Fundamentals of Real Estate
Lecture 16
Spring, 2003
Copyright © Joseph A. Petry
www.cba.uiuc.edu/jpetry/Fin_264_sp03
Chapter 14: Creation of Mortgages
Mortgages
The mortgage creates an interest in a property to
secure payment of a debt or obligation.
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Mortgages are legal documents which give lenders
contingent claims against real estate.
The borrower, who gives the mortgage, is the mortgagor
The lender, who receives the pledge, is the mortgagee
Borrowers are obligated by the promissory note (bond) to
repay the mortgage loan.
Chapter 14: Creation of Mortgages
Mortgages
In the event of borrower default, lenders may exercise
their claim against the property through foreclosure.
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In title-theory states, lenders technically receive title to
property in mortgage contracts. The lender can only
exercise his/her property rights if the borrower defaults.
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Mortgage contracts carry “power-of-sale” clauses in these
states which allows expeditious foreclosure
In lien-theory states lenders get security interest (rather
than title) that grants them the right to force the sale in the
event of default.
In some states, third party trustees receive title (Deeds-oftrust). In case of default, lender asks trustee to take action
to force the foreclosure.
Chapter 14: Creation of Mortgages
Mortgages
The mortgage market consists of two components:
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Primary market
Secondary market
The primary mortgage market
The mortgage contract is originated between the lender and
the borrower. Money flows to the lender from:
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deposits (banking institutions),
insurance policy premiums (insurance companies)
pension contributions (pension funds),
the secondary market.
Chapter 14: Creation of Mortgages
Mortgages
The secondary mortgage market
Firms known as conduits may assist with the sale of the
lender’s mortgage
Mortgages can be transformed from a pool of mortgages into a
mortgage-backed security and sold to multiple investors.
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Chapter 14: Creation of Mortgages
Capital Flows to Mortgages
The Four Quadrants of Real Estate Finance
Private
Public
Equity
Individuals
Equity REITs
Pension Funds
Real Estate Corporations
Mortgage Debt Banks
Mortage-Backed Securities
Insurance Companies
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Chapter 14: Creation of Mortgages
Capital Flows to Mortgages
Studies indicate that the residential mortgage market
and the capital markets are well integrated
Mortgage rates and Treasury bond rates have followed
a nearly identical pattern since the late 1980s
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Mortgage rates are about 100bps higher than the 10 year
treasury
Chapter 14: Creation of Mortgages
Clauses Found in Mortgage Contracts
Requirements of Valid and Enforceable Mortgages:
• Must include essential elements of a standard
contract,
• Must be in writing, and properly describe the
property
• And must include the following:
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Identify the property rights being pledged
Include the words of conveyance,
Include the signature of the mortgagor
Be delivered to the mortgagee and recorded
Contain reference to the note, or obligation
Chapter 14: Creation of Mortgages
Common Mortgage Clauses:
• Acceleration clause,
• Prepayment (and lock-out provisions) and late
payment penalties clause
• Due-on-sale clause,
• Santa clause
• Property tax and hazard insurance clause
• Interest escalation and adjustment clause
Non-uniform clauses may be included for the lender to
comply with respective laws.
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Chapter 14: Creation of Mortgages
Residential Mortgage Documents:
Typical clauses in the standard residential note include:
• Date the note is executed
• Name of the mortgagor and mortgagee
• Acceleration clause
• Terms of the debt (e.g. interest rate, type of
amortization, frequency of payments, maturity date)
• Prepayment penalties
• Escalation clause on delinquent penalties
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Chapter 14: Creation of Mortgages
Typical standard residential mortgage form extends
somewhat longer than the note. The clauses in the
mortgage fall into either:
1. Uniform clauses:
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Require actions on the part of the borrower
• Keep the property in good condition
• Give notice to lender if additional liens are placed on the
property
2. Non-uniform clauses are required by particular states (e.g.):
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Specific acceleration remedies may be available to lenders in
the event of borrower default
The assignment of rents to lenders in the event of default
Chapter 14: Creation of Mortgages
The standard trust deed for residential property differs
from the the mortgage in that:
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Three parties, instead of two, are named
Lenders are given nonpossessionary security interests,
while trustees are given possessionary security interests
Trustees are given the power of sale
Provisions are made for an alternative trustee
Mortgage Borrower and Lender Relationships
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Extensions of the simple mortgage contract
• First mortgage is most common and gives lender
highest priority among lenders. Extensions include:
Chapter 14: Creation of Mortgages
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Junior mortgage represents an additional pledge of the
property to another loan. In event of default, the claims of
the mortgagee on the junior mortgage are second to the first
mortgage.
Wrap-around mortgage involves additional financing,
usually from the seller of the property, in which a new loan
is created around an existing loan that the seller keeps in
place.
Assumption of an existing mortgage occurs when the buyer
takes over the payments of the original loan.
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Subject to mortgage: If the buyer takes title to property subject
to existing mortgage, the buyer does not take on personal
liability—original borrower remains liable. The mortgage is
drafted so that the buyer’s property is used to secure the loan.
Chapter 14: Creation of Mortgages
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Assumption of the mortgage: If the buyer takes title to the
property by assuming the existing mortgage (both the
mortgage and the note change) and only the buyer is liable in
case of default, provided the seller’s liability is relieved by the
lender.
Purchase money mortgage occurs when the owner takes
the role of both the seller of the property and the first
mortgage lender
Land contract occurs when seller financing is provided and
the title to the property changes hands when some
percentage (e.g. 50%) of the loan is repaid.
Single-family residential mortgages
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For existing properties, permanent mortgages for singlefamily homes fall into three categories:
Chapter 14: Creation of Mortgages
1. Conventional
2. Government-supported mortgages (e.g. FHA, VA)
3. Owner (seller) financing
Construction financing finances the development of the site
and construction of the improvements during construction
• A forward commitment (or takeout) occurs when a lender
agrees to provide a long-term loan upon the completion of
construction and often the fulfillment of other conditions.
• Construction loans granted once forward commitments are
in place are termed covered loans
• Construction loans granted without forward commitments
are termed uncovered, or open-end loans.
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Chapter 14: Creation of Mortgages
Income Property Mortgages
• Partial amortization, income and equity participation,
and various prepayment penalty clauses are often
features of loans written on existing income
properties.
• Forward commitments on income-properties may
contain specific performance targets such as
completion date and percent of space occupied.
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Chapter 14: Creation of Mortgages
Adjustments to Borrower and Lender Relationships
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Satisfactory payment in full
Default and foreclosure
1. Delinquency and default
Delinquency occurs when the borrower fails to make timely
payments as specified in the mortgage contract
Mortgage default usually results from nonpayment or lack of
timely payment (prolonged delinquency). Technical default can
occur as a result of non-payment of property taxes and
insurance premiums, or if the borrower fails to adequately
maintain the property.
2. Equity of redemption
The legal right of delinquent borrowers to pay the outstanding
balance, interest and court costs to redeem the equity in their
property. Equity right of redemption occurs before foreclosure.
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Chapter 14: Creation of Mortgages
3. Judicial and nonjudicial foreclosure
Judicial foreclosure means selling the property through a court
procedure to satisfy a lien (generally followed in lien-theory
states).
Nonjudicial foreclosure rules, with respect to notification and sale
procedures, are generally followed in title-theory states.
4. Statutory period of redemption
A period of time enacted in some states in which the borrower can
redeem the property after foreclosure by paying the
outstanding debt, interest and legal fees.
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Assumption of Mortgages
Recasting a Mortgage
Sale of the Mortgage