Chapter 8

MORTGAGE INSTRUMENTS

MORTGAGE. A mortgage is a conditional conveyance of legal title to real property as security for the repayment of a debt. The word "mortgage” is derived from two French words "mort, " meaning death and "gage," meaning pledge. Literally, a mortgage is a "death pledge". The borrower is referred to as the mortgagor and the lender is referred to as the mortgagee. The mortgagor pledges title to the mortgagee as collateral for a loan. When the loan is repaid the pledge is extinguished. Under old common law, the mortgagor did not receive possession of the property until the pledge was terminated. Today, a mortgagor retains possession of the mortgaged property and may enjoy all the rights of ownership so long as there is no default. Upon fulfillment of the terms of the mortgage, title reverts back to the mortgagor and the mortgage is discharged. The process of pledging property but maintaining possession is called hypothecation.

DEED OF TRUST. A deed of trust is similar to a mortgage except that the borrower (trustor) conveys title to a third person (trustee) for the benefit of the lender (beneficiary). The trustee has naked or bare title, which is re-conveyed to the borrower when the loan has been repaid. In case of default, the trustee sells the property at auction and applies the proceeds to satisfy the debt. One advantage to using a deed of trust rather than a mortgage is that the foreclosure process is not as expensive or as complex as a court-ordered proceeding.

PROMISSORY NOTE. A promissory note is the evidence of a debt, payment of which is secured by the mortgage. The note determines the interest rate, terms, and number of periodic payments on interest and principal. It also has provisions for late payment charges and real estate tax deposits. If payment is defaulted, the lender or holder of the note may sue directly on the note or foreclose the mortgage to recover the debt. Promissory notes are negotiable instruments, which means that they may be sold to a third person for legal consideration. However, they are not as easily negotiated as "bearer" notes since there is a named payee.

EQUITY. Equity is the difference between the value of a property and the total indebtedness. For example, a property valued at $200,000 with a $120,000 mortgage has an equity of $80,000.

TITLE THEORY VS. LIEN THEORY. There are two theories concerning the legal effect of a mortgage: (1) Title theory and (2) Lien theory.

Title Theory. The title theory recognizes the mortgagee as the legal owner of the property, subject to the mortgagor’s right to redeem title upon full payment of the debt. Upon default the mortgagee may take possession of the property and seize the rents.

Lien Theory. The lien theory interprets a mortgage purely as a lien on real property. Upon default the mortgagee would have to go through judicial foreclosure to take possession and be entitled to rents.

Regardless of the theory used, a mortgage represents a claim or lien against title and is considered an encumbrance. The method of foreclosure is determined by the terms of the mortgage. A mortgage is considered personal property, since it is an intangible right, which may be assigned by a sale, gift or will.

REQUIREMENTS OF A VALID MORTGAGE. To be enforceable, a mortgage must meet the same requirements as a deed except that it contains a defeasance clause and provisions for default and foreclosure.

RECORDING A MORTGAGE. Recording a mortgage is constructive notice of the lien and establishes priority over subsequently recorded liens. The mortgage with the highest priority is referred to as the first mortgage.

RIGHTS OF THE MORTGAGEE. In case of default, the mortgagee has the right to sue the borrower for the amount due on the note or to sell the property at foreclosure. The mortgagee also has the right to sell the mortgage and note to a third party by means of an assignment.

RIGHTS OF THE MORTGAGOR. The mortgagor has the following rights:

1. Possession and Enjoyment of the Property until Default.

2 . Release of the Mortgage Upon Performance.

3. Right of Redemption After Default.

OBLIGATIONS OF THE MORTGAGOR. The mortgage imposes certain covenants to be met by the mortgagor in order to avoid default. They are:

1. Repay the Loan. Repayment terms are described in the promissory note.

2. Maintain Proper Insurance. The mortgagee must be named as beneficiary in the policy.

3. Prevent Waste. The buildings must be properly maintained to protect the value of the collateral.

4. Maintain the Improvements. No improvements may be removed or altered without the permission of the mortgagee.

5. Pay all Taxes and Assessments when Due.

RELEASE OF A MORTGAGE. When the mortgage has been paid off the mortgagee must acknowledge satisfaction of the debt and return the cancelled promissory note and mortgage to the borrower. In addition, the lender must execute a mortgage release ("Satisfaction Piece"), which is recorded by the borrower as proof that the mortgage has been discharged. Note: A "satisfaction ' or "release of mortgage" is the best proof that a mortgage has been paid in full.

