Financing Residential Real Estate
Lesson 5:
Finance Instruments
© 2012 Rockwell Publishing
Introduction
This lesson will cover:
 types of finance instruments
 how instruments work
 common provisions
© 2012 Rockwell Publishing
Promissory Notes
Promissory note: written promise to pay
money.
Maker: the one who makes the promise.
Payee: the one to whom the promise is
made.
Note: evidence of the debt and a promise to
pay.
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Promissory Notes
Basic provisions
Can be brief, simple document. Usually
contains:
 names of parties
 amount of debt
 interest rate
 how/when money is to be repaid
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Promissory Notes
Basic provisions
Must be signed by maker.
If certain requirements are met, it’s a
negotiable instrument: right to receive
payment can be transferred by endorsement.
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Promissory Notes
Negotiability
Negotiable instrument requirements:
 written, unconditional promise
 to pay a certain sum of money
 on demand or on a certain date
 payable to order or to bearer
 signed by maker
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Promissory Notes
Without recourse
“Without recourse” endorsement: issue of
future payment strictly between maker and
third party the instrument is endorsed to.
 Original payee not liable if maker
fails to pay.
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Promissory Notes
Holder in due course
Holder in due course: someone who buys
negotiable instrument:
 for value
 in good faith
 without notice of defenses
Even if maker has defense against original
payee, maker still required to pay holder in
due course.
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Promissory Notes
Types of notes
Promissory notes classified as to how
principal and interest are paid off.
 Straight note: periodic payments are
interest only, with principal due on
maturity date.
 Installment note: periodic payments
include both principal and interest.
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Summary
Promissory Notes
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Maker
Payee
Negotiable instrument
Without recourse
Holder in due course
Straight note
Installment note
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Security Instruments
Purpose
In real estate transactions, promissory note is
accompanied by security instrument:
 mortgage
 deed of trust
Gives lender right to foreclose on property if
borrower defaults.
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Security Instruments
Purpose
If no collateral, lender can still enforce
promissory note.
 Lender sues borrower, obtains judgment.
 But borrower may be “judgment-proof.”
Secured lender much more likely to collect
payment.
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Security Instruments
Historical background
Personal property used as collateral for early
forms of secured lending.
 Borrower gave lender possession of
collateral property until loan repaid.
 Lender kept property if loan wasn’t
repaid.
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Security Instruments
Historical background
Hypothecation: pledging property as collateral
without giving up possession of it.
 For real property loans, became standard
arrangement for borrower to retain
possession of land.
 Lender held title until debt repaid.
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Security Instruments
Historical background
Legal title: title transferred only as collateral,
without possessory rights.
Equitable title: property rights retained by
borrower, without legal title.
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Security Instruments
Historical background
Eventually, transfer of legal title wasn’t
necessary. More common to place lien
against borrower’s property.
Lien: financial encumbrance on owner’s title,
allowing lienholder to foreclose on property to
collect debt.
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Security Instruments
Mortgage
Two-party security instrument in which
borrower mortgages his property to lender.
 Mortgagor = borrower
 Mortgagee = lender
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Mortgages
Basic provisions
Mortgage must include:
 names of parties
 accurate legal description of property
Also must identify promissory note it secures.
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Mortgages
Covenants
Mortgagor promises to:
 pay property taxes
 keep property insured against
fire and other hazards
 maintain structures in good repair
Mortgagee has right to inspect property.
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Mortgages
Satisfaction
Satisfaction of mortgage: document given to
mortgagor by mortgagee after mortgage is
paid off, releasing property from lien.
 Mortgagor records document.
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Security Instruments
Deed of trust
Similar to mortgage, but involves three
parties, rather than two.
 Grantor/trustor = borrower
 Beneficiary = lender
 Trustee = neutral third party
Trustee arranges for release of property or
foreclosure, as necessary.
