Financing Residential Real Estate
Lesson 5:
Finance Instruments
Introduction
In this lesson, we will cover:
 types of finance instruments
 how they work
 common provisions
Promissory Notes
Promissory note
A written promise to pay money.
Promissory Notes
Promissory note
A written promise to pay money.
Maker – the one who makes the promise.
Promissory Notes
Promissory note
A written promise to pay money.
Maker – the one who makes the promise.
Payee – the one to whom the promise is made.
Promissory Notes
Promissory note
A 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.
Promissory Notes
Basic provisions
A promissory note can be a brief and simple
document.
It usually contains:
 names of the parties,
 amount of the debt,
 interest rate, and
 how/when money is to be repaid.
Promissory Notes
Basic provisions
Promissory note must be signed by the maker.
A legal description isn’t required.
Promissory Notes
Basic provisions
Promissory note must be signed by the maker.
A legal description isn’t required.
If promissory note meets certain requirements, it is
a negotiable instrument.
 Right to receive payment can be
transferred by endorsement.
Security Instruments
Purpose
In real estate transactions, a promissory note is
accompanied by a security instrument:

Mortgage

Deed of trust
Security Instruments
Purpose
Security instrument gives lender the right to
foreclose on the property if borrower defaults.
Security Instruments
Purpose
Security instrument gives lender the right to
foreclose on the property if borrower defaults.
Foreclosure: Lender forces sale of property and
collects debt out of sale proceeds.
Security Instruments
Purpose
Even if debt unsecured (no collateral), lender can
enforce promissory note.
 Lender sues borrower, obtains judgment.
Security Instruments
Purpose
Even if debt unsecured (no collateral), lender can
enforce promissory note.
 Lender sues borrower, obtains judgment.
 But borrower may be “judgment-proof.”
Security Instruments
Purpose
Even if debt unsecured (no collateral), lender can
enforce promissory note.
 Lender sues borrower, obtains judgment.
 But borrower may be “judgment-proof.”
Secured lender much more likely to collect
payment.
So real estate lenders always require
borrowers to sign a security instrument.
Security Instruments
Mortgages
Mortgage
Two-party security instrument in which borrower
mortgages his property to lender.
Mortgagor = Borrower
Mortgagee = Lender
Mortgages
Basic provisions
Mortgage must include:
 names of parties
 accurate legal description of property
Also must identify promissory note it secures.
Mortgages
Covenants
Mortgagor promises to:
 pay property taxes,
 keep property insured against
fire and other hazards, and
 maintain structures in good repair.
Mortgagee has right to inspect property.
Mortgages
Covenants
If mortgagor fails to fulfill covenants imposed by
mortgage, she is in default.
Mortgagee could foreclose (even if
payments are being made as agreed).
Mortgages
Recording
After mortgage agreement signed, mortgagee
records document to establish priority of
mortgagee’s security interest.
Mortgages
Satisfaction
Satisfaction of mortgage
Document given to mortgagor by mortgagee, after
mortgage is paid off, releasing property from
mortgage lien.
Mortgages
Satisfaction
Satisfaction of mortgage
Document given to mortgagor by mortgagee, after
mortgage is paid off, releasing property from
mortgage lien.
 Mortgagor records document.
Security Instruments
Deeds of trust
Deed of trust
Similar to mortgage, but involves three parties,
rather than two.
Grantor (or Trustor) = Borrower
Beneficiary = Lender
Trustee = Neutral third party
Trustee arranges for release of
property or foreclosure, as necessary.
Deeds of Trust
Basic provisions
Deed of trust usually includes same basic
provisions found in a mortgage:
 names of parties,
 property description,
 identification of promissory note,
 grantor’s promises to pay taxes and
insure property, and
 beneficiary’s right to inspect
property.
Deeds of Trust
Reconveyance
Deed of reconveyance
Document releasing property from lien.
Executed by trustee when loan secured
by deed of trust paid off.
Recorded by grantor.
Summary
Security Instruments
Hypothecation
Legal title
Equitable title
Lien
Mortgage
Satisfaction of mortgage
Deed of trust
Deed of reconveyance
Security Instruments
Foreclosure
Key difference between deeds of trust and
mortgages: procedures used for foreclosure.
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.
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.
Methods of Foreclosure
Power of sale
Nonjudicial foreclosure can’t be used unless
security instrument contains a power of sale clause.
 Power of sale clause authorizes trustee to sell
the property in the event of default.