FINANCING INSTRUMENT PROVISIONS

ACCELERATION CLAUSE. An acceleration clause allows the mortgagee the right to declare the entire amount of the note payable in full upon the happening of a certain event such as missing a payment or selling the property.

DUE-ON-SALE CLAUSE. A due-on-sale clause accelerates the due date on the note if title to the mortgaged property is transferred. The purpose of a due-on-sale clause is to prevent a sale with a mortgage take-over. A due-on-sale clause is also referred to as an alienation or non-alienation clause. Note: An alienation clause protects the mortgagee's security position.

NONRECOURSE LOAN. A loan with a nonrecourse provision relieves the borrower of personal liability on the note. A nonrecourse loan is used when the lender feels certain that the collateral is sufficient to cover the amount of the loan.

LATE CHARGE PENALTIES. In Massachusetts, lenders may charge a maximum of 3% for payments fifteen days overdue on owner-occupied houses of up to four units.

TAX AND INSURANCE ESCROW. Most mortgages require the mortgagor to make a monthly payment into an escrow or reserve account to meet future real estate taxes and insurance premiums. At the closing, the borrower deposits sufficient funds in the escrow to cover the unpaid taxes; thereafter, the monthly payments include principal, interest, taxes and insurance premiums (PITI).

SUBORDINATION CLAUSE. A subordination clause allows the mortgagor to make an existing mortgage subordinate to additional financing. For example, a property is sold, and the seller takes back a deferred purchase money mortgage. Subsequently, the buyer applies to a bank for additional financing. Since the bank requires its mortgage to have priority over all other liens, the seller’s mortgage would have to be made subordinate to the new mortgage,

PREPAYMENT PENALTY CLAUSE. Although the borrower has the right to prepay a mortgage at any time, a penalty may be charged if more than a certain percentage of the loan is paid in any given time period. This is referred to as a closed mortgage. An open mortgage is one that may be paid in full at any time without penalty.

OPEN END MORTGAGE. An open-end mortgage allows the borrower to increase the loan up to a maximum amount without having to refinance. The lender can advance additional funds, which will be secured by the original mortgage, thus saving the borrower additional closing costs. An open-end mortgage is used for an equity loan in which the borrower may receive cash advances up to an established maximum credit line.

ASSIGNMENT CLAUSE. An assignment clause gives the mortgagee the right to assign the mortgage to a purchaser of the promissory note. The assignor is the one who assigns (sells) the debt and security. The assignee is the one who receives (buys) the instruments. Selling existing mortgages by one investor to another is known as trading in the secondary mortgage market. This occurs, for example, when the primary lender or loan originator sells a mortgage to the Federal National Mortgage Association in order to free up cash for future loans. In most assignments the mortgagor is not notified of the transfer and continues making payments to the original mortgagee who services the loan by collecting the payments, handling payoffs, releases, and delinquencies.

ESTOPPEL CLAUSE. An estoppel clause bars the mortgagor from challenging the terms of the mortgage or the amount due on principal and interest in the event that the mortgage and note are assigned to a third party. The estoppel clause acknowledges the unpaid amount of the debt, the interest rate, and date up to which interest is paid for the protection of the assignee. Some mortgages contain an additional clause requiring the borrower to sign an estoppel certificate when the mortgage is assigned. This is also referred to as a ’’certificate of no defense”.

PARTIAL RELEASE CLAUSE. A partial release clause allows the mortgage to be released from a portion of the security without releasing the entire mortgage. For example, a bank can partially release a mortgage on a lot in subdivision to allow the developer to build a home on the lot and to sell it to a buyer.