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Deeds of Trust
Basic provisions
Deed of trust usually includes same basic
provisions found in mortgage:
 names of parties
 property description
 identification of promissory note
 grantor’s promises to pay taxes and
insure property
 beneficiary’s right to inspect
property
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Deeds of Trust
Reconveyance
Deed of reconveyance: document releasing
property from lien, executed by trustee when
loan is paid off.
 Recorded by grantor.
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Summary
Security Instruments
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Hypothecation
Legal title
Equitable title
Lien
Mortgage
Satisfaction of mortgage
Deed of trust
Deed of reconveyance
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Security Instruments
Foreclosure
Key difference between deeds of trust and
mortgages: procedures used for foreclosure.
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Foreclosure
Methods
At one time, judicial foreclosure was only
option.
 Lender filed lawsuit against borrower.
 Sheriff’s sale ordered by court if borrower
found to be in default.
Alternative to judicial foreclosure was
eventually developed.
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Methods of Foreclosure
Judicial vs. nonjudicial
Nonjudicial foreclosure is generally
associated with deeds of trust.
 Lender doesn’t have to file lawsuit.
 Trustee arranges for property to be
sold at trustee’s sale.
 Property sold to highest bidder.
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Methods of Foreclosure
Power of sale
Nonjudicial foreclosure requires power of sale
clause in security instrument.
Power of sale clause: authorizes trustee to
sell property in event of default.
 All deeds of trust contain one.
 May be included in mortgage, but usually
not.
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Methods of Foreclosure
Judicial foreclosure
Judicial foreclosure used when:
 state law doesn’t allow nonjudicial
foreclosure
 there’s no power of sale clause in
security instrument
 circumstances make it better choice for
lender
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Judicial Foreclosure
Steps in judicial foreclosure
1. Acceleration of debt
2. Foreclosure lawsuit
3. Equitable redemption or
cure and reinstatement
4. Writ of execution
5. Sheriff’s sale
6. Statutory redemption
7. Sheriff’s deed
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Judicial Foreclosure Steps
Acceleration & Lawsuit
1. Acceleration of debt: if mortgagor defaults,
mortgagee notifies mortgagor that entire
outstanding loan balance is due.
2. Foreclosure lawsuit: unless mortgagor
pays off accelerated debt, mortgagee files
foreclosure action.
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Judicial Foreclosure Steps
Stopping a pending foreclosure
3. Equitable redemption or cure &
reinstatement: while lawsuit is pending,
mortgagor has right to stop proceedings by
paying mortgagee.
 Depending on state law, may be:
 equitable right of redemption, or
 right to cure and reinstate.
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Judicial Foreclosure Steps
Stopping a pending foreclosure
Equitable right of redemption: mortgagor’s
right to stop proceedings by paying entire
amount owed, plus costs.
 Loan is paid off and property is
redeemed.
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Judicial Foreclosure Steps
Stopping a pending foreclosure
Cure and reinstatement: mortgagor may
“cure” default by paying just delinquent
amount plus costs.
 Foreclosure proceedings terminate, loan
is reinstated.
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Judicial Foreclosure Steps
Court order
4. Writ of execution: if loan not cured or
redeemed, judge schedules hearing to
determine if default exists.
 If so, judge issues writ of execution.
 Directs sheriff to seize and sell
property.
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Judicial Foreclosure Steps
Sale of property
5. Sheriff’s sale: public auction where
property is sold to highest bidder.
 Purchaser given certificate of sale.
 Proceeds of sale pay costs and debt.
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Judicial Foreclosure Steps
Sale of property
If proceeds aren’t enough to pay off
foreclosed mortgage, court may award
deficiency judgment against debtor for
amount of deficiency.
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Judicial Foreclosure Steps
After sheriff’s sale
6. Statutory right of redemption: additional
period after sheriff’s sale to redeem property.
 Must pay purchaser amount paid at
auction, plus interest.
 Depending on state law, period can be 6
months to 2 years.
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Judicial Foreclosure Steps
Rights of sheriff’s sale purchaser
7. Sheriff’s deed given to purchaser at end of
redemption period.
 State law may allow purchaser to:
 take possession of property
immediately, or
 collect rent from debtor during
redemption period.