All deeds of trust include a power of sale clause.
Power of sale clause can be included in a
mortgage, but in many states mortgages
ordinarily don’t have one.
Methods of Foreclosure
Power of sale
Typical power of sale clause might read:
“Upon default by Grantor in the payment of any
indebtedness secured hereby or in the
performance of any agreement contained
herein, and upon written request of Beneficiary,
Trustee shall sell the trust property, in
accordance with the Deed of Trust Act of this
state, at public auction to the highest bidder.”
Nonjudicial Foreclosure
Steps in a nonjudicial foreclosure
1. Notice of default
2. Notice of sale
3. Cure and reinstatement
4. Trustee’s sale
5. Trustee’s deed
Steps in a Nonjudicial Foreclosure
Notice to borrower
1. Notice of default
To begin nonjudicial foreclosure, trustee must give
notice of default to grantor.
Steps in a Nonjudicial Foreclosure
Notice to public
2. Notice of sale
Trustee must wait certain length of time after notice
of default before issuing notice of sale.
Usually between 3 to 6 months.
Minimum time period also required
between notice of sale and date of sale.
Steps in a Nonjudicial Foreclosure
Stopping the foreclosure
3. Cure and reinstatement
Grantor is allowed to cure default and reinstate loan
by paying delinquent amounts plus costs.
Right ends shortly before trustee’s sale
is held.
No statutory right of redemption after
trustee’s sale.
Steps in a Nonjudicial Foreclosure
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, and then to junior liens.
 Any surplus goes to debtor.
Steps in a Nonjudicial Foreclosure
No post-sale redemption period
5. Trustee’s deed
Highest bidder receives trustee’s deed immediately
after sale.
 Debtor’s title terminates immediately.
 Must vacate property in short period (for
example, within 30 days).
Nonjudicial Foreclosure
Restrictions
State law may place restrictions on nonjudicial
foreclosures, such as:
 Requiring a post-sale redemption period for
agricultural property.
 Prohibiting beneficiary from obtaining
deficiency judgment after sale.
Judicial vs. Nonjudicial Foreclosure
Lender’s point of view
Advantages of judicial foreclosure:
 Borrower can’t reinstate loan.
 Right to deficiency judgment.
Judicial vs. Nonjudicial Foreclosure
Lender’s point of view
Advantages of judicial foreclosure:
 Borrower can’t reinstate loan.
 Right to deficiency judgment
Advantages of nonjudicial foreclosure:
 Quick and inexpensive.
Judicial vs. Nonjudicial Foreclosure
Borrower’s point of view
Advantages of judicial foreclosure:
 Slow process.
 Post-sale redemption.
Judicial vs. Nonjudicial Foreclosure
Borrower’s point of view
Advantages of judicial foreclosure:
 Slow process.
 Post-sale redemption.
Advantages of nonjudicial foreclosure:
 Right to cure and reinstate.
Summary
Foreclosure
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
Alternatives to Foreclosure
Three alternatives allow borrowers on the verge of
default to avoid foreclosure:
Alternatives to Foreclosure
Three alternatives allow borrowers on the verge of
default to avoid foreclosure:
 Loan workout
Alternatives to Foreclosure
Three alternatives allow borrowers on the verge of
default to avoid foreclosure:
 Loan workout
 Deed in lieu
Alternatives to Foreclosure
Three alternatives allow borrowers on the verge of
default to avoid foreclosure:
 Loan workout
 Deed in lieu
 Short sale
Alternatives to Foreclosure
Lender’s consent needed
All three alternatives require lender’s cooperation
and consent.
Alternatives to Foreclosure
Lender’s consent needed
All three alternatives require lender’s cooperation
and consent.
Lender’s incentives:
avoiding foreclosure costs
ending money-losing situation
more quickly
Alternatives to Foreclosure
Workouts
First step for borrower hoping to avoid foreclosure:
asking lender for a loan workout.
Two types of workouts:
 Repayment plan
 Loan modification
Workouts
Repayment plans
With a repayment plan, lender allows borrower to
change the timing of a limited number of payments.
Workouts
Repayment plans
With a repayment plan, lender allows borrower to
change the timing of a limited number of payments.
For example, borrower might be allowed to:
 take additional time to make one or more
payments, or
Workouts
Repayment plans
With a repayment plan, lender allows borrower to
change the timing of a limited number of payments.
For example, borrower might be allowed to:
 take additional time to make one or more
payments, or
 skip one or more payments, with skipped
payments added on to repayment period.
