buyer to tender the entire balance remaining due on
the assumed mortgage, subject to the buyer’s right to reinstate the
delinquencies; and
• proceed with foreclosure under the performance trust deed to recover
the property and cure the default on the mortgage assumed by the
buyer.
A buyer-seller assumption, like a subject-to transaction, does not alter the
lender’s right to enforce its due-on clause on discovery of the conveyances.
A lender may enter into an agreement with both the buyer and the seller for
the buyer’s assumption of the mortgage and a release of the seller’s liability. In
7 CC §1624
8 Braun, supra
9 Everts v. Matteson (1942) 21 C2d 437
assumption
agreement
A promise given by a
buyer to the seller or
an existing mortgage
holder to perform
all the terms of the
mortgage taken over
by the buyer on the
sale. [See RPI Form
431 and 432]
Indemnified
for losses
Novation
Chapter 66: Assumptions: formal and subject-to 433
exchange, the lender charges a fee together with a demand for a modification
of mortgage interest rate and terms of repayment. This agreement is called a
novation or substitution of liability.
On a buyer-lender assumption of a mortgage secured by an owner-occupied,
one-to-four unit residential property, the lender is required to release the
seller from liability for the mortgage assumed by the buyer.10
A novation agreement is comparable to the existing lender originating a
new mortgage with the buyer, except the trust deed executed by the seller
remains of record and the note remains unpaid.
10 12 Code of Federal Regulations §591.5(b)(4)
novation
An agreement
entered into by a
mortgage holder,
buyer and seller to
shift responsibility for
a mortgage obligation
to the buyer by an
assumption and
release the seller of
liability.
Form 431
Assumption
Agreement –
Unsecured and
Subrogated
434 Real Estate Principles, Second Edition
Existing financing encumbering a property may remain of record and be
taken over by a buyer under a subject-to transfer, a formal assumption, a
subject-to assumption or a novation agreement.
A subject-to transaction is structured by a provision in a purchase
agreement calling for the principal amount of an existing mortgage
to be part of the purchase price paid for the property. The lender may
enforce its due-on clause by calling the mortgage on its later discovery
of the sale, regardless of how the sales transaction is structured.
A seller is not liable for a deficiency in property value to satisfy the
mortgage on foreclosure of a nonrecourse purchase-money debt taken
over under any procedure by the buyer. On a recourse mortgage, the
seller can reduce their risk of loss on a buyer’s takeover of the mortgage
by negotiating for the buyer to enter into an assumption agreement
with the seller.
A buyer-seller assumption does not alter the lender’s right to enforce its
due-on clause on discovery but does give the seller the right to recover
from the buyer any losses they may have incurred due to the lender’s
losses on a default and foreclosure.
The lender can enter into an agreement with both the buyer and seller
for the buyer’s assumption of the mortgage and a release of the seller’s
liability on the mortgage, called a novation. A novation agreement is
comparable to the existing lender originating a new mortgage with the
buyer, except the trust deed executed by the seller remains of record and
the note remains unpaid.
assumption agreement …………………………………………………… pg. 432
beneficiary statement …………………………………………………….. pg. 430
due-on clause …………………………………………………………………… pg. 430
nonrecourse ……………………………………………………………………… pg. 430
novation …………………………………………………………………………… pg. 433
purchase-money mortgage …………………………………………….. pg. 431
recourse mortgage ……………………………………………………………. pg. 431
subject-to transaction ……………………………………………………… pg. 430
Chapter 66
Summary
Chapter 66
Key Terms
Quiz 12 Covering Chapters 62-67 is located on page 617.
Chapter 67: Due-on-sale regulations 435
After reading this chapter, you will be able to:
• understand the nature of a due-on clause in trust deeds as a
restriction on the mobility of an owner’s title and pricing in times
of rising interest rates;
• explain ownership activities which trigger due-on enforcement
by mortgage holders;
• apply the exemptions barring mortgage holders from due-on
enforcement; and
• negotiate a limitation or waiver of a mortgage holder’s due-on
rights.
Due-on-sale
regulations
Chapter
67
A burden on the use and mobility of ownership is created by the existence
of the due-on clause buried within all trust deeds held by lenders and
carryback sellers.
The occurrence of an event triggering due-on enforcement automatically
allows the mortgage holder to:
• call the mortgage, demanding the full amount remaining due to be
paid immediately, also known as acceleration; or
• recast the mortgage, requiring a modification of the mortgage’s terms
as a condition for the mortgage holder’s consent to a transfer, called a
waiver by consent.
Mortgage
holder
interference
is federal
policy
acceleration
due-on clause
waiver agreement
Learning
Objectives
Key Terms
For a further discussion of this topic, see Chapter 22 of Real Estate
Finance.
436 Real Estate Principles, Second Edition
In times of stable or falling interest rates, mortgage holders usually permit
assumptions of mortgages at the existing note rate, unless a prepayment
penalty clause exists. Mortgage holders have no financial incentive to recast
mortgages, or call and relend the funds at a lower rate when interest rates are
dropping. [See Chapter 63]
However, in times of steadily rising rates, mortgage holders seize any event
triggering the due-on clause to increase the interest yield on their portfolio.
They employ title companies to advise them on recorded activity affecting
title to the properties they have mortgages on. Once the due-on clause is
triggered, the mortgage holder requires the mortgage to be recast at current
market rates as a condition for allowing an assumption, lease or further
encumbrance of the property by the owner.
Thus, real estate ownership encumbered by due-on trust deeds becomes
increasingly difficult to transfer as interest rates rise. This tends to imprison
owners in their home as they are unable to sell and relocate without
accepting a lower price.
Due-on clauses are most commonly known as due-on-sale clauses.
However, “due-on clause” is a more accurate term. A sale is not the only event
triggering the clause. Still, as the name “due-on-sale” suggests, the primary
event triggering the mortgage holder’s due-on clause is a sale of property
which is subject to the mortgage holder’s trust deed lien.
The due-on clause is triggered not only by a transfer using a grant deed or
quitclaim deed, but by any conveyance of legal or equitable ownership of
real estate, recorded or not. [See RPI Form 404 and 405]
Examples include a:
• land sales contract [See RPI Form 168];
• lease-option sale [See RPI Form 163]; or
• other wraparound carryback devices, such as an all-inclusive trust
deed (AITD). [See RPI Form 421]
The due-on clause is also triggered by:
• a lease with a term over three years; or
• a lease for any term when coupled with an option to buy.1
This interference addresses owners of commercial income property which
they lease to user tenants. Typically, the owners want long-term leases which
run more than three years in their term. Here, the leasing periods have to be
held to three year each, the initial term, and each extension of the periods of
occupancy under a lease agreement. Otherwise, the mortgage holder can call
the mortgage if the initial period is more than three years, or when exercised
the extension of the lease term is for more than three years.
1 12 Code of Federal Regulations §591.2(b)
Economic
recessions
and
recoveries
acceleration
A demand for
immediate payment of
all amounts remaining
unpaid on a loan or
extension of credit by
a mortgage lender or
carryback seller.
Due-on-sa
le
due-on clause
A trust deed provision
used by lenders to call
the loan immediately
due and payable, a
right triggered by the
owner’s transfer of
any interest in the real
estate, with exceptions
for intra-family
transfers of their home.
Due-on-lease
Chapter 67: Due-on-sale regulations 437
A senior mortgage holder may call a mortgage due on completion of the
foreclosure sale by a junior mortgage holder on any type of real estate. A
trustee’s deed on foreclosure is considered a voluntary transfer by the owner,
since the power of sale authority in the junior trust deed was agreed to by the
owner of the real estate.
The due-on clause is not only triggered by the voluntarily agreed-to trustee’s
sale. It is also triggered by any involuntary foreclosure, such as a tax lien sale.2
Federal regulations allow due-on enforcement on any transfer of real estate
which secures the lien, whether the transfer is voluntary or involuntary.3
Transfers of real estate which trigger due-on enforcement include the
inevitable transfer resulting from the death of a vested owner. However,
2 Garber v. Fullerton Savings and Loan Association (1981) 122 CA3d 423 (Disclosure: the legal editor of this publication was an
attorney in this case.)
3 12 CFR §591.2(b)
Due-on-
foreclosure
Due-on-death
exceptions
Trust deed called or recast at the mortgage holder’s option
Events triggering the due-on clause
Sale:
• transfer of legal title (grant or quitclaim deed);
• land sales contract or holding escrow;
• court-ordered conveyance; or
• death.
Lease:
• lease for more than three years; or
• lease with an option to buy.
Further encumbrance:
• creation or refinance of a junior lien; or
• foreclosure by junior lienholder.
Transfers not triggering due-on enforcement (owner-occupied, four-or-less
residential)
• creation of junior lien where owner continues to occupy;
• transfers to spouse or child who occupies;
• transfer into inter vivos trust (owner obtains mortgage holder’s consent and
continues to occupy);
• death of a joint tenant; or
• transfer on death to a relative who occupies.
Sidebar
It has recently
come to our
attention…
438 Real Estate Principles, Second Edition
as with due-on enforcement triggered by further encumbrances, narrow
exceptions apply to the death of an owner who occupied a one-to-four unit
residential property.
For example, the transfer of a one-to-four unit residential property to a
relative on the death of the owner-occupant does not trigger the due-on
clause. However, this is conditioned on the relative becoming an occupant
of the property.4
Also, where two or more people hold title to one-to-four unit residential
property as joint tenants, the death of one joint tenant does not trigger due-
on enforcement.
However, at least one of the joint tenants, whether it was the deceased or
a surviving joint tenant, needs to have occupied the property when the
mortgage was originated. Conversely, occupancy is not required for a
surviving joint tenant who qualifies for the joint tenancy exception.5
In all other transfers, the death of a vested owner, joint tenant or other co-
owner triggers the mortgage holder’s due-on clause.
Federal due-on regulations bar due-on enforcement on the transfer of one-to-
four unit residential property to a spouse after a divorce, so long as the spouse
occupies the property.6
However, if the acquiring spouse chooses to lease the residential property
for any period of time rather than occupy it, the mortgage holder may call or
recast the mortgage.
The due-on clause is not triggered by an owner’s transfer of their one-to-four
unit residential property to a spouse or child who occupies the property.7
This inter-family transfer exception applies only to transfers from an owner
to a spouse or child. Any transfer from a child to a parent triggers due-on
enforcement.
An owner wishing to enter into a transaction to sell, lease or further encumber
their real estate without mortgage holder interference needs to first negotiate
a limitation or waiver of the mortgage holder’s due-on rights.
