Principles of California Real Estate
Lesson 9:
Principles of
Real Estate Financing
© 2010 Rockwell Publishing
Economics of Real Estate Finance
Real estate cycles
In real estate, there may be periodic shifts in
market activity levels.
Buyer’s market: Few people buying homes,
and homes take longer to sell.
Seller’s market: Many people buying, and
homes sell quickly.
© 2010 Rockwell Publishing
Economics of Real Estate Finance
Real estate cycles
Real estate cycles follow law of supply and
demand:

Housing prices go up when demand is
high and supply low.

Prices go down when supply is high and
demand low.
© 2010 Rockwell Publishing
Economics of Real Estate Finance
Interest rates and federal policy
Interest rates represent price of mortgage
funds; fluctuate in response to supply and
demand.

When mortgage funds plentiful, interest
rates are low.

When funds are scarce, interest rates are
high—called a tight money market.
© 2010 Rockwell Publishing
Interest Rates and Federal Policy
Fiscal policy
Fiscal policy: Activities federal government
pursues through spending, taxation and
management of national debt.
 For deficits, U.S. Treasury borrows money
by selling interest-bearing securities to
investors (T-Bills, T-Bonds).
 Government borrowing leaves less money
for private sector, driving interest rates up.
© 2010 Rockwell Publishing
Interest Rates and Federal Policy
Monetary policy
Monetary policy: Federal government’s
control of money supply and interest rates.
 Monetary policy determined by Federal
Reserve (the “Fed”).
Economy tied to money supply & demand.
 Low interest rates, economic activity
increases.
 If funds scarce, slowdown will result.
© 2010 Rockwell Publishing
Interest Rates and Federal Policy
Monetary policy
Federal Reserve sets monetary policy using
these adjustment tools:
 key interest rates
 reserve requirements

open market operations
© 2010 Rockwell Publishing
Interest Rates and Federal Policy
Monetary policy
Key interest rates: When the Fed raises or
lowers interest rates member banks pay the
Fed, banks adjust interest rates for their
customers, too.
 Lower interest rates can stimulate
economy.
© 2010 Rockwell Publishing
Interest Rates and Federal Policy
Monetary policy
Reserve requirements: Amount the Fed
requires banks to keep on deposit to meet
requests for withdrawals.
 If the Fed lowers reserve requirement,
more money becomes available for
loans and interest rates go down (and
vice versa).
© 2010 Rockwell Publishing
Interest Rates and Federal Policy
Monetary policy
Open market operations: The Fed’s buying
and selling of government securities (such
as Treasury notes).
 When Fed purchases government
securities, more private money becomes
available and interest rates go down
(and vice versa).
© 2010 Rockwell Publishing
Summary
Economics of Real Estate Finance
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Real estate cycles
Supply and demand
Fiscal policy
Monetary policy
Key interest rates
Reserve requirements
Open market operations
© 2010 Rockwell Publishing
Real Estate Finance Markets
Mortgage loans bought and sold like other
investments, such as stocks and bonds.
 Loan value depends on rate of return and
risk of default.
 “Seasoned loan” (one with history of timely
payments) is more valuable.
© 2010 Rockwell Publishing
Real Estate Finance Markets
Primary market
Primary market: Market in which mortgage
lenders make loans directly to borrowers.
Although primary market has become more
regional or even national, local conditions still
have big impact on funding lenders have
available for loans.
© 2010 Rockwell Publishing
Real Estate Finance Markets
Secondary market
Secondary market: National market in which
private investors and government agencies
buy and sell mortgages.
 Lets local lenders sell loans to national
investors; moderates local cycles.
 Secondary market transactions are
between mortgagees (lenders/investors).
© 2010 Rockwell Publishing
Real Estate Finance Markets
Secondary market
Secondary market investors generally buy
loans at discount (less than face value).
 But discounted loans can be foreclosed
for full face amount if borrower defaults.