INTEREST. Interest is a charge paid for the use of borrowed money. The rate of interest and method of payment are specified in the promissory note. Interest may be paid in advance or in arrears at the end of each month.

USURY LAWS. States may enact usury laws, which determine the maximum rate of interest for first and second mortgages. During the 1970’s when interest rates rose dramatically, the VA/FHA interest rates were higher than those allowed by some state usury laws. As a result, effective March 31, 1980, federal law exempted residential first mortgage loans from state interest limitations.

DEFEASANCE CLAUSE. A defeasance clause defeats or cancels the mortgage upon full performance of the terms of the mortgage and repayment of the debt.

BALLOON PAYMENT. A final payment on a mortgage loan, which is larger than the preceding periodic payments and usually pays off the loan in full, is known as a balloon payment.

DEFAULT AND FORECLOSURE

DEFAULT. A mortgagor is in default when he or she fails to comply with the terms of the mortgage or fails to make the monthly payments as required by the promissory note. The promissory note usually requires a late payment fee and allows a grace period to bring the payments up to date. On an FHA loan, the grace period is three months. If payments are not received within the grace period, the mortgagee may accelerate the note by declaring the entire loan balance due and payable at once and proceed to foreclose.

FORECLOSURE. Foreclosure is the process of terminating a defaulted mortgagor's equitable right of redemption. Foreclosure methods vary depending upon the jurisdiction. Generally, there are two kinds of foreclosure proceedings:

1. Judicial Foreclosure. This method requires the lender to bring a lawsuit asking the court to cut off the borrower’s rights and to allow a sale of the property at public auction to satisfy the debt. The borrower may be allowed up to a year or more to bring the payments up to date.

2. Statutory Foreclosure. Most states have passed legislation providing for a quicker method of foreclosing a mortgage. Generally, lenders are permitted to make an entry and to take possession of the mortgaged property without having to ask for court permission. If the deficiency is not paid within a required time period, the mortgagor's equitable right of redemption is terminated, and the mortgage debt is deemed paid to the extent of the value of the property. While in possession, the lender has the right to the rents and must manage and maintain the property for the benefit of the mortgagor. Any net income after expenses must be applied to the reduction of the debt.

POWER OF SALE FORECLOSURE. In Massachusetts, mortgages contain a ’’power of sale" clause, which gives the lender the right to foreclose a mortgage by selling the property at public auction. Notice of the sale must be given to the mortgagor by registered mail and newspaper publication. If the sale is fairly conducted and notice of the sale is properly recorded, the mortgagor’s equitable right of redemption is terminated at the moment of the sale. The lender is required to file a sworn statement with the Land Court indicating compliance with the Soldiers and Sailors Civil Relief Act which bars a foreclosure against a person in military service or until the person has been out of service for three months.

MORTGAGOR’S EQUITABLE RIGHT OF REDEMPTION. The equitable right of redemption allows the mortgagor in default to redeem title prior to a foreclosure sale. In Massachusetts, the equitable right of redemption is terminated at the moment of the foreclosure sale. Title may not be redeemed after the sale, as with tax sales or sheriff’s sales. Some states have a statutory right of redemption, which allows the borrower to redeem title within a certain time period after the sale by paying the sale price, interests, and costs. Massachusetts has no statutory right of redemption.

DEFICIENCY DUE AFTER SALE. Any excess proceeds of the foreclosure sale after deducting expenses are paid to the mortgagor. However, if the proceeds of the sale are insufficient to pay the amount due plus costs, the borrower is liable for the deficiency unless it is a nonrecourse loan. The deficiency may be forgiven by the bank, in which case it is treated as taxable income to the mortgagor.

EFFECT OF A MORTGAGE FORECLOSURE SALE UPON OTHER LIENS. A foreclosure sale con­ cludes the rights of all lienholders of record dated subsequent to the mortgage, except for federal, state and city tax liens, and labor liens. The purchaser at foreclosure sale receives a deed containing no warranties, subject to all restrictions and easements of record, unpaid taxes and labor liens. Note: Payment of back-taxes always takes priority over other debts following a foreclosure sale.