4 12 CFR §591.5(b)(1)(v)(A)]
5 12 CFR §591.5(b)(1)(iii)
6 12 CFR §591.5(b)(1)(v)(C)
7 12 CFR §591.5(b)(1)(v)(B)
Divorce and
inter-family
transfers
Waiver by
negotiation
and by
conduct
Chapter 67: Due-on-sale regulations 439
Lenders and carryback sellers are allowed to enforce due-on sale clauses
in trust deeds on most transfers of any interest in any type of real
estate. The occurrence of an event which triggers due-on enforcement
automatically allows the mortgage holder to call or recast the mortgage.
In times of rising rates, mortgage holders seize any event triggering the
due-on clause to increase the interest yield on their portfolio.
The due-on clause is triggered by any conveyance of legal or equitable
ownership of real estate, such as a sale. A due-on clause is also triggered
by:
• a lease with a term over three years;
• a lease for any term when coupled with an option to purchase;
• further encumbrance of a non-owner-occupied, one-to-four unit
residential property; and
• on completion of the foreclosure sale by a junior mortgage holder
or carryback seller on any type of real estate.
Further, transfers of real estate resulting from the death of a vested
owner also trigger due-on enforcement, with some narrow exceptions
based on occupancy of residential property.
Exceptions to due-on enforcement exist. Due-on enforcement based
on the further encumbrance of an owner-occupied, one-to-four unit
residential property is not permitted. Similarly, the due-on clause is not
triggered by an owner’s transfer of property to a spouse or child who then
occupies the property, or on the transfer of one-to-four unit residential
property to a spouse after a divorce if the spouse occupies the property.
An owner wishing to sell, lease or further encumber their real estate
without mortgage holder interference needs to first negotiate a
limitation or waiver of the mortgage holder’s due-on rights.
Chapter 67
Summary
Waiver agreements are trade-offs. In return for waiving or agreeing to limit
the exercise of its due-on rights in the future, the mortgage holder demands
consideration such as:
• additional points if an origination;
• additional security;
• principal reduction;
• increased interest;
• a shorter due date; or
• an assumption fee.
waiver agreement
An agreement in
which a mortgage
holder consents to
the owner’s present
or future transfer of
an interest in the
mortgaged property
as a waiver of the
mortgage holder’s due-
on rights. Also known
as an assumption
agreement. [See RPI
Form 431 and 432]
440 Real Estate Principles, Second Edition
Quiz 12 Covering Chapters 62-67 is located on page 617.
acceleration ……………………………………………………………………… pg. 436
due-on clause ……………………………………………………………………. pg. 436
waiver agreement ……………………………………………………………. pg. 439
Chapter 67
Key Terms
Chapter 68: Reinstatement and
redemption
441
After reading this chapter, you will be able to:
• understand how a property owner or junior lienholder terminates
foreclosure proceedings by reinstating or redeeming a mortgage;
• distinguish the timeframes an owner has to cure a default and
reinstate the mortgage from periods for trustee’s notices, postings
and advertising periods;
• advise a client on their financial options when faced with
foreclosure; and
• recognize defaults curable only by redemption.
Learning
Objectives
Reinstatement and
redemption
Chapter
68
acceleration
future advances
power-of-sale provision
redemption
reinstatement
For a further study of this discussion, see Chapter 47 of Real Estate
Finance.
Trust deeds securing a debt obligation contain a boilerplate provision
authorizing mortgage holders to call due and payable all amounts remaining
unpaid after a material default on the trust deed, called an acceleration
clause. Similarly, the trust deed under its power-of-sale provision
authorizes the trustee to initiate a non-judicial foreclosure sale of the property
on a declaration of default and instructions to foreclose from the beneficiary.
Under the power-of-sale provision, the trustee records a notice of default
(NOD) to initiate the trustee’s foreclosure procedures when instructed by the
beneficiary to do so. As a result of the tandem effect of the acceleration clause
Nullifying the
mortgage
holder’s
call during
foreclosure
Key Terms
442 Real Estate Principles, Second Edition
when an NOD is recorded, all sums remaining to be paid on the note and
trust deed become due and immediately payable, subject to the owner’s and
junior lienholder’s reinstatement rights.
After an NOD is recorded and prior to five business days before the trustee’s
sale, the owner can terminate the foreclosure proceedings by paying:
• the delinquent amounts due on the note and trust deed as described in
the NOD and foreclosure charges, called reinstatement;1 or
• the entire amount due on the note and trust deed, plus foreclosure
charges, called redemption.2
A trust deed on which a foreclosure has been initiated is reinstated when the
beneficiary receives:
• all amounts referenced as delinquent in the NOD, including principal,
interest, taxes and insurance (collectively known as PITI), assessments,
and advances;
• installments that become due and remain unpaid after the recording
of the NOD;
• any future advances made by the beneficiary after the recording of the
NOD to pay taxes, senior liens, assessments, insurance premiums, and
to eliminate any other impairment of the security; and
• costs and expenses incurred by the mortgage holder to enforce the trust
deed, including statutorily limited trustees fee’s or attorney fees.3
After an NOD is recorded, an owner or junior lienholder may bring current
any monetary or curable default stated in the NOD prior to five business
days before the trustee’s sale, called the reinstatement period. If the sale is
postponed, the reinstatement period is extended, ending the day before the
fifth business day prior to the postponed sale date.4 [See Figure 1]
Until the NOD is recorded by a trustee, the beneficiary is compelled to accept
the tender of all delinquent amounts noticed in the NOD.
After recording the NOD, the mortgage holder’s trustee needs to allow three
months to pass before advertising and posting notice of the date of the
trustee’s sale.5 [See Figure 1]
The trustee needs to begin advertising and post a Notice of Trustee’s Sale
(NOTS) at least 20 days before the date of the sale. The property may be sold
by the trustee no sooner than the twenty-first day after advertising begins
and the posting of notice occurs.6 [See Figure 1]
1 Calif. Civil Code §2924c
2 CC §2903
3 CC §2924c(a)(1)
4 CC §2924c(e)
5 CC §2924
6 CC §2924f(b)
After the NOD
is recorded
acceleration
A demand for
immediate payment of
all amounts remaining
unpaid on a loan or
extension of credit by
a mortgage lender or
carryback seller.
power-of-sale
provision
A trust deed provision
authorizing the
trustee to initiate
a non-judicial
foreclosure sale of the
described property on
instructions from the
beneficiary.
redemption
A property owner or
junior lienholder’s
right to clear title
to property of a
mortgage lien prior
to the completion
of a trustee’s sale or
following a judicial
foreclosure sale by
paying all amounts
due on the mortgage
debt, including
foreclosure charges.
Chapter 68: Reinstatement and redemption 443
Additionally, if the billing address for the owner is different than the address
of a residential property in foreclosure, the NOTS needs to be accompanied by
a notice to the occupants regarding their rights during and after foreclosure.7
[See RPI Form 573]
The owner in foreclosure is not allowed to delay the trustee’s sale by
requesting a postponement.8
Thus, the owner or junior lienholder has approximately 105 days after
recording the NOD to cure the default and reinstate the note and trust deed.
Doing so avoids a full payoff or foreclosure of the property.
To determine the last day for reinstatement of the note and trust deed,
consider a trustee’s sale scheduled for a Friday. Count back five business
days beginning with the first business day prior to the scheduled Friday sale.
Since weekends are not business days, the fifth day counting backward from
the scheduled trustee’s sale is the previous Friday (if no holidays exist).
7 CC §2924.8
8 CC §2924g
reinstatement
A property owner or
junior lienholder’s
right to reinstate a
mortgage and cure any
default prior to five
business days before
the trustee’s sale by
paying delinquent
amounts due on the
note and trust deed,
plus foreclosure
charges.
Reinstatement
of the note
and trust deed
Trustee’s
Notices
* NOD = Notice of
Default
** NOTS = Notice of
Trustee’s Sale
Owner’s
Right to
Cure
Reinstatement
Period
Redemption Period
Three Month Period
20 Day Advertising
Period
• no less than 3 months and 10 days
• pay off mortgage holder’s demand and
trustee’s fees and costs
• five business days before trustee’s
sale
• pay off mortgage holder’s demand and
trustee’s fees and costs
• a unit in a CID has an additional 90 days
after the trustee’s sale foreclosing on an
HOA assessment lien to redeem the unit
• trustee’s fees due
• trustee’s fee increase
D
el
a
y
i
n
R
ec
o
rd
in
g
N
O
D
R
ec
o
rd
ed
*
D
a
y
o
f
Tr
u
st
ee
’s
S
a
le
N
O
TS
R
ec
o
rd
ed
**
Periods for Notices and Reinstatement Figure 1
Periods for
Notice and
Reinstatement
444 Real Estate Principles, Second Edition
Thus, the very last day to reinstate the mortgage is on the Thursday eight
calendar days before the trustee’s sale.
The mortgage holder’s failure to identify or include the dollar amount of
all known defaults in the NOD does not invalidate the NOTS. Further, the
mortgage holder may enforce payment of any omitted defaults by recording
another, separate NOD.9
On reinstatement of the note and trust deed, the NOD is rescinded by the
trustee, removing the recorded default from the title to the property.10
Any call due to a default is eliminated when the note and trust deed have
been reinstated. Upon reinstatement, the owner continues their ownership
of the property as though the mortgage had never been in default.
Failure to cure a default before the reinstatement period expires allows a trust
deed holder to require the owner to redeem the property prior to completion
of the trustee’s sale by:
• paying all sums due under the note and trust deed; and
• reimbursing the costs of foreclosure.
The owner’s right of redemption runs until the trustee completes the bidding
and announces the property has been sold. Any owner, junior lienholder,
or other person with an interest in the property may satisfy the debt and
redeem the property prior to the completion of the trustee’s sale.11
To redeem the property, the owner or junior lienholder is required to pay:
• the principal and all interest charges accrued on the principal;
• permissible penalties;
• foreclosure costs; and
• any future advances made by the foreclosing mortgage holder to
protect its security interest in the property.
Unless all amounts due on the note and trust deed resulting from the owner’s
default are paid in full during the redemption period, the owner will lose
ownership to the property at the trustee’s foreclosure sale.
When the owner fails to meet their obligations regarding the care, use and
maintenance of the secured real estate, the owner is in default under the
waste provision in the trust deed. The default on the trust deed exists even
though the owner may be current on all payments called for in the note.