Workouts
Loan modifications
Borrower in more dire situation may need a
loan modification: permanent change in the
terms of repayment.
Workouts
Loan modifications
Borrower in more dire situation may need a
loan modification: permanent change in the
terms of repayment.
Examples:
converting ARM to fixed-rate loan
before payment resets higher
reducing interest rate
reducing principal owed
Alternatives to Foreclosure
Deed in lieu of foreclosure
If borrower can’t negotiate a workout and will lose
the property anyway, can offer lender a deed in lieu.
Alternatives to Foreclosure
Deed in lieu of foreclosure
If borrower can’t negotiate a workout and will lose
the property anyway, can offer lender a deed in lieu.
If lender accepts deed in lieu:
 borrower deeds property to lender
 debt satisfied
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 a
promissory note for the shortfall, but
that isn’t typical.
Deed in Lieu of Foreclosure
Impact on borrower
Compared to foreclosure, deed in lieu is:
 simpler
 less public
Deed in Lieu of Foreclosure
Impact on borrower
Compared to foreclosure, deed in lieu is:
 simpler
 less public
However, borrower’s credit rating suffers almost as
much from deed in lieu as from foreclosure.
Deed in Lieu of Foreclosure
Junior liens
Lender who accepts deed in lieu takes title subject
to other liens.
 Not like foreclosure, which extinguishes
junior liens.
 Therefore lender will usually refuse deed
in lieu if there are junior liens.
Alternatives to Foreclosure
Short sales
Short sale: When borrower sells the property to a
third party for less than the amount owed.
Alternatives to Foreclosure
Short sales
Short sale: When borrower sells the property to a
third party for less than the amount owed.
 If borrower facing foreclosure can find a buyer,
may ask lender to approve a short sale.
Alternatives to Foreclosure
Short sales
Short sale: When borrower sells the property to a
third party for less than the amount owed.
 If borrower facing foreclosure can find a buyer,
may ask lender to approve a short sale.
 Lender receives sale proceeds and
releases lien.
Alternatives to Foreclosure
Short sales
Short sale: When borrower sells the property to a
third party for less than the amount owed.
 If borrower facing foreclosure can find a buyer,
may ask lender to approve a short sale.
 Lender receives sale proceeds and
releases lien.
 Might require borrower to sign a
promissory note for the shortfall.
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, not just lender
threatening foreclosure.
 Junior lienholders unlikely to consent.
Alternatives to Foreclosure
Obtaining lender’s consent
To arrange a workout, offer a deed in lieu, or
request approval of a short sale, borrower contacts
loan servicer.
May need approval from more than one
department or entity.
Obtaining Lender’s Consent
Application process
Borrower must demonstrate financial hardship
(inability to make payments).
Application and documentation required.
Obtaining Lender’s Consent
Application process
Borrower must demonstrate financial hardship
(inability to make payments).
Application and documentation required.
Some lenders won’t even consider
borrower’s request until at least 90 days
behind on loan payments.
Obtaining Lender’s Consent
Assistance for borrowers
Borrower who wants help with process should
contact nonprofit HUD-approved housing
counseling service.
Obtaining Lender’s Consent
Assistance for borrowers
Borrower who wants help with process should
contact nonprofit HUD-approved housing
counseling service.
 Problems in many places with predatory
for-profit loan modification companies.
Obtaining Lender’s Consent
Assistance for borrowers
Borrower who wants help with process should
contact nonprofit HUD-approved housing
counseling service.
 Problems in many places with predatory
for-profit loan modification companies.
 Many states now have “distressed property
laws” regulating these companies.
Obtaining Lender’s Consent
Securitized loans
If loan has been securitized, can be very difficult to
obtain consent.
 Under some MBS contracts, any purchaser
(investor) can object and prevent loan
modification or settlement of debt.
Obtaining Lender’s Consent
Securitized loans
If loan has been securitized, can be very difficult to
obtain consent.
 Under some MBS contracts, any purchaser
(investor) can object and prevent loan
modification or settlement of debt.
 Impossible or at least impractical to obtain
consent of all investors.
Alternatives to Foreclosure
Income tax implications
IRS views debt relief (reduction in amount owed)
as income.
 Borrower who enters into an arrangement that
reduces amount owed on mortgage may have
to pay income taxes on the debt relief.