DEED IN LIEU OF FORECLOSURE. In order to avoid the expense of a foreclosure sale, the mortgagee may accept a deed (friendly foreclosure) from the mortgagor in full payment of the debt. However, the disadvantage to this is that the conveyance is subject to all the existing liens, whereas they would be eliminated by a foreclosure sale.

BANKRUPTCY - EFFECT UPON FORECLOSURE. Filing for bankruptcy by the mortgagor will .prevent or delay a foreclosure sale until the bankruptcy court determines the rights of all creditors. Eventually, a sale will be permitted with the same results.

SECOND MORTGAGES

Basically, all mortgages are written alike, regardless whether they are first, second, or third mortgages. The determining factor of the priority of a mortgage is the recording date. Thus, if there are two mortgages on a property, the one first recorded is the first mortgage, and the latter is the second or junior mortgage. In the event of default and foreclosure on either mortgage, the proceeds of the sale are credited first to satisfy the first mortgage debt. The priority of mortgages may be changed by a subordination agreement executed by the mortgagor and mortgagee.

Because of the risk involved, interest rates on junior mortgages are generally higher and the terms shorter, resulting in high monthly payments. Consequently, most lenders do not permit the buyer to finance the down payment with a second mortgage, insisting that it be paid in cash. Frequently, when a young buyer receives a cash gift from a parent for the down payment, the lender will require the donor to certify in writing that it is a gift and not a loan. For all home mortgages, which must meet HUD requirements, the borrower is required to certify that the down payment is being made in cash.

Junior mortgages and purchase money mortgages are most commonly used to finance the purchase of income properties. The seller is usually willing to take back a second or third mortgage to cover part of the down payment in order to complete the sale. If the effective net income is sufficient to cover the payments on both mortgages, the holder of the first mortgage is less likely to object to the junior financing.

PURCHASE MONEY MORTGAGE. A (deferred) purchase money mortgage is taken back by the seller to defer the payment of part of the purchase price. It may be a first or a second mortgage.

EQUITY MORTGAGE. A homeowner’s equity may be used as collateral in order to establish a line of credit. The lender agrees to advance funds up to a maximum of seventy or eighty percent of the value of the home over and above any first mortgage. The loan is secured by an open-end mortgage with an adjustable interest rate at one or two points over the prime rate. The borrower does not have to use all the money available and pays interest only on the money borrowed. The Tax

Reform Act of 1986 has resulted in a growing demand for equity loans, since the tax deduction allowed for consumer purchase loan interest has been phased out. Closing costs for an equity loan are usually lower than a conventional loan, since the loan does not have to meet the secondary mortgage market requirements.

MORTGAGE TAKE-OVER

TAKE-OVER MORTGAGE. If the seller has an existing, assumable mortgage, it is often to the advantage of both parties to sell the property with the buyer taking subject to or assuming the existing mortgage as part of the consideration. Selling subject to a mortgage is not possible if the mortgage contains a due-on-sale clause or non­ alienation clause. Most conventional mortgages are not assumable. VA/FHA mort­ gages are assumable by lender-qualified buyers.

EFFECT OF A MORTGAGE TAKE-OVER. The buyer receives title subject to the seller's mortgage and takes over the monthly payments. Unless released by the lender, the seller remains principally liable for the debt and is responsible for any deficiency in the event of foreclosure. If the buyer agrees to assume the mortgage, the buyer becomes equally responsible with the seller to the mortgage holder. The original borrower may be released only by a novation in which the lender substitutes the new owner as the party primarily liable for the debt.