Other activities are considered a default on the trust deed, such as the owner’s
failure to pay:
• property taxes;
9 CC §2924
10 CC §2924c(a)(2)
11 CC §2903
Redemption
Mortgage
holder
remedies on
a default
Chapter 68: Reinstatement and redemption 445
The owner’s
alternatives
Aside from reinstatement and redemption, an owner of property has several other
options when faced with losing their property through foreclosure:
1. Refinance — The owner obtains a new mortgage to pay off the one in default.
2. Foreclosure consultant — The owner seeks the services of a financial advisor or
investment counselor, called a foreclosure consultant. For a fee, a foreclosure
consultant will:
• prevent a mortgage holder from enforcing or accelerating the note;
• help the owner reinstate the mortgage or receive an extension of the
reinstatement period; or
• arrange a mortgage or an advance of funds for the owner. [CC §2945.1(a)]
A property owner grappling with foreclosure can obtain similar services at no
cost from a mortgage counselor subsidized by the federal government.
3. Deed-in-lieu — The owner deeds the property directly to the mortgage holder
in exchange for cancelling the secured debt.
4. Litigate — The owner disputes the validity of the foreclosure by filing an action,
restraining and enjoining the foreclosure.
5. Bankruptcy — The owner files for bankruptcy protection which automatically
stays the foreclosure until a release of the stay is obtained by the mortgage
holder from the court. [11 United States Code §362(a)]
Unless the owner can make up the de fault or have the mortgage amount
“crammed down” as part of the reorganization plan, bankruptcy only delays
the inevitable foreclosure. Once the automatic stay is lifted, the foreclosure
sale may take place no sooner than seven calendar days later. [CC §2924g(d)]
6. Sale — The owner sells the property before the trustee’s sale.
A recorded notice of default (NOD) needs to state the owner has the right to sell
their property which is in foreclosure. [CC §2924c(b)]
In an effort to protect owners from being unlawfully deprived of the equity in
their property when selling the property during the foreclosure period, special
requirements exist for purchase agreements between owners and equity
purchase investors on owner-occupied, one-to-four unit residential property in
foreclosure. [CC §1695 et seq; see Chapter 70]
However, selling property in foreclosure is difficult for the owner, due to time
constraints and the difficulty of finding a buyer able to meet the financing
needs to assume or payoff existing mortgages, cure defaults and correct the
deferred maintenance on the property.
7. Walk — The owner simply vacates the property when the mortgage holder
completes foreclosure.
This is an economically viable alternative for an owner with little or no cash
investment in the property, especially if payments saved during continued
occupancy exceed the cash invested and the mortgage balance exceeds the
property’s value.
446 Real Estate Principles, Second Edition
• hazard insurance premiums;
• assessments; and
• amounts due on senior trust deed liens.
A trust deed holder may advance funds to cure a default on the trust deed or
preserve the value of the property. The amount of the advance is then added
to the debt owed by authority of the trust deed’s future advances provision.
The trust deed holder may then demand the immediate repayment of the
advance from the owner.
A property owner’s ability to reinstate a mortgage by curing a default
depends on the trust deed provision in default.
For example, an owner of real estate encumbered by a trust deed fails to pay
property taxes. The trust deed mortgage holder records an NOD, specifying
the delinquent property taxes as the owner’s default under the trust deed.
Can the property owner reinstate the mortgage and retain the property by
eliminating the default?
Yes! The default is monetary, entitling the owner to reinstate the mortgage
by simply paying the delinquent property taxes, and the trustee’s fees and
charges incurred in the foreclosure proceeding.
Some trust deed defaults do not allow debt to be reinstated. Reinstatement
of the note on those defaults is only available if agreed to by the mortgage
holder. Defaults triggering a call and requiring redemption of the property
by a payoff of the entire debt without the ability to reinstate the trust deed
include:
• a breach of a due-on clause;
• a waste provision; or
• a violation of law provision in the use of the property.
future advances
A trust deed provision
authorizing a mortgage
holder to advance
funds for payment of
conditions impairing
the mortgage holder’s
security interest
in the mortgaged
property, such as
delinquent property
taxes, assessments,
improvement bonds,
mortgage insurance
premiums or
elimination of waste.
[See RPI Form 450
§2.5]
Trust deed
defaults and
reinstatement
Defaults
cured only by
redemption
Chapter 68: Reinstatement and redemption 447
Trust deeds contain a boilerplate acceleration provision authorizing
mortgage holders to call the mortgage after a material default on the trust
deed. Similarly, the trust deed’s power-of-sale provision authorizes the
beneficiary to instruct the trustee to initiate a non-judicial foreclosure
sale of the property.
After the NOD has been recorded and prior to five business days before
the trustee’s sale, the owner may terminate the foreclosure proceedings
by paying:
• the delinquent amounts due on the note and trust deed, plus
foreclosure charges, called reinstatement; or
• the entire amount due on the note and trust deed, plus foreclosure
charges, called redemption.
The owner or junior lienholder has approximately 105 days after
recording the NOD to cure the default and reinstate the note and trust
deed. Doing so avoids a full payoff or foreclosure sale of the property.
On reinstatement of the note and trust deed, the NOD is rescinded by
the trustee, removing the recorded default from the title of the property.
The owner continues their ownership of the property as though the
trust deed had never been in default.
A property owner’s ability to reinstate a trust deed by curing a default
depends on the trust deed provision in default.
Failure to cure a default before the reinstatement period expires allows
a trust deed holder to require the owner to redeem the property and
avoid the trustee’s sale by:
• paying all sums due under the note and trust deed; and
• reimbursing the costs of foreclosure prior to completion of the
trustee’s sale.
The owner’s right of redemption exists until the trustee completes the
bidding and announces the property has been sold.
Other activities are considered a default on the trust deed, such as the
owner’s failure to maintain the property, called waste, or failure to pay:
• property taxes;
• hazard insurance premiums;
• assessments; or
• amounts due on senior trust deed liens.
A trust deed holder may advance funds to cure a default on the trust
deed and then add the advance to the debt owed. The trust deed holder
may then demand the immediate repayment of the advance from the
owner.
Chapter 68
Summary
448 Real Estate Principles, Second Edition
acceleration ……………………………………………………………………… pg. 442
future advances ……………………………………………………………….. pg. 446
power-of-sale provision ………………………………………………….. pg. 442
redemption ………………………………………………………………………. pg. 442
reinstatement ………………………………………………………………….. pg. 443
Chapter 68
Key Terms
Quiz 13 Covering Chapters 68-72 is located on page 618.
Chapter 69: Trustee’s foreclosure procedures 449
After reading this chapter, you will be able to:
• advise on an owner’s rights during the different periods in the
trustee foreclosure process;
• understand the pre-foreclosure workout process mandated for
one-to-four unit residential property; and
• counsel buyers and owners on the procedures for a trustee’s sale,
including advertising, postponing, and accepting bids.
Learning
Objectives
Trustee’s foreclosure
procedures
Chapter
69
bona fide purchaser (BFP)
Declaration of Default and
Demand for Sale
full credit bid
non
judicial foreclosure
notice of default (NOD)
power-of-sale provision
pre-foreclosure workout
recourse mortgage
rescind
surplus funds
trustee
trustee’s sale guarantee
Key Terms
For a further study of this discussion, see Chapter 49 of Real Estate
Finance.
A lender or carryback seller holding a note secured by a trust deed in default
has two foreclosure methods available to enforce collection of the secured
debt. These two foreclosure methods are:
• a judicial foreclosure sale, also called a sheriff’s sale [See Chapter
70];1 or
• a nonjudicial foreclosure sale, also called a trustee’s sale.2
1 Calif. Code of Civil Procedure §726
2 Calif. Civil Code §2924
Power-of-sale
provision
nonjudicial
foreclosure
When property is sold
at a public auction by
a trustee as authorized
under the power-of-
sale provision in a trust
deed.
450 Real Estate Principles, Second Edition
The key to the trust deed holder’s ability to nonjudicially foreclose by a
trustee’s sale on the secured real estate is the power-of-sale provision
contained in the trust deed. [See Figure 1]
Other security devices used to create a lien on real estate to secure a debt
which may also contain a power-of-sale provision include:
• a land sale contract [See RPI Form 165];3
• a lease-option sale [See RPI Form 163 §19];
• a UCC-1 financing statement;4 or
• the conditions, covenants and restrictions (CC&Rs) of a homeowners’
association (HOA) for collection of assessments.5
The grant of the power-of-sale provides a private contract remedy for the
recovery of money. The power-of-sale is voluntarily agreed to by the owner
of the secured property, authorizing the secured creditor on a default to hold
a nonjudicial foreclosure sale by public auction.6
However, if the note evidences a recourse debt with a remaining balance
exceeding the fair price of the mortgage holder’s security position in real
estate, the mortgage holder may choose a judicial foreclosure. A judicial
foreclosure allows the lienholder to seek a money judgment for any deficiency
in the property’s value to satisfy the debt. [See Chapter 70]
However, by foreclosing under the power-of-sale provision, the lienholder
avoids a costly (and potentially time consuming) court action for judicial
foreclosure.
Editor’s note — When a mortgage holder completes a nonjudicial foreclosure
by trustee’s sale, they cannot later obtain a deficiency judgment against the
owner of the secured real estate. Alternatively, the owner cannot redeem
the property after the mortgage holder’s trustee’s sale as they can after a
judicial foreclosure sale. [See Chapter 70]
A trust deed is a security device which imposes a lien on real estate. The
trust deed creates a fictional trust which appears to “hold title” to the secured
real estate for the benefit of the lienholder.
Thus, a trust deed has three parties:
• at least one trustor (the owner(s) of the secured real estate);
3 Petersen v. Hartell (1985) 40 C3d 102
4 Lovelady v. Bryson Escrow, Inc. (1994) 27 CA4th 25
5 CC §1367
6 CC §2924
power-of-sale
provision
A trust deed provision
authorizing the
trustee to initiate
a non-judicial
foreclosure sale of the
described property on
instructions from the
beneficiary.
recourse mortgage
A mortgage debt in
which a lender may
pursue collection from
a property owner for a
loss due to a deficiency
in the value of the
secured property to
fully satisfy the debt if
the lender forecloses
judicially.
Who
conducts the
sale
GRANTS TO TRUSTEE IN TRUST, WITH POWER OF SALE
3.6 TRUSTEE’S SALE — On default of any obligation secured by this Deed of
Trust and acceleration of all sums due. Beneficiary may instruct Trustee to
proceed with a sale of the secured property under the power of sale granted
herein, noticed and held in accordance with Calif. Civil Code §2924 et seq.
Figure 1
Excerpt from
Form 450
Long Form
Trust Deed and
Assignment of
Rents
Long Form Trust Deed and Assignment of Rents
– Securing a Promissory Note
Chapter 69: Trustee’s foreclosure procedures 451
• a trustee who need not be named; and
• at least one beneficiary (a lender, carryback seller, HOA or other
lienholder).
The trustee’s sale is conducted by the trustee who is either:
• named in the trust deed; or
• appointed by the beneficiary of the trust deed at the time the beneficiary
initiates the foreclosure process.