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Real Estate Finance Markets
Secondary market agencies
The federal government established
secondary market agencies to help
secondary market operate more smoothly:
 Fannie Mae
 Freddie Mac
 Ginnie Mae
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Real Estate Finance Markets
Secondary market agencies
Agencies buy large numbers of home loans
and then sell securities to investors using
purchased loans as collateral.
 These are mortgage-backed securities.
© 2010 Rockwell Publishing
Real Estate Finance Markets
Secondary markets agencies
Underwriting standards: To help lessen risk
of loan defaults, federal agencies have
established standard criteria for evaluating
loan applicants.
 If primary market lenders want to sell
loans in secondary market, they need to
conform to these standards.
© 2010 Rockwell Publishing
Real Estate Finance Markets
Secondary market agencies
Federal National Mortgage Association
(FNMA) or “Fannie Mae”:
 Established to provide secondary market
for FHA loans. (Now handles all loan
types.)
 Government-sponsored enterprise (GSE).
© 2010 Rockwell Publishing
Real Estate Finance Markets
Secondary market agencies
Federal Home Loan Mortgage Corporation
(FHLMC) or “Freddie Mac”:
 Established to provide secondary
market for savings and loans, but now
handles all loan types.
 Like Fannie Mae, a governmentsponsored enterprise.
© 2010 Rockwell Publishing
Real Estate Finance Markets
Secondary market agencies
Government National Mortgage Association
(GNMA) or “Ginnie Mae”:
 Government agency within HUD.
 Buys and securitizes FHA and VA loans.
© 2010 Rockwell Publishing
Real Estate Finance Markets
Secondary market agencies
In 2008, federal government placed Fannie
Mae and Freddie Mac into conservatorship:
essentially a government takeover of both
agencies.
 Result of recent recession.
 New government regulator created for
the two agencies: Federal Housing
Finance Agency (FHFA).
© 2010 Rockwell Publishing
Summary
Real Estate Finance Markets
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Primary market
Secondary market
Loan discounting
Underwriting standards
Secondary market agencies
GSEs
© 2010 Rockwell Publishing
Real Estate Finance Documents
Most real estate transactions include:
 promissory note
 security instrument (mortgage or deed
of trust)
© 2010 Rockwell Publishing
Real Estate Finance Documents
Promissory notes
Promissory note: Written promise to repay
debt, plus specified amount of interest.
 Borrower = Maker
 Lender = Payee
© 2010 Rockwell Publishing
Real Estate Finance Documents
Promissory notes
Basic provisions:
 loan balance (principal amount)
 interest rate (fixed or variable)
 payment amount and schedule
 names of borrower and lender
© 2010 Rockwell Publishing
Real Estate Finance Documents
Promissory notes
State usury laws may prohibit interest rate in
note from exceeding specified amount.
 In CA, however, most loans secured by
real property are exempt from usury law.
© 2010 Rockwell Publishing
Real Estate Finance Documents
Promissory notes
If each borrower is individually liable for
entire loan amount, note will state that
borrowers are jointly and severally liable for
debt.
© 2010 Rockwell Publishing
Real Estate Finance Documents
Promissory notes
Because note does not concern property, it
need not include a legal description and is
usually not recorded.
© 2010 Rockwell Publishing
Types of Promissory Notes
Straight note
Straight note: Promissory note used for term
loan or interest-only loan.
 Payments made during loan term cover
interest only (no principal).
 At end of term, borrower must pay entire
principal with balloon payment.
© 2010 Rockwell Publishing
Types of Promissory Notes
Installment note
Installment note: Promissory note used for
amortized loan, with part of each payment
going to interest and principal.
 Each payment reduces principal balance,
until loan paid off.
 Borrower pays less interest with
installment note (vs. straight note).
© 2010 Rockwell Publishing
Promissory Notes
Simple interest
Interest paid on real estate loan is always
simple interest (not compound interest).
 Computed annually on (remaining)
principal balance only.