Alternatives to Foreclosure
Income tax implications
Exceptions – Debt relief not taxable if:
debt was secured by principal residence
and forgiven since 2007, or
Alternatives to Foreclosure
Income tax implications
Exceptions – Debt relief not taxable if:
debt was secured by principal residence
and forgiven since 2007, or
debtor was insolvent when debt forgiven.
Summary
Alternatives to Foreclosure
Loan workout
Repayment plan
Loan modification
Deed in lieu
Short sale
Housing counseling service
Distressed property laws
Debt relief
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, and/or
 alienation clause.
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.
Finance Instrument Provisions
Subordination clauses
Typical subordination clause:
“Lender agrees that this instrument shall be
subordinate to a lien to be given by Borrower
to secure funds for the construction of
improvements on the Property, provided said
lien is duly recorded and the amount secured
by said lien does not exceed $125,000.”
Finance Instrument Provisions
Subordination clauses
Inclusion of subordination clause must be
negotiated during the earlier transaction.
If not, holder of earlier mortgage may be
willing to sign a separate subordination
agreement later on.
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.
Finance Instrument Provisions
Prepayment provisions
Prepayment provision imposes penalty on borrower
who repays some or all of principal before it is due.
Prepayment deprives lender of some of the interest
it expected to receive over loan term.
Finance Instrument Provisions
Prepayment provisions
Typical prepayment provision:
“If, within five years from the date of this note,
Borrower makes any prepayments of principal
in excess of twenty percent of the original
principal amount in any twelve-month
period beginning with the date of this note or
anniversary dates thereof (“loan year”),
Borrower shall pay the Note Holder three
percent of the original principal amount.”
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.
Finance Instrument Provisions
Prepayment provisions
Prepayment provision usually allows lender to
charge penalty only if loan is prepaid during first
few years of loan term.
Unreasonable prepayment penalties are considered
a predatory lending practice.
 Some states have laws limiting penalty
amounts and imposing other restrictions.
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.
Finance Instrument Provisions
Partial release clauses
Typical partial release clause:
“Upon payment of all sums due with respect to
any lot subject to this lien, Lender shall release
said lot from the lien at no cost to Borrower.”
Finance Instrument Provisions
Acceleration clauses
Acceleration clause allows lender to declare
outstanding loan balance due immediately in the
event of default.
Most lenders wait 90 days before
accelerating.
Some states now have laws requiring
lenders to wait a specified period.
Finance Instrument Provisions
Acceleration clauses
Typical acceleration clause:
“In case the Mortgagor [or Trustor] fails to pay
any installment of principal or interest secured
hereby when due or to keep or perform any
covenant or agreement aforesaid, then the
whole indebtedness hereby secured shall
become due and payable, at the election of the
Mortgagee [or Beneficiary].”
Finance Instrument Provisions
Alienation clauses
Alienation clause is designed to prevent borrower
from selling the security property without lender’s
permission unless loan is paid off at closing.
 If title transferred without permission, lender
can accelerate loan.
 Also called a due-on-sale clause.
Alienation Clauses
Triggered by transfer of any interest
Most alienation clauses are triggered not just by
transfer of title, but by transfer of any significant
interest.
 Includes long-term leases, or leases with
options to purchase.
 Lender can’t forbid transfer, but can demand
payment of loan.
Alienation Clauses
Typical clause
Typical alienation clause:
“If all or any part of the Property or an interest
therein is sold or transferred by Borrower
without Lender’s prior written consent, Lender
may, at Lender’s option, declare all the sums
secured by this instrument to be immediately
due and payable.”
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.
Alienation Clauses
Transfer of title without loan payoff
Three possibilities:
1. New owner takes title subject to loan but
does not assume it.
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.
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.
Transfer Without Loan Payoff
Taking title “subject to” loan
If new owner takes title subject to an existing
mortgage but does not assume it:
 New owner is not personally liable for payment
of mortgage.
 But lender still has power to foreclose (transfer
of title doesn’t extinguish lien).
Transfer Without Loan Payoff
Assumption without release
If new owner assumes loan:
 New owner takes on primary liability for
repaying loan.
 Unless lender agrees to a release, original
borrower is secondarily liable.
 Original borrower can be forced to pay
deficiency judgment if new owner doesn’t.
Transfer Without Loan Payoff
Assumption and release
Alienation clause allows lender to evaluate
creditworthiness of proposed buyer.
 If buyer not creditworthy, lender tells original
borrower loan will be accelerated if sale goes
forward.
 If buyer is creditworthy, lender approves
assumption and releases original borrower.
 Original borrower has no further liability.