A broker, attorney, trust deed service, subsidiary of the lender, or the lender
itself may be appointed at any time as the trustee.
The trustee begins foreclosure by recording a notice of default (NOD). The
trustee ends the process on delivery of the trustee’s deed and disbursement of
any sales proceeds.7 [See Figure 2, RPI Form 471]
Generally, trust deeds are prepared and distributed by title or escrow
companies naming their corporation as the trustee. However, a trust deed or
other security device does not need to name the trustee at all. The beneficiary
later simply appoints a trustee to handle the NOD or reconveyance. [See RPI
Form 450]
Also, the beneficiary may appoint a substitute trustee to replace the trustee
named in the trust deed.
Before recording an NOD on a trust deed securing a purchase-assist mortgage
on a borrower’s principal residence, a mortgage holder needs to conduct a
pre-foreclosure workout with the owner.
At least 30 days prior to recording an NOD, the mortgage holder needs to
contact the borrower to:
• assess the borrower’s financial situation;
• explore options for the borrower to avoid foreclosure;
• advise the borrower of their right to an additional meeting within 14
days to discuss their financial options;
• provide borrowers with the toll-free Department of Housing and Urban
Development (HUD) phone number to find a HUD-certified housing
counseling agency; and
• in the event personal or phone contact cannot be made, the mortgage
holder is to exercise due diligence through further attempts to contact
the borrower.
If the mortgage holder is unable to make contact with the borrower, the
mortgage holder sends the borrower a certified letter, return receipt requested,
containing a toll-free number with access to a representative during business
hours.
7 Bank of America National Trust & Savings Association v. Century Land & Water Co. (1937) 19 CA2d 194
trustee
One who holds title to
real estate in trust for
another.
notice of default
(NOD)
The notice filed to
begin the nonjudicial
foreclosure process.
Generally, the NOD is
filed following three
or more months of
delinquent mortgage
payments.
Pre-
foreclosure
workout prior
to NOD
pre-foreclosure
workout
Negotiations between
a mortgage holder and
defaulting property
owner with the
purpose of exploring
options to avoid
foreclosure.
Long Form Trust Deed and Assignment of Rents
– Securing a Promissory Note
452 Real Estate Principles, Second Edition
A trustee’s actions under a power-of-sale provision are strictly controlled by
California statutes. To successfully complete a trustee’s foreclosure sale, the
trustee and beneficiary of the trust deed are to adhere to the procedures fully
detailed in the foreclosure statutes for handling a trustee’s sale.8
The foreclosure process has three stages:
1. the notice of default (NOD) is recorded and mailed;
2. the notice of trustee’s sale (NOTS) is recorded, posted and mailed; and
3. the trustee’s sale of the real by auction, trustee’s deed and distribution
of sales proceeds
8 Garfinkle v. Superior Court of Contra Costa County (1978) 21 C3d 268
The stages of
foreclosure
For a full-size, fillable copy of this or any
other form in this book that may be used
in your professional practice, go to
realtypublications.com/forms
Figure 2
Form 471
Notice of
Default with
Substitution of
Trustee
Chapter 69: Trustee’s foreclosure procedures 453
While the trustee is concerned about the three stages for processing the
foreclosure, the owner of the real estate and the beneficiary are concerned
primarily with two different periods of time which control payment of the
debt:
• the reinstatement period, which runs from the recording of the
NOD and ends prior to five business days before the trustee’s sale; and
• the redemption period, which also runs from the recording of the
NOD but ends with the completion of the trustee’s sale of the secured
property. [See Chapter 68]
When a trust deed is in default and the beneficiary has chosen to foreclose,
the beneficiary delivers a Declaration of Default and Demand for Sale
to the trustee.
The declaration contains instructions directing the trustee to initiate
foreclosure on the secured real estate as authorized under the power-of-sale
provision contained in the trust deed. [See Figure 2, RPI Form 471]
Even though the trustee may have received the beneficiary’s declaration of
default, the trustee’s foreclosure process and the periods imposing rights and
obligations do not begin until the trustee or beneficiary records a notice of
default (NOD).9
Once the NOD is recorded, the trustee is to strictly follow statutory notice
requirements. To be assured the required notices are served on all the proper
persons, the trustee orders a trustee’s sale guarantee from a title company
before or at the time the NOD is recorded. [See Chapter 69]
The trustee’s sale guarantee provides coverage to the trustee for failure to
serve notices on any party due to an omission of that person’s identity in the
guarantee.
When ordering a trustee’s sale guarantee from a title insurance company,
the trustee instructs the title company to record the NOD in the office of the
county recorder in the county where the real estate is located.10
The NOD contains statutorily mandated statements which sets forth the
monetary default on the note or other obligation secured by the trust
deed.11
The NOD does not need to state the actual amounts of the monetary defaults
on the recurring obligations. However, the NOD needs to state the nature of
the present defaults on the note and the trust deed.12
To determine the amount needed to cure the default, the NOD directs the
owner seeking to reinstate the trust deed or redeem the property to contact
9 System Investment Corporation v. Union Bank (1971) 21 CA3d 137
10 CC §2924
11 CC §2924c(b)(1)
12 CC §2924c(a)(1)(B)
Trustee’s sale
guarantee
Declaration
of Default and
Demand for Sale
A document delivered
to the trustee under a
power of sale provision
by the mortgage holder
instructing the trustee
to initiate foreclosure
on the secured real
estate by recording
a notice of default
(NOD).
trustee’s sale
guarantee
A policy issued by
a title insurance
company to a trustee
before or at the time
the notice of default
is recorded providing
coverage for the trustee
should they fail to
serve notices on any
party of record due
to an omission in the
guarantee.
The notice of
default and
election to
sell
454 Real Estate Principles, Second Edition
the trustee. Thus, the trustee insulates the beneficiary from all direct contact
with the owner or junior lienholder after the date the NOD is recorded until
canceled or a trustee’s sale takes place.
Within 10 business days after recording the NOD, two copies of the NOD
are mailed to:
• the owner of the property;
• the administrator of a deceased owner’s estate; and
• each person who has recorded a request to receive a copy of the NOD.13
Within one month after recording the NOD, the trustee sends a copy of the
NOD by registered or certified mail and another copy by first-class mail to
holders of a recorded interest in the secured property.
Any person interested in obtaining a copy of the NOD who will not
automatically receive the notice records a request for NOD. The request for
NOD assures the interested person they will be notified of the default. [See
RPI Form 412]
A trustee or person depositing the NOD into the mail to give notice to others
is to prepare a proof of service and include a copy of the form with the NOD
in each mailing.14
A trustee or beneficiary may begin noticing the date set for the sale of a
property on the day following three months after the NOD is recorded.15
The date the sale will be held may be set for any business day, Monday through
Friday, between the hours of 9 a.m. and 5 p.m.16
In general practice, a date down of the trustee’s sale guarantee issued to the
trustee is ordered out from the title company the day before or on the day the
title company records the NOTS.
The date down notifies the trustee of any interests recorded on the title to the
property after the NOD is recorded. However, the trustee is not required to
give notice of the impending trustee’s sale to any person who recorded an
interest in the property after the NOD was recorded.17
The trustee prepares an NOTS which contains:
• the trustee’s name or their agent’s name, street address and telephone
number (or toll-free number if located out of state);
• the street address or common designation of the secured property;
• the county assessor’s parcel number of the secured property;
13 Estate of Yates v. West End Financial Corporation, Inc. (1994) 25 CA4th 511; CC §2924b(b)(1)
14 CC §2924b(e)
15 CC §2924
16 CC §2924g(a)
17 CC §2924b(c)(1)
Delivering the
NOD
The notice of
trustee’s sale
Chapter 69: Trustee’s foreclosure procedures 455
• the dollar amount of the debt in default, including reasonably
estimated advances for hazard insurance premiums, property taxes
due and foreclosure costs; and
• a statutory statement informing the owner they are in default.18 [See
RPI Form 474]
Further, if the mortgage secured by the trust deed was negotiated in Spanish,
the trust deed may contain a request for a Spanish-language NOD. The trustee
is then obligated to serve the owner an NOD translated into Spanish.19
At least 20 calendar days before the trustee’s sale, the trustee sends two
copies of the NOTS to each party the trustee previously sent the NOD.20
To ensure the sale at a public auction is properly advertised, the notice
requirements for the NOTS are more comprehensive than the notice
requirements for the NOD.
In addition to mailing the notice to all interested parties of record, the trustee
performs all of the following at least 20 calendar days prior to the sale:
• post a copy of the NOTS in one public place in the city of the sale, or
if the sale is not to be held in a city, the judicial district in which the
property is to be sold;
• post a copy of the NOTS in a conspicuous place on the property to be
sold; and
• start publishing a copy of the NOTS once a week for three consecutive
calendar weeks in a newspaper of general circulation in the city where
the property is located.21
A trustee’s sale is a public auction by private agreement where the property
is sold to the highest bidder.22
The trustee’s sale is held in the county where the secured real estate is
located.23
Before the auction begins, the trustee may:
• demand all prospective bidders to show evidence of their
financial ability to pay as a precondition to recognizing their bids; and
• hold the prospective bidders’ amounts to be bid.24
A bidder at auction can tender their bid amount in U.S. dollars in the form of:
• cash;
• a cashier’s check drawn on a state or national bank;
18 CC §2924f
19 CC §2924c(b)(1)
20 CC §2924b(c)(3)
21 CC §2924f(b)(1)
22 CC §2924h
23 CC §2924g(a)
24 CC §2924h(b)(1)
Delivering the
NOTS
Sold to the
highest
bidder
456 Real Estate Principles, Second Edition
• a check issued by a state or federal thrift, savings and loan association
(S&L), savings bank or credit union; or
• a cash equivalent designated by the trustee in the NOTS, such as a
money order.25
Each bid made at a trustee’s sale is an irrevocable offer to purchase the
property. However, any subsequent higher bid cancels a prior bid.26
The trustee’s sale is considered final on the trustee’s acceptance of the last
and highest bid.27
Once the highest bid has been accepted by the trustee, the trustee may require
the successful bidder to immediately deposit the full amount of the final bid
with the trustee.28
If the successful bidder tenders payment by a check issued by a credit union
or a thrift, the trustee can refrain from issuing the trustee’s deed until the
funds become available.29
If a successful bidder tenders payment by check and the funds are not
available for withdrawal:
• the trustee’s sale is automatically rescinded; and
• the trustee will send the successful bidder a notice of rescission for
failure of consideration.30
To hold a new trustee’s sale auction, the trustee sets a new trustee’s sale date
and records, serves and publishes a new NOTS. The new NOTS is to follow all
the same statutory requirements as the original NOTS.