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Nonjudicial Foreclosure
Steps
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2.
3.
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5.
Notice of default
Notice of sale
Cure and reinstatement
Trustee’s sale
Trustee’s deed
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Nonjudicial Foreclosure Steps
Notice to borrower
1. Notice of default: to begin, trustee must
give notice of default to grantor.
2. Notice of sale: trustee must wait certain
time after notice of default before issuing
notice of sale. Usually 3 to 6 months.
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Nonjudicial Foreclosure Steps
Stopping the foreclosure
3. Cure and reinstatement: grantor allowed to
cure default and reinstate loan by paying
delinquent amounts plus costs.
 Right ends shortly before trustee’s sale.
 No right of redemption after trustee’s
sale.
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Nonjudicial Foreclosure Steps
Sale of property
4. Trustee’s sale: like sheriff’s sale, trustee’s
sale is public auction.
 Proceeds first applied to costs, then to
debt, then junior liens.
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Nonjudicial Foreclosure Steps
No redemption period
5. Trustee’s deed: highest bidder receives
trustee’s deed immediately after sale.
 Debtor’s title terminates immediately.
 Must vacate property within short period
(such as 30 days).
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Nonjudicial Foreclosure
Restrictions
State law may place restrictions on
nonjudicial foreclosures, such as:
 requiring post-sale redemption period for
agricultural property
 prohibiting beneficiary from obtaining
deficiency judgment after sale
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Judicial vs. Nonjudicial
Lender’s point of view
Judicial foreclosure advantages:
 borrower can’t reinstate loan
 right to deficiency judgment
Nonjudicial foreclosure advantages:
 quick and inexpensive
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Judicial vs. Nonjudicial
Borrower’s point of view
Judicial foreclosure advantages:
 slow process
 post-sale redemption
Nonjudicial foreclosure advantages:
 right to cure and reinstate
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Summary
Foreclosure
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Judicial foreclosure
Equitable right of redemption
Sheriff’s sale
Deficiency judgment
Statutory right of redemption
Nonjudicial foreclosure
Power of sale
Cure and reinstatement
Trustee’s sale
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Alternatives to Foreclosure
Three alternatives allow borrowers who can
no longer make payments to avoid
foreclosure:
 loan workout
 deed in lieu
 short sale
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Alternatives to Foreclosure
Lender’s consent needed
All three alternatives require lender’s consent.
Lender’s incentives to cooperate:
 avoiding foreclosure costs
 ending money-losing situation
more quickly
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Alternatives to Foreclosure
Workouts
First step for borrower hoping to avoid
foreclosure: asking lender for loan workout.
Two types of workouts:
 repayment plan
 loan modification
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Workouts
Repayment plans / loan modifications
With repayment plan, lender allows borrower
to change timing of limited number of
payments.
Borrower in more dire situation may need
loan modification: permanent change in terms
of repayment (like reduced principal or
interest rate).
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Alternatives to Foreclosure
Deed in lieu of foreclosure
If borrower can’t negotiate workout and will
lose property anyway, can offer lender deed
in lieu.
If lender accepts deed in lieu:
 borrower deeds property to lender
 debt satisfied
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Deed in Lieu of Foreclosure
Settlement of debt
Lender agrees to release borrower even
though property is usually worth less than
amount owed.

Lender could require borrower to sign
promissory note for shortfall, but that isn’t
typical.
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Deed in Lieu of Foreclosure
Impact on borrower
Compared to foreclosure, deed in lieu is:
 simpler
 less public
Borrower’s credit rating suffers almost as
much as from foreclosure.
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Deed in Lieu of Foreclosure
Junior liens
Lender takes title subject to other liens.
 Not like foreclosure, which extinguishes
junior liens.
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Alternatives to Foreclosure
Short sales
Short sale: when borrower sells property to
third party for less than amount owed.
 Borrower facing foreclosure may ask
lender to approve short sale.
 If lender approves buyer, lender
receives sale proceeds and releases
lien.