Assumption and Release
Assumption fee
Lender will charge new owner an assumption fee,
which is typically as large as an origination fee.
Assumption and Release
Estoppel letter
Lender will also provide an estoppel letter, which
acknowledges transfer of ownership and waives
lender’s right to accelerate loan.
Lender estopped from trying to enforce
alienation clause later on.
Lender may charge fee for estoppel letter.
Summary
Finance Instrument Provisions
Subordination clause
Late charge provision
Prepayment provision
Partial release clause
Acceleration clause
Alienation clause
Assumption
Estoppel letter
Types of Real Estate Loans
Junior or senior mortgage
Junior mortgage
Mortgage with lower lien priority than another
mortgage or deed of trust against same property.
Types of Real Estate Loans
Junior or senior mortgage
Junior mortgage
Mortgage with lower lien priority than another
mortgage or deed of trust against same property.
Senior mortgage
Mortgage with higher lien priority than another
mortgage or deed of trust against same property.
Types of Real Estate Loans
First position mortgage
The lien having the most senior (first) position is
called the first mortgage.
Junior mortgages may be referred to as second
mortgage, third mortgage, etc.
Types of Real Estate Loans
Junior or senior mortgage
Property may be encumbered with two or more
mortgages in various situations:
1. Junior mortgage provides secondary financing
to supplement primary loan.
2. Purchase mortgage is subordinated to a
construction mortgage.
3. Borrower takes out home equity loan secured
by same property as purchase loan.
Types of Real Estate Loans
Junior or senior mortgage
After foreclosure, junior mortgage paid only after
senior lender has been paid in full.
If proceeds insufficient, junior lender
receives nothing.
Junior lender can still sue borrower, but
debt is now unsecured.
Types of Real Estate Loans
Purchase money mortgage
Purchase money mortgage:
1. Any mortgage loan used to finance the
purchase of the property that is the collateral
for the loan.
2. A mortgage that buyer gives to seller in
seller-financed transaction.
Types of Real Estate Loans
Home equity loan
Home equity loan is loan secured by mortgage
against borrower’s equity in home she already
owns.
Equity = difference between property’s
current market value and liens against it.
Types of Real Estate Loans
Home equity loan
Home equity loan may be used for:
 remodeling or property improvements, or
 expenses unrelated to property (such as
paying off credit cards).
Interest rates on home equity loans are higher than
rates on purchase loans.
Types of Real Estate Loans
Home equity loan
Home equity line of credit (HELOC)
Line of credit with a limit and minimum monthly
payments that homeowners can draw upon as
needed.
Automatically secured by borrower’s home.
Types of Real Estate Loans
Refinance mortgage
Refinancing refers to a new loan used to pay off
existing mortgage against same property.
Often used:
to take advantage of market interest rate drop;
or
when large balloon payment is required on
existing mortgage.
Types of Real Estate Loans
Refinance mortgage
Cash-out refinancing
New loan amount is more than amount of existing
mortgage balance, so borrowers receive cash from
refinance lender.
A way to tap into home equity while
also refinancing.
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.
Types of Real Estate Loans
Construction loan
Construction loan is a short-term loan used to
finance construction of improvements on land
already owned by borrower.
Types of Real Estate Loans
Construction loan
Construction loan is a short-term loan used to
finance construction of improvements on land
already owned by borrower.
Construction loans:
are considered high-risk loans
typically have high loan fees and
interest rates
Types of Real Estate Loans
Construction loan
Fixed disbursement plan: typical disbursement
schedule for construction loans.
 Calls for a series of predetermined
disbursements (obligatory advances) at
certain stages of construction.
 Interest starts to accrue at first disbursement.
Types of Real Estate Loans
Construction loan
Once construction is completed, construction loan
is replaced by a take-out loan.
Borrower repays amount borrowed over
specified term.
Types of Real Estate Loans
Reverse equity mortgage
Reverse equity mortgage provides elderly
homeowners with a source of income, without
requiring them to sell their home.
 Homeowner borrows against equity.
 Receives monthly check from lender, rather
than making monthly payments.
 Borrower typically required to be over
a certain age.
 Home sold after death to repay loan.
Summary
Types of Real Estate Loans
 Purchase money mortgage
 Home equity loan or HELOC
 Refinancing
 Bridge loan
 Budget mortgage
 Package mortgage
 Blanket mortgage
 Construction loan
 Nonrecourse mortgage
 Wraparound mortgage
 Reverse equity mortgage