The successful bidder who fails to tender payment when demanded is liable
to the trustee for all resulting damages, including:
• court costs;
• reasonable attorney fees; and
• the costs for recording and serving the new NOTS.31
The beneficiary is frequently the only bidder at the trustee’s sale. Thus, the
beneficiary automatically becomes the successful bidder.
The beneficiary may bid without tendering funds up to an amount equal to
the debt secured by the property being sold, plus trustee’s fees and foreclosure
expenses. This amount is called a full credit bid.32
If the beneficiary is the successful bidder under a full credit bid, the trustee
retains possession of the beneficiary’s note (or other evidence of the secured
debt) in exchange for the trustee’s deed to the property.
25 CC §2924h(b)(1)
26 CC §2924h(a)
27 CC §2924h(c)
28 CC §2924h(b)(2)
29 CC §2924h(c)
30 CC §2924h(c)
31 CC §2924h(d)
32 CC §2924h(b)
Failure to
deliver payment
of a bid
rescind
The cancellation of a
contract which restores
the parties to the same
position they held
before they entered
into the contract.
Bids by the
beneficiary, a
credit
full credit bid
The maximum amount
the foreclosing
mortgage holder
may bid at a trustee’s
sale without adding
cash, equal to the
debt secured by the
property being sold,
plus trustee’s fees and
foreclosure expenses.
Chapter 69: Trustee’s foreclosure procedures 457
The beneficiary is not required to bid the full amount of the indebtedness to
acquire the property at the trustee’s sale. The beneficiary can bid an amount
below the full amount of the debt, called an underbid.
On the completion of a trustee’s sale, the trustee uses a trustee’s deed to
transfer title to the property on to the successful bidder at the auction.
When a buyer other than the beneficiary purchases the property for value
and without notice of title or trustee’s sale defects, the buyer is considered a
bona fide purchaser (BFP). The title received by the third-party BFP is clear
of any interest claimed by the owner, lienholders or tenants whose interests
are junior to the foreclosed trust deed.33
The price paid for property by the successful bidder at a trustee’s sale
occasionally exceeds the amount of debt and costs due under the foreclosed
trust deed. The excess amounts are called surplus funds.
The trustee has a duty to distribute the surplus funds to the junior lienholders
and the owner(s). The gross proceeds from the trustee’s sale are distributed in
the following order:
• to pay the costs and expenses of the trustee’s sale, including trustee’s
fees or attorney fees;
• to pay the indebtedness secured by the property in default, including
advances made by the beneficiary;
• to satisfy the outstanding balance of junior lienholders of the property,
distributed in the order of their priority; and
• to the owner, the owner’s successor-in-interest or the vested owner of
record at the time of the trustee’s sale.34
33 Hohn v. Riverside County Flood Control and Water Conservation District (1964) 228 CA2d 605
34 CC §2924k(a)
Conveyance
by a trustee’s
deed
bona fide purchaser
(BFP)
A buyer who
purchases a property
for valuable
consideration in good
faith without notice
or knowledge of pre-
existing encumbrances
or conditions affecting
their right to full
ownership.
Surplus funds
surplus funds
The price paid for
property by the
successful bidder at a
trustee’s sale in excess
of the amount of debt
and costs due under
the foreclosed trust
deed.
A trust deed is a security device which imposes a lien on real estate.
A power-of-sale provision in the trust deed allows the deed holder
to nonjudicially foreclose by a trustee’s sale. By foreclosing using the
power-of-sale provision, the holder of a lien avoids a court action for
judicial foreclosure.
A trustee’s sale is conducted by a trustee either named in the trust deed
or appointed by the beneficiary at the start of the foreclosure process.
The trustee initiates nonjudicial foreclosure by recording and serving
a notice of default (NOD). Before recording an NOD on a one-to-four
Chapter 69
Summary
458 Real Estate Principles, Second Edition
residential property, a mortgage holder conducts a pre-foreclosure
workout with the owner to explore options to avoid foreclosure and
provide financial counseling to the owner.
Copies of the NOD are sent to the owner and each person who has
requested a copy within 10 business days after it was recorded, and to
recorded junior interests in the property within one month.
A trustee or beneficiary may begin noticing the date set for the sale of
a property by posting and serving a notice of trustee’s sale (NOTS) on
the day following three months after the day the NOD is recorded. If
the billing address of the defaulting owner is different from the secured
property’s address, residential tenants of the property are served with a
90-day notice to vacate.
Copies of the NOTS are sent to each party who received copies of the
NOD at least 20 calendar days before the trustee’s sale. The NOTS is also
posted in a public place in the city of the sale, posted in a conspicuous
place on the property to be sold, and published in a local newspaper for
three consecutive weeks prior to the sale.
A trustee’s sale is held in the county where the secured real estate is
located. A trustee’s sale is a public auction where the property is sold
to the successful bidder. The sale is considered final on the trustee’s
acceptance of the last and highest bid.
On completion of a trustee’s sale, the trustee uses a trustee’s deed to
convey title to the successful bidder. A successful bidder without notice
of title or sale defects is considered a bona fide purchaser (BFP) and
takes title clear of any claims to the property on interests junior to the
foreclosed trust deed.
bona fide purchaser (BFP) ……………………………………………….. pg. 457
Declaration of Default and Demand for Sale ………………… pg. 453
full credit bid ……………………………………………………………………. pg. 456
nonjudicial foreclosure ………………………………………………….. pg. 449
notice of default (NOD) …………………………………………………… pg. 451
power-of-sale provision ………………………………………………….. pg. 450
pre-foreclosure workout …………………………………………………. pg. 451
recourse mortgage …………………………………………………………… pg. 450
rescind ………………………………………………………………………………. pg. 456
surplus funds …………………………………………………………………… pg. 457
trustee ………………………………………………………………………………. pg. 451
trustee’s sale guarantee ………………………………………………….. pg. 453
Chapter 69
Key Terms
Quiz 13 Covering Chapters 68-72 is located on page 618.
Chapter 70: Judicial foreclosure 459
After reading this chapter, you will be able to:
• distinguish foreclosure proceedings as either judicial or
nonjudicial;
• discuss the procedural process of a judicial foreclosure;
• advise a client of their right to reinstate a mortgage in default or
redeem a property following a judicial foreclosure sale; and
• calculate any deficiency in value an owner may owe a mortgage
holder after a property has been sold at a judicial foreclosure sale.
Learning
Objectives
Judicial foreclosure
Chapter
70
certificate of sale
fair value hearing
foreclosure decree
judicial foreclosure
levying officer
lis pendens
litigation guarantee
money judgment
nonjudicial foreclosure
probate referee
recourse mortgage
Key Terms
For a further study of this discussion, see Chapter 48 of Real Estate
Finance.
When a mortgage is in default, the mortgage holder’s collection efforts are
limited to judicial or non-judicial activities, both of which are very structured.
If the note evidences a recourse debt, the mortgage holder may recover
against both the property and the named borrower.
To initiate either type of collection effort, the mortgage holder needs to first
exhaust the security by foreclosing on the real estate. The mortgage holder’s
security interest in a property is exhausted when the mortgage holder
completes a foreclosure sale on the property. Further, the mortgage holder’s
security interest is wiped out by a senior trust deed holder’s foreclosure.
Deficient
property
value;
recourse
paper
460 Real Estate Principles, Second Edition
Only when the note evidences a recourse debt may the mortgage holder
pursue a money judgment against the borrower for any deficiency in the
property’s value to fully satisfy the debt.1
Foreclosure is an activity comprised of notices and an auction to sell real
estate. Foreclosure of the property eliminates the right of redemption held
by the owner and any persons holding junior interests in the property. [See
Chapter 69]
A trust deed holder may foreclose on a property in one of two ways:
• judicial foreclosure, under mortgage law, also called a sheriff’s
sale;2 or
• nonjudicial foreclosure, under the power-of-sale provision in the
trust deed, also called a trustee’s sale.3 [See Chapter 69]
Judicial foreclosure is the court-ordered sale by public auction of the secured
property. The process can last from eight months to multiple years before it
is completed.
Alternatively, when a trust deed holder nonjudicially forecloses by a
trustee’s sale, the property is sold as authorized by the trust deed provisions
at a public auction, called a trustee’s sale. [See Chapter 69]
Trustee’s sales are considerably less expensive and quicker than judicial
foreclosures. A judicial sale requires the filing of a lawsuit, which includes:
• litigation expenses;
• appraisals; and
• attorney fees.
However, when the value of a secured property drops below the balance
owed on a recourse debt, the mortgage holder may elect to foreclose by judicial
action. A judicial foreclosure is the only foreclosure method which allows
a mortgage holder to obtain a money judgment against the borrower for
any deficiency in the value of the secured property to fully satisfy a recourse
debt.4
The first step in a judicial foreclosure is filing a complaint in the Superior
Court of the county where the property is located. The foreclosure complaint
names as defendants the original borrowers named in the trust deed as the
trustor or in the trust deed note. The complaint also names anyone else
holding a recorded interest in the secured property junior to the foreclosing
mortgage holder’s trust deed lien.
The mortgage holder foreclosing judicially needs to obtain a litigation
guarantee of title insurance. The litigation guarantee lists all parties with a
recorded interest in the property and their addresses of record. The guarantee
1 Calif. Code of Civil Procedure §726
2 CCP §725a
3 Calif. Civil Code §2924
4 CCP §580d
nonjudicial
foreclosure
When property is sold
at a public auction by
a trustee as authorized
under the power-of-
sale provision in a trust
deed.
Judicial
foreclosure
versus
nonjudicial
foreclosure
judicial foreclosure
The court-ordered
sale by public auction
of the mortgaged
property. Also known
as a sheriff’s sale.
Suing to
foreclose
litigation guarantee
A title insurance
policy which lists all
parties with a recorded
interest in a property
and their addresses
of record, ensuring
that all persons with
a recorded interest
in a property are
named and served in
litigation.
recourse mortgage
A mortgage debt in
which a lender may
pursue collection from
a property owner for a
loss due to a deficiency
in the value of the
secured property to
fully satisfy the debt if
the lender forecloses
judicially.
money judgment
An award for money
issued by a court
resulting from a
lawsuit for payment of
a claim.
Chapter 70: Judicial foreclosure 461
further ensures that persons with a recorded junior interest in the property
are named and served. Thus, their interest is also eliminated from title by the
judicial foreclosure sale.
At the time the lawsuit is filed, the foreclosing mortgage holder records a
Notice of Pending Action against the secured property, also called a lis
pendens.
The lis pendens places a cloud on the title of the secured property, giving
notice of the judicial foreclosure action and subjecting later acquired interests
to the results of the litigation.