© 2010 Rockwell Publishing
Promissory Notes
Negotiable instruments
Most promissory notes used in real estate are
negotiable instruments.
 Can be assigned to others by
endorsement (signing over to another).
 If endorsed “without recourse,”
endorsement is made without any
assurances or warranty.
© 2010 Rockwell Publishing
Promissory Notes
Holder in due course
Holder in due course: Third party who
purchases negotiable instrument in good faith,
unaware of any problems.
 Entitled to payment even if there were
problems with original transaction
between payee and maker.
© 2010 Rockwell Publishing
Real Estate Finance Documents
Security instruments
Security instrument: Contract that makes
borrower’s property collateral for loan.
 If borrower doesn’t repay loan,
lender can foreclose.
 Forced sale of property.
 Lender collects debt from proceeds.
© 2010 Rockwell Publishing
Security Instruments
Create lien
Security instrument secures loan by creating
lien on property.
 Borrower gives property as collateral,
but doesn’t give up possession.
© 2010 Rockwell Publishing
Security Instruments
Securing personal property
Buyer of property may keep possession of
property while repaying loan by using a
security agreement.
 In contrast, transferring personal
property to lender pending repayment of
loan is called a pledge (like pawnshop).
© 2010 Rockwell Publishing
Security Instruments
Recording
Security instrument need not be recorded
to be legal, but it should be, to give
constructive notice of lender’s interest.
 Real estate licensee who acts as
mortgage loan broker is responsible for
recording security instrument before
funds disbursed (or within 10 days).
© 2010 Rockwell Publishing
Security Instruments
Classification as personal property
While real estate notes, mortgages, and trust
deeds are connected to real property, they
are classified as personal property for
owners.
 Promissory note may be pledged as
security for another loan.
© 2010 Rockwell Publishing
Security Instruments
Offset statement
If loan is sold or assigned, investor may
request an offset statement from borrower to:
 confirm status of loan
 describe any claims that could affect
investor’s interests
Same statement from lender is called a
beneficiary’s statement.
© 2010 Rockwell Publishing
Security Instruments
Lender’s permission
Borrower must get lender’s permission
before making any changes that affect
property’s value or lien priority.
 Lender’s lien also includes any afteracquired title borrower gains in property
(such as an easement).
© 2010 Rockwell Publishing
Security Instruments
Mortgages vs. deeds of trust
Two types of security instruments:
 mortgages
 deeds of trust
Main difference: foreclosure is easier with
deed of trust.
© 2010 Rockwell Publishing
Security Instruments
Mortgages vs. deeds of trust
Two parties to a mortgage:
 mortgagor (borrower)
 mortgagee (lender)
© 2010 Rockwell Publishing
Security Instruments
Mortgages vs. deeds of trust
Three parties to a deed of trust:
 trustor or grantor (borrower)
 beneficiary (lender)
 trustee (neutral third party who handles
foreclosure, if necessary)
© 2010 Rockwell Publishing
Security Instruments
Mortgages vs. deeds of trust
In California (and other states), lenders
usually prefer deeds of trust because
foreclosure is easier and faster.
 Trustee holds deed “in trust” until loan
has been repaid.
 Trustee has power of sale in event of
default (can sell without going to court).
© 2010 Rockwell Publishing
Summary
Real Estate Finance Documents
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Promissory note
Straight note
Installment note
Security instrument
Mortgage
Deed of trust
© 2010 Rockwell Publishing
Finance Document Provisions
Real estate documents contain numerous
provisions: some mandatory, others optional.
 Certain provisions are unique to security
instruments, others also appear in
promissory notes.
© 2010 Rockwell Publishing
Finance Document Provisions
Property description
Security instrument must adequately
describe the real property serving as
collateral.
© 2010 Rockwell Publishing
Finance Document Provisions
Mortgaging or granting clause
Security instrument must state that property
is pledged as security for loan.
 Mortgaging clause in a mortgage.
 Granting clause in a deed of trust.