WRAP-AROUND MORTGAGE. This is a method of financing in which a second mortgage is written for the amount of the second loan plus the balance due on the first mortgage. The mortgagor makes one payment to the holder of the second mortgage who assumes the responsibility for paying the first. For example, an owner has a mortgage with a balance due of §40,000 at 10% interest and needs an additional $20,000 financing. The owner takes out a second mortgage for $60,000 at 11% interest with a new lender and receives $20,000 cash. The owner makes a single monthly payment on the $60,000 loan to the second mortgagee who agrees to take over the payments on the owner’s first mortgage. As a profit incentive, the second mortgagee will earn 1% interest on the $40,000 balance of the first mortgage. In the event the second mortgage holder defaults on the payments on the first mortgage, the owner would have the right to withhold payments on the second and make direct payments to the first.

Wrap-around mortgages may also be used to finance the purchase of property with the seller taking back a wrap-around as part of the purchase price. However, since there is a change of ownership, the first mortgage would have to be assumable in order for it to work.

SPECIAL PURPOSE FINANCING

Special Purpose Financing includes a variety of mortgages and innovative financing methods, which are designed to meet specific, needs. These financing techniques vary according to their purpose and according to who is making the loan. Special purpose financing includes the following:

CONSTRUCTION MORTGAGE. A construction loan is a short-term loan to cover the con­struction costs of a building or development. The money is advanced to the builder at certain stages in the construction. Because of the greater risk, construction loans are usually made at higher-than-market interest rates. The builder must supply the lender with releases of all mechanic’s liens for work covered by the payment. The lender usually requires a "take out" provision for permanent financ­ing to pay off the construction loan when the project is completed.

END LOAN. As an inducement to taking a construction loan, the lender may require that the final or end loans to the eventual buyers be placed with the same bank. End loans are also referred to as "take-out” loans.

BLANKET MORTGAGE. A blanket mortgage covers more than one parcel of real estate, providing for partial release upon repayment of portions of the debt.

BRIDGE LOAN. A bridge loan is taken on the equity of a seller’s house in order to raise cash for the purchase of a new home. A bridge loan makes it possible for the seller to purchase a new home prior to selling the old one. A bridge loan is a form of equity loan.

CHATTEL MORTGAGE. A chattel mortgage is used to secure a lien on personal property. In most states, the use of a chattel mortgage is being replaced by security agree­ments under the Uniform Commercial Code.

PACKAGE MORTGAGE. A package mortgage is a type of residential mortgage, which covers the real estate, as well as certain equipment and appliances located on the premises.

REVERSE ANNUITY MORTGAGE (RAM) . A reverse annuity mortgage allows a property to be mortgaged in order to get a flow of periodic payments from the lender. The lender pays out the loan, not in one lump sum, but monthly, over a five or ten year period. Part of the monthly cash payment is withheld to pay the interest on the loan. A RAM will provide a monthly income for an elderly homeowner with little or no income. If the borrower survives the terms of the annuity, the loan must be repaid. Otherwise, the loan will be paid out of the borrower's estate or from the proceeds of the sale when the property is sold.

ADVANCE FINANCING TECHNIQUES. Investors and property developers have devised financing techniques, which provide a greater incentive to the lenders through the sharing of the profits of the venture.

Shared Appreciation Mortgage. A shared appreciation mortgage loan is made at a reduced interest rate in return for which the lender shares in the appreciation of the mortgaged property when the property is sold. For example, a developer obtains a construction loan at two points less than the current market rate of interest in return for which the developer agrees to pay the lender one third of the apprecia­tion when the property is sold.

Equity Sharing (participation) . Equity sharing is an arrangement between a buyer and an investor, whereby the investor puts up all or part of the down payment and closing costs and assists in the monthly mortgage payments. In return, the investor is permitted to buy a share of the equity at a discount. For example, a bank lends $5 million dollars at an attractive interest rate in return for being able to buy a half interest in the equity for $500,000. Another variation of equity sharing is discussed 9-8

CREATIVE FINANCING. This is a term used to describe any financing method that will help close a sale during a tight money market, or involving unusual circumstances. Creative financing includes such methods as equity sharing, reverse annuity mortgages, buy-downs, installment sales, purchase money mortgages and mortgage take-overs. Creative financing is fully discussed in Chapter 9.

KEY WORDS AND PHRASES