Until the court enters a judgment ordering the sale of the secured property,
called a foreclosure decree, the borrower has the right to bring the
delinquencies current. A foreclosure decree ends the reinstatement
period. [See Chapter 69]
A foreclosure decree orders the sale of the real estate to satisfy:
• the outstanding debt; and
• cover foreclosure sale expenses incurred by the mortgage holder.5
The foreclosure decree also states whether the borrower will be held
personally liable for any deficiency in the property’s fair market value
(FMV) to satisfy the debt owed.6 FMV is never determined by the amount of
the high bid at the judicial foreclosure sale.
A judicial foreclosure sale is conducted by a court-appointed receiver or
sheriff, called a levying officer.
After the judicial foreclosure sale is ordered by the court, the foreclosing
mortgage holder is issued a writ of sale by the court clerk. The writ of sale
authorizes the receiver or sheriff to record a notice of levy. Both describe
the property to be sold and state the levy is against the security interest the
mortgage holder holds in title to the property under its trust deed lien.7
The receiver or sheriff who conducts the sale records the writ of sale and the
notice of levy in the county where the property is located. The receiver or
sheriff also mails the writ of sale and the notice of levy to the owner and any
occupant of the property.8
Similar to the notice of trustee’s sale used in a nonjudicial foreclosure, the
receiver’s or sheriff’s notice of sale states the necessary details of the auction,
such as the:
• date;
• time; and
5 CCP § 726(a), (b)
6 CCP §726(b)
7 CCP §712.010;
8 CCP §700.010
lis pendens
A notice recorded
for the purpose of
warning all persons
that the title or right
to possession of the
described real property
is in litigation.
The
foreclosure
decree
foreclosure decree
A court judgment
ordering the sale of
mortgaged property.
Notice of
Levy
levying officer
A court-appointed
receiver or sheriff who
conducts a judicial
foreclosure sale.
The notice of
judicial sale
462 Real Estate Principles, Second Edition
• location of the sale.9
When a deficiency judgment is sought by the foreclosing mortgage holder,
the notice of judicial sale also states:
• the property is being sold subject to the borrower’s right of redemption;
and
• the amount of the secured debt, plus accrued interest and foreclosure
costs.10
If a money judgment for any deficiency is prohibited, as occurs with a
nonrecourse debt, the receiver or sheriff waits at least 120 days after service
of the notice of levy before proceeding to notice the judicial sale.11
However, if the mortgage holder seeks a deficiency judgment, no waiting
period applies before noticing the sale. The receiver or sheriff may notice the
judicial sale immediately after the decree is issued.12
At least 20 days before the sale, the notice of judicial sale is:
• served on the borrower personally or by mail;13
• mailed to any person who has recorded a request for a notice of judicial
sale;14
• posted in a public place in the city or judicial district where the property
is located, and on the property itself; and
• published weekly in a local newspaper of general circulation.15
The public sale held by a court-appointed receiver or sheriff is conducted as
an auction. The property is sold to the highest bidder.16
Payment at the public sale is made in cash or by certified check at the time of
the sale. The foreclosing mortgage holder is entitled to a credit bid up to the
full amount of the debt owed. However, amounts over $5,000 permit a credit
transaction.17
If the successful bidder fails to pay the amount bid, the receiver may sell the
property to the highest bidder at a subsequent sale. The defaulting bidder is
liable for interest, costs and legal fees for their failure to pay their bid.18
The foreclosing mortgage holder is often the highest — or only — bidder at
a judicial sale. When intending to seek a deficiency judgment, the mortgage
holder needs to bid no less than an amount it believes the court will set as
the FMV of the property. Any successful bids for less than the property’s FMV
on the date of the sale will generate an uncollectible loss on the mortgage for
the mortgage holder.19
9 CCP §701.540(a)
10 CCP §729.010(b)(1)
11 CCP §701.545
12 CCP §729.010(b)(2), (3)
13 CCP §701.540(c)
14 CCP §701.550(a)
15 CCP §701.540(g)
16 CCP §701.570
17 CCP §701.590(a), (c)
18 CCP §701.600
19 Luther, supra
Highest
bidder
acquires the
property
Chapter 70: Judicial foreclosure 463
Figure 1
Collecting a
recourse debt
A certificate of sale is issued to the successful bidder on the completion of
a judicial sale.
Although the bidder purchased the property at the public auction, they will
not become the owner of the property or be able to take possession of it until
the applicable redemption period expires.20 [See Chapter 69]
The certificate of sale reflects the owner’s continuing right to redeem the
property and avoid losing it to the highest bidder.21
20 CCP §729.090
21 CCP §729.020
Judicial sale
completed
certificate of sale
A certificate issued to
the successful bidder
on the completion
of a judicial sale of a
property.
Collecting a recourse debt
Default on a secured mortgage
Judicial action
Notice of sale
Security
available
1 to 3 years
to complete
Foreclosure
suit filed
Reinstatement
available prior
to judgment
Deficiency:
Notice recorded
immediately
1-year
redemption
period
No deficiency:
120-days before
notice recorded
3-month
redemption
period
Security
exhausted
6 months to
2 years to
complete
Action filed
on the note
Money
judgment
464 Real Estate Principles, Second Edition
On a judicial foreclosure, if a trust deed secures a mortgage holder’s purchase-
assist mortgage on a buyer-occupied, one-to-four unit residence, or a seller
carryback note as a lien solely on the property sold no matter its use, the
property owner:
• is not liable for any deficiency in the property value to fully satisfy the
debt;22 and
• has three months after the judicial sale to redeem the property by
paying off the entire debt and costs.23
However, if the owner is liable on a recourse debt for a deficiency in the
property’s value, the owner has up to one year after the judicial sale to
redeem the property.24
The property can only be redeemed by the owner or the owner’s successor-
in-interest since all junior lienholders are wiped out by the judicial
foreclosure sale.
Successors-in-interest to the owner are lienholders or buyers who acquire
the owner’s interest in the property by deed prior to the judicial foreclosure
sale.25
The redemption price for the owner (or successor) to recover the property
sold at a judicial foreclosure sale is the total of:
• the price paid for the property by the highest bid at the judicial
foreclosure sale (even if it is less than the property’s FMV on that date);
• taxes, assessments, insurance premiums, upkeep, repair or
improvements to the property paid by the successful bidder; and
• interest on the above amounts at the legal rate on money judgments
(10%) from the date of the payments through the date the redemption
amount is tendered in full.26
On redemption, the owner (or successor) is entitled to:
• an offset for any net rents collected by the mortgage holder under an
assignment of rents provision in the trust deed; and
• an offset for the rental value of the premises for any period of time the
successful bidder occupied the property following the sale.27
If the property is not redeemed by the owner or successor within the
redemption period, the sale is final.28
22 CCP §580b
23 CCP §729.030
24 CCP §729.030
25 CCP §729.020;
26 CCP §729.060
27 CCP §§729.060, 729.090
28 CCP §729.080
Redemption
follows
foreclosure
Chapter 70: Judicial foreclosure 465
The remaining balance owed on a note may be greater than the fair price of
the mortgage holder’s security interest in the real estate. The spread when the
fair price is lower than the balance due is the deficiency in the value of the
property to cover the debt.
A money judgment for the deficiency in the property value to fully satisfy
the debt is available if not barred by anti-deficiency statutes. The mortgage
holder will be awarded a money judgment for any deficiency in value at a
hearing following the foreclosure sale. At the fair value hearing, noticed
within three months after the foreclosure sale, the amount of the deficiency
is set by the court.29
The amount awarded as a deficiency judgment is based on the debt owed on
the date of the judicial foreclosure sale, and the greater of:
• the FMV of the property on the date of the foreclosure sale, minus any
amounts owed on liens senior to the trust deed being foreclosed, the
result setting the fair price of the mortgage holder’s security interest; or
• the amount bid for the property at the judicial foreclosure sale.30
The mortgage holder is awarded a money judgment for the portion of the
debt not covered by the fair price of the mortgage holder’s secured position
on title, or the price bid at the sale if it is higher.
The mortgage holder and borrower present evidence at the fair value hearing
to establish the property’s FMV on the sale of the foreclosure sale. The court
may appoint an appraiser, called a probate referee, to advise the court on
the property’s FMV.31
29 CCP §§580a, 726(b)
30 CCP §580a
31 CCP §§580a, 726(b)
Obtaining a
deficiency
judgment
fair value hearing
The court proceeding
at which a money
judgment is awarded
for any deficiency in
the secured property’s
fair market value
(FMV) at the time of
the judicial foreclosure
sale to fully satisfy all
debt obligations owed
the mortgage holder.
probate referee
An appraiser
appointed by the court
in a judicial foreclosure
action to advise the
court on a property’s
fair market value
(FMV) on the date of
the judicial foreclosure
sale.
Judicial foreclosure is the court-ordered sale by public auction of the
secured property. A judicial foreclosure is the only foreclosure method
which allows a mortgage holder holding a recourse debt to obtain a
money judgment against the borrower for any deficiency in value of
the secured property to satisfy the debt.
The first step in a judicial foreclosure is filing a complaint in the Superior
Court of the county where the property is located. At the time the lawsuit
is filed, the foreclosing mortgage holder records a Notice of Pending
Action against the secured property, also called a lis pendens, to cloud
title of the secured property.
Until a foreclosure decree ordering the sale is issued by the court,
the borrower has the right to reinstate the mortgage by bringing any
delinquencies in the note and trust deed current.
Chapter 70
Summary
466 Real Estate Principles, Second Edition
Quiz 13 Covering Chapters 68-72 is located on page 618.
If the borrower does not reinstate the mortgage, the court will then
appoint a sheriff to conduct the sale by recording a writ of sale and
notice of levy.
At least 20 days before the sale, the notice of judicial sale is:
• served on the borrower personally or by mail;
• mailed to any person who has recorded a request for a notice of
judicial sale;
• posted in a public place in the city or judicial district where the
property is located, and on the property itself; and
• published weekly in a local newspaper of general circulation.
The sheriff’s sale is conducted as a public auction and the property is
sold to the highest bidder. A certificate of sale is issued to the successful
bidder on the completion of the judicial sale.
The successful bidder will not become the owner of the property until
the redemption period expires. The owner can redeem the debt by
paying the redemption price.