© 2010 Rockwell Publishing
Finance Document Provisions
Acceleration clause
Acceleration clause: Gives lender right to
demand immediate payment of loan balance
if borrower defaults; also known as “calling
the note.”
 If borrower doesn’t meet the demand,
lender can foreclose.
 Can appear in promissory note and
security instrument
© 2010 Rockwell Publishing
Finance Document Provisions
Alienation clause
Alienation clause: Lets lender accelerate
loan (demand immediate payment of loan
balance) if borrower sells property or
transfers it to someone else.
 Also called a due-on-sale clause.
 Lender may agree to assumption by
creditworthy purchaser, but will likely
charge a fee and raise the interest rate.
© 2010 Rockwell Publishing
Finance Document Provisions
Alienation clause
Alienation clause does not prohibit sale of
property, but borrower must be able to pay
off loan if property sold without lender
approval.
© 2010 Rockwell Publishing
Finance Document Provisions
Alienation clause
If loan isn’t paid off when property sold or
transferred, new purchaser can:
 assume seller’s mortgage or deed of
trust, or
 take title subject to mortgage or deed of
trust.
© 2010 Rockwell Publishing
Finance Document Provisions
Assumption
In assumption:
 new buyer assumes primary liability for
repaying lender
 original borrower remains secondarily
liable, unless released by lender
© 2010 Rockwell Publishing
Finance Document Provisions
Taking title subject to existing lien
If new buyer takes title subject to existing
mortgage (instead of assuming it):
 original borrower remains primarily liable
for repayment
 new buyer not personally liable for loan
Lender can still foreclose if original borrower
defaults.
© 2010 Rockwell Publishing
Finance Document Provisions
Late payment penalty
Late payment charges allowed only if clearly
defined in finance documents.
 In CA, payment isn’t late until at least 10
days after due date, and
 penalties can’t exceed (the greater of) 6%
of principal and interest due or $5.
 Federal law: limit of 4%, grace period of 15
days
© 2010 Rockwell Publishing
Finance Document Provisions
Lock-in clause
Lock-in clause: Prohibits borrower from
paying loan off early.
● In CA, loans on residential property
with four units or less cannot contain
lock-in clauses.
© 2010 Rockwell Publishing
Finance Document Provisions
Prepayment penalty
Prepayment penalty: Allows lender to charge
borrower penalty if more than set amount of
principal is paid back before due.
 With owner-occupied residences,
prepayment penalty only allowed during
first 5 years of loan term under state
law, or first 3 years under federal law.
 If current interest rates high, lender
more likely to waive prepayment
penalties.
© 2010 Rockwell Publishing
Finance Document Provisions
Open mortgage
Open mortgage: Loan without a
prepayment penalty provision.
© 2010 Rockwell Publishing
Finance Document Provisions
Subordination clause
Subordination clause: Makes it possible for
security instrument recorded later to have
higher lien priority (than earlier recorded
instrument).
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Finance Document Provisions
Subordination clause
Often found in security instrument for loan
purchasing vacant land.
 Buyer plans to obtain construction loan.
 Later lender will want first lien position
for construction loan (higher risk).
© 2010 Rockwell Publishing
Finance Document Provisions
Defeasance clause
Defeasance clause: Lender agrees to cancel
security instrument when debt is paid.
 If security instrument was deed of trust,
lien removed through deed of
reconveyance.
 When mortgage paid, certificate of
discharge removes lien.
© 2010 Rockwell Publishing
Finance Document Provisions
Defeasance clause
For deed of trust, beneficiary must submit
request for reconveyance to trustee within 30
days after loan paid.
Trustee has 21 days to execute deed of
reconveyance.
 Need not be recorded, but should be to
protect trustor.
© 2010 Rockwell Publishing
Summary
Finance Document Provisions
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Acceleration clause
Alienation clause
Late payment penalty
Lock-in clause
Prepayment penalty
Subordination clause
Defeasance clause
© 2010 Rockwell Publishing
Foreclosure
Foreclosure is lender’s remedy when
borrower defaults.