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Short Sales
Junior liens
Like ordinary sale, short sale doesn’t
extinguish junior liens.
 If there are junior liens, short sale must
be approved by all lienholders.
 Junior lienholders unlikely to consent.
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Alternatives to Foreclosure
Obtaining lender’s consent
To arrange workout, deed in lieu, or short
sale, borrower contacts loan servicer.
 May need approval from more than one
department or entity.
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Obtaining Lender’s Consent
Assistance for borrowers
Borrower wanting help with process should
contact nonprofit HUD-approved housing
counseling service.
 Problems with predatory for-profit loan
modification companies.
 Many states now have “distressed
property laws” regulating them.
© 2012 Rockwell Publishing
Obtaining Lender’s Consent
Securitized loans
If loan has been securitized, it’s difficult to
obtain consent.
 Under some MBS contracts, any
purchaser (investor) can object and
prevent loan modification or settlement.
 Impractical to obtain consent of all
investors.
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Alternatives to Foreclosure
Income tax implications
Generally, IRS views debt relief (reduction in
amount owed) as income.
 Borrower who enters arrangement
reducing amount owed may have to pay
income tax on debt relief.
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Alternatives to Foreclosure
Income tax implications
Exceptions: debt relief not taxed if:
 debt was secured by principal residence
and forgiven between 2007-2012
 debtor was insolvent when debt forgiven
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Summary
Alternatives to Foreclosure
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Loan workout
Repayment plan
Loan modification
Deed in lieu
Short sale
Housing counseling service
Distressed property laws
Debt relief
© 2012 Rockwell Publishing
Finance Instrument Provisions
Rights and responsibilities of borrower and
lender may be affected by:
 subordination clause
 late charge provision
 prepayment provision
 partial release clause
 acceleration clause
 alienation clause
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Finance Instrument Provisions
Subordination clauses
Subordination clause: gives a mortgage lower
priority than another mortgage that will be
recorded later on.
 Common in construction financing.
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Finance Instrument Provisions
Late charge provisions
Promissory notes usually provide for late
charges if borrower doesn’t make payments
on time.
State laws may override late charge
provision, to protect borrowers from
excessive charges.
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Finance Instrument Provisions
Prepayment provisions
Prepayment provision: imposes penalty on
borrower who repays some or all of principal
before due.
Prepayment deprives lender of some of
interest it expected to receive over loan term.
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Finance Instrument Provisions
Prepayment provisions
Not standard in residential loan agreements.
 Fannie Mae/Freddie Mac promissory
note gives borrower right to prepay.
 Prepayment penalties prohibited with
FHA and VA loans.
 Dodd-Frank Act places new restrictions
on prepayment penalties.
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Finance Instrument Provisions
Partial release clauses
Partial release clause: obligates lender to
release part of property from lien when part of
debt is paid.
 Typically found in deed of trust or
mortgage that covers subdivision,
allowing release of individual lot from lien
when lot is sold.
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Finance Instrument Provisions
Acceleration clauses
Acceleration clause: allows lender to declare
outstanding loan balance due immediately in
event of default.
 Most lenders wait 90 days before
accelerating.
 Some states now have laws requiring
specific waiting period.
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Finance Instrument Provisions
Alienation clauses
Alienation clause: prevents borrower from
selling security property without lender’s
permission unless loan paid off at closing.
 If title transferred without permission,
lender can accelerate loan.
 Also called due-on-sale clause.
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Alienation Clauses
Triggered by transfer of any interest
Most alienation clauses triggered by transfer
of any significant interest in property.
 Includes long-term leases, or leases with
options to purchase.
 Lender can’t forbid transfer, but can
demand payment of loan.
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Alienation Clauses
Transfer of title without loan payoff
To understand purpose of alienation clause,
consider what happens when borrower sells
property without paying off loan.
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Alienation Clauses
Transfer of title without loan payoff
Three possibilities:
1. New owner takes title subject to loan but
does not assume it.
2. New owner assumes loan but original
borrower is not released.
3. New owner assumes loan and lender
agrees to release original borrower.