A money judgment for the deficiency in the property value to fully
satisfy the debt is available to the mortgage holder if not barred by anti-
deficiency statutes. The mortgage holder is awarded a money judgment
at a fair value hearing following the foreclosure sale.
certificate of sale ……………………………………………………………… pg. 463
fair value hearing ……………………………………………………………. pg. 465
foreclosure decree ……………………………………………………………. pg. 461
judicial foreclosure …………………………………………………………. pg. 460
levying officer …………………………………………………………………. pg. 461
lis pendens ……………………………………………………………………….. pg. 461
litigation guarantee ………………………………………………………… pg. 460
money judgment ……………………………………………………………… pg. 460
nonjudicial foreclosure ………………………………………………….. pg. 460
probate referee …………………………………………………………………. pg. 465
recourse mortgage …………………………………………………………… pg. 460
Chapter 70
Key Terms
Chapter 71: The homeowner is covered: an anti-deficiency primer 467
After reading this chapter, you will be able to:
• apply anti-deficiency rules available to a buyer to avoid mortgage
holder claims of personal liability for payment of nonrecourse
mortgage obligations;
• advise homeowners on California’s anti-deficiency protections
available to them on trust deed notes, refinancing, mortgage
modifications and short sales.
The homeowner is
covered: an anti-
deficiency primer
Chapter
71
anti-deficiency
purchase-money debt
short pay-off
For a further study of this discussion, see Chapter 45 of Real Estate
Finance.
Key Terms
Learning
Objectives
Mortgage debt under California’s anti-deficiency statutes is broken into two
types of obligations. All mortgage debt is categorized by responsibility for
payment as either:
• recourse; or
• nonrecourse. [See Chapter 69 and 70]
Nonrecourse debt is created by statute covering mortgages in two sets of facts:
• purchase-money debt of any priority on title (first, second or
even third trust deed), is a mortgage which funded the purchase
or construction of a homebuyer’s one-to-four unit owner-occupied
residence; or
Protected:
nonrecourse
mortgage debt
anti-deficiency
California legislation
limiting a mortgage
holder’s ability to
recover losses on a
default when the
mortgaged property’s
value is insufficient to
satisfy the mortgage
debt.
468 Real Estate Principles, Second Edition
• seller financing, also called a credit sale, installment sale or
carryback paper, on the sale of any type of real estate when the debt is
secured solely by the property sold.1
A mortgage holder holding a nonrecourse mortgage may not pursue the
homeowner personally to collect for a deficiency in the secured property’s
value to fully pay off the nonrecourse debt following any type of foreclosure,
judicial or nonjudicial. [See Chapter 69 and 70]
Recourse debt is any mortgage other than mortgages classified as nonrecourse
debt. A mortgage holder may only pursue a homeowner for a loss on a
recourse mortgage due to a deficiency in the price of the secured property
through judicial foreclosure, and then only if:
• the court-appraised value of the property at the time of the judicial
foreclosure sale is less than the debt; and
• the bid is for less than the debt owed.2
Refinanced purchase-money debt only retains its purchase-money
nonrecourse status if:
• the mortgage holder of the original purchase-money debt is the
refinancing mortgage holder;3
• the refinanced debt is substantially the same debt as the original
purchase-money debt;4 and
• the refinanced debt is secured by the same property as the original
purchase-money debt.5
In absence of any of the three conditions, the refinanced debt is considered
recourse debt subject to a mortgage holder’s money judgment for any
deficiency in the value at the time of the judicial foreclosure sale.
The same logic is used when considering whether the modification of a
purchase-money mortgage retains its nonrecourse status. If the modified
mortgage is secured by the same property as the original purchase-money
mortgage, modification of payments, interest rates or due dates do not change
the purchase-money status of the modified mortgage.6
The extension of nonrecourse status to the mortgage holder’s continuation
of the same debt under different terms for repayment is important.
Taxwise, nonrecourse status for a mortgage means any debt forgiven on the
modification is exempt from taxation as cancellation of debt income.
Additionally, a mortgage holder may not require a homeowner to waive
their anti-deficiency protection as a condition of granting a mortgage
1 Calif. Code of Civil Procedure §580b
2 CCP §580a
3 Union Bank v. Wendland (1976) 54 CA3d 393
4 DeBerard Properties, Ltd. v. Lim (1999) 20 C4th 649
5 Goodyear v. Mack (1984) 159 CA3d 654
6 DeBerard, supra
purchase-money
debt
A mortgage which
funds the purchase
or construction of
a one-to-four unit
owner-occupied
residence, also called a
nonrecourse debt.
Refinanced
purchase-money
debt: recourse
or not?
What about
mortgage
modifications?
Chapter 71: The homeowner is covered: an anti-deficiency primer 469
modification when the mortgage remains secured by the same property. The
result would simply be a magic trick performed by the mortgage holder to flip
nonrecourse into recourse status on a default — an unenforceable departure
from the legislative intent of anti-deficiency statutes.7
Anti-deficiency protection has also been extended to homeowners who
negotiate short payoffs (short sales) with their mortgage holders and close
a short sale to dispose of their homes.
Regardless of the recourse or nonrecourse status of the mortgage, a mortgage
holder who agrees to accept a shortpay from an owner-occupant on the sale
of a one-to-four unit residential property is barred from seeking a money
judgment for any loss incurred on the short sale.8
7 Palm v. Schilling (1988) 199 CA3d 63
8 CCP §580e
Special rules
for short
sales
short payoff
A sale in which the
lender accepts the net
proceeds at closing
in full satisfaction of
a greater amount of
mortgage debt.
There are two kinds of mortgage debt established by California’s anti-
deficiency statutes: nonrecourse or recourse debt.
Nonrecourse debt is:
• purchase-money debt of any priority which funded the purchase
or construction of a homebuyer’s one-to-four unit owner-occupied
residence; or
• seller carryback paper when the debt is secured solely by the
property sold.
A mortgage holder holding a nonrecourse debt may not pursue the
homeowner for a deficiency in the secured property’s value following a
judicial or nonjudicial foreclosure, unless the owner maliciously injures
the property causing its value to drop.
Refinanced purchase-money debt only retains its purchase-money
nonrecourse status if:
• the mortgage holder of the original purchase-money debt is the
refinancing mortgage holder;
• the refinanced debt is substantially the same debt as the original
purchase-money debt; and
• the refinanced debt is secured by the same property as the original
purchase-money debt.
If a modified mortgage is secured by the same property as the original
purchase-money mortgage, modification of payments, interest rates or
due dates do not change the purchase-money status of the modified
mortgage.
Chapter 71
Summary
470 Real Estate Principles, Second Edition
Regardless of the recourse or nonrecourse status of the mortgage, a
mortgage holder who agrees to accept a short payoff from an owner-
occupant of a one-to-four unit residential property is barred from
seeking a money judgment against the owner for any loss incurred on
the short sale.
anti-deficiency ………………………………………………………………… pg. 467
purchase-money debt ……………………………………………………… pg. 468
short pay-off …………………………………………………………………….. pg. 469
Chapter 71
Key Terms
Quiz 13 Covering Chapters 68-72 is located on page 618.
Chapter 72: Home mortgages interest deductions 471
After reading this chapter, you will be able to:
• understand the government policies encouraging tenants to
become homeowners through the mortgage interest tax deduction
(MID);
• distinguish when interest paid on a
home equity mortgage
secured by a principal or second residence is tax deductible;
• advise buyers on the ceiling thresholds for mortgage interest
deductions; and
• determine a buyer’s income tax reduction due to interest paid
on mortgages for the purchase or improvement of a principal
residence or second home by use of a tax analysis form.
Learning
Objectives
For a further discussion of this topic, see Chapter 1 and 2 of Tax Benefits
of Ownership.
Home mortgage
interest deductions
Chapter
72
adjusted gross income
(AGI)
fair market value (FMV)
home equity mortgage
itemized deductions
mortgage interest
deduction (MID)
points
principal residence
qualified interest
second home
Key Terms
The federal government has a long-standing policy of encouraging residential
tenants to become homeowners. The incentive provided by the government
to individual tenants comes in the form of a reduction in the income taxes
they pay. To qualify, they need to take out a mortgage to finance the
purchase of a residence or a vacation home.
Two residences,
two deductions
472 Real Estate Principles, Second Edition
For a residential tenant considering their income taxes, the monthly
payment on a purchase-assist home mortgage is not just a substitute for their
monthly rent payment — it also reduces their combined state and federal
income taxes.
A buyer’s agent representing prospective buyers in their purchase of a
single family residence (SFR) needs to be able to intelligently discuss this
tax reduction incentive. With knowledge about allowable ownership
deductions and tax bracket rates, they will be better able to persuade tenants
to buy based on the full range of financial benefits of homeownership.
Two categories of mortgages exist to control the deduction of interest paid
on any mortgages secured by the principal residence or second home, which
include:
• interest on the balances of purchase or improvement mortgages up to
a combined principal amount of $1,000,000; and
• interest on all other mortgage amounts up to an additional $100,000 in
principal, called home equity mortgages.
As a tax loophole for personal use expenditures, the home mortgage
interest deduction (MID) rule for income tax reporting allows mortgaged
homeowners to deduct from their adjusted gross income (AGI) the interest
paid on first and second homes to reduce their taxable income. The mortgage
interest is reported as an itemized deduction, if:
• the mortgages funded the purchase price or paid for the cost of
improvements for the owner’s principal residence or second home;
and
• the mortgages are secured by either the owner’s principal residence
or second home.1
Without the MID rule, interest paid on a mortgage which funded the
purchase or improvement of a principal residence or second home is not
deductible. These types of expenditures are for personal use, not a business
or investment use.
Also, interest paid on home equity mortgages secured by the property
owner’s principal residence or second home is deductible under the home
MID rules. These additional MID rules apply whether or not the mortgage’s
net proceeds were used for personal or business/investment purposes.
The mortgage interest deductions for the first and second home reduce the
property owner’s taxable income, and thus reduces the amount of tax they
will pay. As an itemized deduction, the accrued interest paid is subtracted
from the owner’s AGI under both the standard income tax (SIT) and the
alternative minimum tax (AMT) reporting rules. In contrast, the other
income tax loophole for real estate property tax deductions on the first and
second homes applies only to reduce the owner’s SIT, not their AMT.
1 Internal Revenue Code §163(h)
The MID
deduction
rule
home equity
mortgage
A junior mortgage
encumbering the
value in a home
remaining after
deducting the
principal on the senior
mortgage from the
market value of the
home.
mortgage interest
deduction (MID)
An itemized deduction
for income tax
reporting allowing
homeowners to
deduct interest and
related charges they
pay on a mortgage
encumbering their
primary or second
homes.
principal residence
The residential
property where the
homeowner resides a
majority of the year.
itemized deductions
Deductions taken by a
taxpayer for allowable
personal expenditures
which, to the extent
allowed, are subtracted
from adjusted gross
income (AGI) to set
the taxable income
for determining the
income tax due, called
Schedule A.