 Can be done judicially (in court) or
nonjudicially.
Actions constituting default include:
 failure to repay loan
 using property for illegal purpose
 failing to insure or maintain property
© 2010 Rockwell Publishing
Judicial Foreclosure
If borrower defaults, mortgagee files lawsuit
(foreclosure action) in county where property
located.
 Judge issues decree of foreclosure.
 Property sold at public auction
(“sheriff’s sale”).
© 2010 Rockwell Publishing
Judicial Foreclosure
Reinstatement
While foreclosure action pending, borrower
has right to reinstatement.
 Reinstatement period lasts until
foreclosure decree is issued.
To reinstate loan, borrower must pay:
 past due amount
 any foreclosure costs incurred
© 2010 Rockwell Publishing
Judicial Foreclosure
Redemption
Even after sheriff’s sale of property,
borrower has statutory right of redemption.
Borrower may redeem property by paying
off:
 entire debt
 interest
 all foreclosure expenses
© 2010 Rockwell Publishing
Judicial Foreclosure
Redemption
In California, redemption period lasts:
 three months if sale proceeds were
enough to cover debt, or
 one year if sale proceeds were not
enough to cover the debt
No redemption period if lender waives
deficiency judgment or not allowed to seek
deficiency judgment.
© 2010 Rockwell Publishing
Judicial Foreclosure
Redemption
During redemption period, borrower may
retain possession of property but must pay
rent.
Successful purchaser at sheriff’s sale
receives sheriff’s deed after redemption
period, which transfers title and possession.
© 2010 Rockwell Publishing
Judicial Foreclosure
Surplus or deficiency
After all liens paid off, borrower receives any
surplus from foreclosure sale.
If proceeds don’t cover loan amount, lender
may be entitled to deficiency judgment;
 Not allowed with most residential loans.
© 2010 Rockwell Publishing
Nonjudicial Foreclosure
Power of sale clause: Provision in deed of
trust that authorizes trustee to sell property if
borrower defaults (without going to court).
 Most mortgages have no equivalent
provision.
© 2010 Rockwell Publishing
Nonjudicial Foreclosure
Nonjudicial foreclosure must be conducted in
accordance with statutory procedures.
 Trustee sends notice of default to borrower
and other lienholders.
 Three months later, trustee posts and
advertises notice of sale.
 Trustee holds auction (trustee’s sale) at
least 3 months and 20 days after notice of
default.
 Winning bidder receives trustee’s deed.
© 2010 Rockwell Publishing
Nonjudicial Foreclosure
Reinstatement and redemption
Borrower may reinstate loan (and redeem
property) by paying past due amount plus
costs, up to 5 days before trustee’s sale.
 Reinstatement period lasts at least 3
months and 15 days.
No post-sale redemption option (unlike
judicial foreclosures).
© 2010 Rockwell Publishing
Nonjudicial Foreclosure
Deficiency judgments
Deficiency judgments not permitted in
nonjudicial foreclosures.
 Lenders may pursue judicial foreclosure
to seek deficiency judgment.
Notice to other lienholders important
because junior lienholders’ claims
terminated by trustee’s sale.
© 2010 Rockwell Publishing
Alternatives to Foreclosure
If borrower can’t reinstate loan, lender may
accept deed in lieu of foreclosure.
 Transfers title from borrower to lender.
 Lender takes title subject to liens.
Other alternatives to foreclosure include
short sales and loan modification.
© 2010 Rockwell Publishing
Alternatives to Foreclosure
Recent law
State law imposes special requirements on
lenders that are foreclosing on residential
loans made during boom years (2003-2007),
including longer notice periods.
Generally, persons providing consultancy to
homeowners facing foreclosure must have a
written agreement with borrower. Various
other rules apply.
© 2010 Rockwell Publishing
Foreclosure vs. Bankruptcy
Bankruptcy and foreclosure are separate
legal procedures.