© 2012 Rockwell Publishing
Summary
Finance Instrument Provisions
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Subordination clause
Late charge provision
Prepayment provision
Partial release clause
Acceleration clause
Alienation clause
Assumption
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Types of Real Estate Loans
Junior or senior mortgage
Junior mortgage: mortgage with lower lien
priority than another against same property.
Senior mortgage: mortgage with higher lien
priority than another on same property.
 At foreclosure, junior mortgage paid only
after senior has been paid in full.
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Types of Real Estate Loans
First mortgage
Lien having most senior (first) position is
called first mortgage.
 Junior mortgages may be referred to as
second mortgage, third mortgage, etc.
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Types of Real Estate Loans
Purchase money mortgage
Purchase money mortgage: any mortgage
loan used to finance purchase of property that
is collateral for loan.
 A mortgage that buyer gives to seller in
seller-financed transaction.
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Types of Real Estate Loans
Home equity loan
Home equity loan: loan secured by mortgage
against borrower’s equity in home she
already owns. (Interest rates higher than on
purchase loans.)
Equity: difference between property’s market
value and total liens against it.
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Types of Real Estate Loans
Home equity loan
Home equity line of credit (HELOC): line of
credit with limit and minimum monthly
payments; homeowner can draw upon as
needed.
 Automatically secured by borrower’s
home.
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Types of Real Estate Loans
Refinance mortgage
Refinancing: new loan used to pay off existing
mortgage against same property.
Often used:
 to take advantage of market interest rate
decrease
 when balloon payment due on existing
loan
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Types of Real Estate Loans
Bridge loan
Bridge loan: provides cash for purchase of
new home pending sale of old home.
 Secured by equity in old home.
 Usually has interest-only payments.
 Also called swing loan or gap loan.
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Types of Real Estate Loans
Budget mortgage
Budget mortgage: loan with monthly
payments that include property taxes and
hazard insurance.
 Lender holds tax and insurance portions
of borrower’s payments in impound
account until payments due.
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Types of Real Estate Loans
Package mortgage
Package mortgage: loan secured by personal
property as well as real property.
Alternatively, personal property may be
financed separately, using separate security
agreement.
 Lender must file financing statement with
Secretary of State.
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Types of Real Estate Loans
Blanket mortgage
Blanket mortgage: loan secured by more than
one parcel of land; contains partial release
clause.
Partial release clause: requires lender to
release some of security property from lien
when portion of debt is paid off.
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Types of Real Estate Loans
Construction loan
Construction loan: short-term loan used to
finance construction on land already owned
by borrower.
Once construction completed, construction
loan replaced by take-out loan.
 Borrower repays amount over specified
term.
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Types of Real Estate Loans
Nonrecourse mortgage
Nonrecourse mortgage: loan that gives lender
no recourse against borrower.
 Lender’s only remedy in event of default
is foreclosure on collateral property.
 Borrower not personally liable for loan
repayment.
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Types of Real Estate Loans
Participation / shared appreciation
Participation mortgage: allows lender to
participate in earnings generated by
mortgaged property, in addition to collecting
interest payments.
Shared appreciation mortgage: entitles lender
to share of increase in property’s value.
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Types of Real Estate Loans
Wraparound mortgage
Wraparound mortgage: new mortgage that
includes existing first mortgage on property.
 Used almost exclusively in sellerfinanced transactions.
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Types of Real Estate Loans
Reverse mortgage
Reverse mortgage: provides elderly
homeowners source of income, without
requiring sale of home.
 Homeowner borrows against equity.
 Monthly check from lender.
 Borrower required to be over certain age.
 Home sold after death to repay loan.
© 2012 Rockwell Publishing
Summary
Types of Real Estate Loans
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Purchase money mortgage
Home equity loan or HELOC
Refinancing
Bridge loan
Budget mortgage
Package mortgage
Blanket mortgage
Construction loan
Nonrecourse mortgage
Wraparound mortgage
Reverse mortgage
© 2012 Rockwell Publishing