Chapter 72: Home mortgages interest deductions 473
Interest paid on mortgages and carryback credit arrangements originated
to purchase or substantially improve an owner’s first or second home
is deductible on combined principal balances of up to $1,000,000 for an
individual and for couples filing a joint return if the mortgage is secured by
either home.
Thus, if the mortgage funds are used to acquire, construct, or further improve
a principal residence or second home, and the mortgage funds collectively
exceed $1,000,000, only the interest paid on $1,000,000 of the mortgage
balances is deductible under this part of the MID rule.
Purchase/
improvement
mortgages
Form 351
Individual Tax
Analysis (INTAX)
474 Real Estate Principles, Second Edition
To qualify home improvement mortgages for interest deductions, the new
improvements need to be substantial. Improvements are substantial if
they:
• add to the property’s market value;
• prolong the property’s useful life; or
• adapt the property to residential use.
Mortgage funds spent on repairing and maintaining property to keep it
in good condition and maintain its value do not qualify as funding for
substantial improvements.2
Further additional deductions are permitted for interest paid on the excess
mortgage amounts, up to an additional $100,000. Interest on this additional
principal qualifies for deduction as interest paid on a home equity mortgage.
If an owner refinances a purchase/improvement mortgage, the portion of
the refinancing funds used to finance the payoff qualifies as a purchase/
improvement mortgage for future interest deductions. However, interest
may only be written off as a purchase/improvement mortgage on the
amount of refinancing funds used to pay off the principal balance on the
existing purchase/improvement mortgage, unless the excess monies funded
the further improvement of the home.
For example, consider an owner who borrows $200,000 to fund the purchase
of their principal residence. The mortgage balance is paid down to $180,000
and the owner refinances the residence, paying off the original purchase/
improvement mortgage. However, the new mortgage is for a greater principal
amount than the payoff demanded on the original mortgage.
In this scenario, interest on only $180,000 of the refinance mortgage is
deductible as interest paid on a purchase or improvement mortgage, unless:
• the excess funds generated by the refinance are used to improve the
residence; or
• the excess mortgage amount qualifies as a home equity mortgage
under its separate ceiling of $100,000 in principal.
Interest on mortgage amounts secured by the first or second home may not
qualify for the purchase/improvement home mortgage interest deduction.
This will be due either to a different use of the mortgage proceeds, or the
$1,000,000 mortgage limitation.
The interest on mortgage amounts secured by the first or second residence,
but do not qualify as a purchase/improvement mortgage, is deductible by
a couple as interest paid on additional or other mortgage amounts up to
$100,000 in principal.
2 IRC §163; Temporary Revenue Regulations §1.163-8T
second home
An individual’s
alternative residence
where they do not
reside a majority of the
year.
Refinancing
limitations
$100,000
home equity
mortgages
Chapter 72: Home mortgages interest deductions 475
For married persons filing separately, the cap for the principal amount of
equity mortgages on which interest may be deducted is limited to $50,000,
half of the joint $100,000 ceiling.3
Home equity mortgages are typically junior encumbrances, but also include
excess proceeds from a refinance which:
• do not qualify as purchase/improvement funds; or
• exceed the $1,000,000 ceiling.
The proceeds from home equity mortgages may be used for any purpose,
including personal uses unrelated to the property.
Interest paid on any portion of a mortgage balance which exceeds the fair
market value (FMV) of a residence is not deductible. In practice, the FMV
rule applies almost exclusively to home equity mortgages. This includes
refinancing proceeds of a greater amount than the balance paid off on the
purchase/improvement mortgage that was refinanced.4
The FMV of each residence is presumed to be the original amount of the
purchase price, plus any improvement costs. Thus, any future drop in
property value below the balance remaining on a purchase-assist mortgage
does not affect the interest deduction.5
To qualify for the MID, the mortgages need to be secured by the principal
residence or second home.
A principal residence is an individual’s home where the homeowner’s
immediate family resides a majority of the year, also called the primary
residence or first home. The principal residence is close to the homeowner’s
place of employment and banks which handle the homeowner’s accounts,
and its address is used for tax returns.6
A second home is any residence selected by the owner from year to year,
including:
• real estate;
• mobile homes;
• recreational vehicles; and
• boats.
If the second home is rented out for portions of the year, the interest qualifies
for the home mortgage interest deduction if the owner occupies the property
for more than 14 days or 10% of the number of days the residence is rented,
whichever number is greater.7
3 IRC §163(h)(3)(C)(ii)
4 IRC §163(h)(3)(C)(i)
5 Temp. Rev. Regs. §1.163-10T
6 IRC §163(h)(4)(A)(i)(I)
7 IRC §280A(d)(1)
Property
value ceiling
fair market value
(FMV)
The price a reasonable,
unpressured buyer
would pay for property
on the open market.
Qualifying
the principal
residence and
second home
476 Real Estate Principles, Second Edition
If the owner does not rent out their second home at any time during the year,
the property qualifies for the home mortgage interest deduction whether or
not the owner occupies it.8
Interest deductions on home mortgages are only allowed for interest which
has accrued and been paid, called qualified interest.9
Interest on first and second home mortgages is deducted from an owner’s
adjusted gross income (AGI) as an itemized deduction. Further, limitations
exist on the total amount of all deductions the homeowner may claim.
Conversely, business, rental or investment interest are adjustments that
reduce the AGI. Thus, the two types of home mortgage interest deductions
directly reduce the amount of the owner’s taxable income (if the interest
deductible is not limited by ceilings on the homeowner’s itemized deductions).
The inability to reduce the owner’s AGI by use of the home mortgage interest
makes a substantial difference for high income earners. The higher an owner’s
AGI, the lesser the amounts allowed for rental loss deductions, by itemized
deduction phaseout, and on any tax credits available to the owner.10
Points paid to a lender to originate a mortgage are considered prepaid
interest for both tax and financial purposes. One point equals 1% of the
mortgage amount. Points essentially buy down the mortgage’s par rate in
the market to the note rate, fixed for the life of the mortgage. Alternatively,
no points means a higher par rate of interest will be the nominal note rate.
As prepaid interest, general tax rules limit its deduction to an annual
fraction of the points paid as the interest accrues annually over the life of
the mortgage. Thus, each year the owner may deduct that year’s accrued
portion of the points from AGI to reduce the owner’s income tax. When the
mortgage is fully prepaid, any remaining unaccrued prepaid interest is then
deducted. However, homeowners have another specific loophole to this
prepaid interest rule.
As an exception to the life-of-mortgage accrual reporting, and thus a loophole
to avoid taxes, the entire amount of the points paid on mortgages that assist
in the purchase or improvement of an individual’s principal residence is
allowed as a personal deduction in the year the mortgage originated.
The immediate deduction for all points paid in connection with these
homeowner mortgages is another government subsidy, part of the overall
policy to encourage homeownership in lieu of renting.11
The points deduction exception for a principal residence does not include
points paid on mortgages secured by a second homes such as the ownership
of a vacation residence.
8 IRC §163(h)(4)(A)(iii)
9 IRC §163(h)(3)(A)
10 IRC §163(a), (h)(2)(A)
11 IRC §461(g)(2)
Taking the
deductions
qualified interest
Interest on a mortgage
which has accrued
and been paid and
is an allowable
interest deduction for
ownership of a first
and second home.
adjusted gross
income (AGI)
The total of the
taxpayer’s reportable
income and losses
from all three income
categories.
The points of
interest
points
A fee charged by a
lender as prepaid
interest which in turn
reduces the note rate
on the mortgage, with
a point equaling 1%
of the amount of the
mortgage.
Chapter 72: Home mortgages interest deductions 477
Further, the deductibility of the mortgage points in the year paid, instead of
over the life of the mortgage, depends on who paid the points — the buyer,
the seller or the lender.
To deduct the points in the year they are paid, the purchase-assist or
improvement mortgage needs to be secured by a buyer’s or homeowner’s
principal residence.
Likewise, points paid by a buyer to finance the purchase or improvement
of a second residence need to be deducted as they accrue over the life of
the mortgage. For example, points paid on a purchase-assist mortgage for
a vacation home, payable monthly with a 30-year amortization, will be
deductible 1/360th for each month of the tax year as the prepaid interest
accrues.
Mortgage costs incurred and paid by the owner to originate a purchase or
improvement on any type of real estate are capitalized by the owner. Thus,
mortgage costs are added to, and become part of, the owner’s cost basis in
the property and are not deducted as interest
Mortgage charges are non-recurring costs incurred to acquire or improve
property, not daily recurring interest which may be deducted as it accrues
and is paid.12
Capitalized costs for originating a mortgage on property other than the first
and second home are partly recovered by annual depreciation deductions,
and fully recovered when the property is sold.
12 Lovejoy v. Commissioner of Internal Revenue Service (1930) 18 BTA 1179
Deductible
points
478 Real Estate Principles, Second Edition
The federal government encourages residential tenants to become
homeowners by allowing them to reduce their income taxes if they
finance the purchase of a residence or vacation home. Under the
mortgage interest deduction (MID) tax scheme, the interest accrued and
paid on mortgages funding the purchase price or cost of improvements
for a principal residence or second home is deductible from the
homeowner’s AGI as an itemized deduction which reduces the owner’s
taxable income and in turn their income tax.
Interest may be deducted from AGI to lower taxable income on:
• purchase or improvement mortgages up to $1,000,000; and
• home equity mortgages up to $100,000.
Interest paid on home equity mortgages secured by a principal or second
residence is also deductible.
When an owner refinances a purchase or improvement mortgage,
interest may only be written off on the amount of refinancing funds
used to pay off the principal balance of the original mortgage.
Interest paid on any portion of a mortgage balance which exceeds the
fair market value of a residence is not deductible. In practice, the FMV
rule applies almost exclusively to home equity mortgages.
Points paid to a lender to originate a mortgage are subject to different
deductibility criteria than standard interest. As prepaid interest and
under the general rule of deductibility, only the fraction of the points
paid which accrues annually over the life of the mortgage may be
deducted against that year’s income. A specific exception exists for points
on mortgages for principal residences which may be fully deducted in
the year paid.
adjusted gross income (AGI) ……………………………………………. pg. 476
fair market value (FMV) …………………………………………………… pg. 475
home equity mortgage …………………………………………………….. pg. 472
itemized deductions ………………………………………………………… pg. 472
mortgage interest deduction (MID) ………………………………… pg. 472
point ………………………………………………………………………………….. pg. 476
principal residence ………………………………………………………….. pg. 472
qualified interest ……………………………………………………………… pg. 476
second home …………………………………………………………………….. pg. 474
Chapter 72
Summary
Chapter 72
Key Terms
Quiz 13 Covering Chapters 68-72 is located on page 618.
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