 If borrower facing foreclosure files for
bankruptcy, foreclosure proceedings
are temporarily put on hold.
© 2010 Rockwell Publishing
Summary
Foreclosure
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Judicial foreclosure
Nonjudicial foreclosure
Reinstatement
Redemption
Deficiency judgment
Deed in lieu of foreclosure
Bankruptcy
© 2010 Rockwell Publishing
Types of Mortgage Loans
Even though various loans secured by real
property are often called “mortgage loans,”
in California security instrument for these
loans will usually be deed of trust (not
mortgage).
© 2010 Rockwell Publishing
Types of Mortgage Loans
First mortgage
First mortgage: Loan with first lien priority.
 Loans with lower priority are known
as second mortgages, third mortgages,
and so on.
 Generally, called junior mortgages.
© 2010 Rockwell Publishing
Types of Mortgage Loans
Purchase money mortgage
Purchase money mortgage: Any mortgage
loan used to buy property that serves as
security for loan.
 May also refer to seller financing, where
seller extends credit instead of requiring
full payment at closing. (Also called soft
money mortgage.)
© 2010 Rockwell Publishing
Types of Mortgage Loans
Hard money mortgage
Hard money mortgage: When borrower
gives lender mortgage and receives cash
in exchange.
© 2010 Rockwell Publishing
Types of Mortgage Loans
Package mortgage
Package mortgage: Mortgage used to
finance real property and personal property.
 Example: office or farm equipment
included in sale of real property.
© 2010 Rockwell Publishing
Types of Mortgage Loans
Construction mortgage
Construction mortgage: Temporary (or interim)
loan used to finance construction of land
improvements.
 Loan funds are usually disbursed to
borrower as construction proceeds using
fixed disbursement plan.
© 2010 Rockwell Publishing
Types of Mortgage Loans
Construction mortgage
When construction complete, interim loan
replaced by permanent financing (called a
take-out loan).
Lender’s promise to give a (future) take-out
loan is called a standby loan commitment.
© 2010 Rockwell Publishing
Types of Mortgage Loans
Blanket mortgage
Blanket mortgage: When several properties
are used to secure one loan.
 Common in subdivision development.
Partial release clause: Requires lender to
release some of properties from blanket lien
when specified portions have been paid off.
© 2010 Rockwell Publishing
Types of Mortgage Loans
Open-end mortgage
Open-end mortgage: Mortgage that allows
borrower who has paid back part of loan to
re-borrow funds, up to a limit.
 Often used by builders and farmers.
© 2010 Rockwell Publishing
Types of Mortgage Loans
Subprime mortgage
Subprime mortgage: Loan made to borrower
who may not qualify for ordinary mortgage
loan, often because of poor credit history,
high debt-to-income ratio, or lack of
documentation.
 Lender usually charges higher interest
rates and fees to offset risk.
© 2010 Rockwell Publishing
Types of Mortgage Loans
Home equity loan
Home equity loan: Borrower uses equity in
residence to get mortgage loan.
 Money can be used for expenses
unrelated to property—medical bills,
college tuition, etc.
Home equity line of credit (HELOC): Revolving
line of credit, much like credit card, but debt
secured by borrower’s home.
© 2010 Rockwell Publishing
Types of Mortgage Loans
Refinancing
Refinancing: Borrower obtains new
mortgage loan to replace existing one, using
funds from refinance to pay off old loan.
Often used when:
 interest rates are low
 date of balloon payment approaching
© 2010 Rockwell Publishing
Land Contracts
In seller-financed transaction, seller may use
land contract to extend credit, rather than
mortgage or deed of trust.
 Land contract serves as both promissory
note and security instrument.
 Also called contract for deed or
installment sales contract.
© 2010 Rockwell Publishing
Summary
Mortgage Loans and Land Contracts
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Purchase money mortgage
Package mortgage
Construction mortgage
Blanket mortgage
Open-end mortgage
Home equity loan
Refinancing
Land contract
© 2010 Rockwell Publishing