One of the most important components of any real estate transaction is the financing. Without adequate financing the sale can be lost. This article explains interest rates, the various clauses found in notes and mortgages, and the different types of mortgages available to the borrower. Also discussed are the various documents that are necessary in a commercial loan and some facts about title insurance.
Interest is rent for the use of money. Interest rates depend upon many complex economic factors, including
- the risk involved in making the loan;
- the business outlook for the future;
- the market rate for alternate investments such as Treasury bonds (If there are fewer buyers for bonds, then bond prices fall, which results in a corresponding increase in rates); and
- the outlook for inflation in the future
Since investors are in business to make a profit, they require a certain rate of return on their investments. Under the free market system in the United States, the market rates of interest are not set by the government, but by auction process.
MORTGAGE PAYMENT METHODS
Under a term loan, the borrower pays only the interest due for each period, with the interest and principal sum borrowed repaid on the due date of the loan. Term loans are used by builders and land developers who need short-term financing.
Fully Amortized Mortgages
The most common means of repaying a mortgage is by making equal payments that gradually reduce the balance of the loan within a stated period of time. The equal payments include a portion for interest and a portion for principal, which reduces the interest and principal unpaid balance. Basically, amortization is the liquidation of a financial obligation on repaid in equal the installment basis. For example, on a $90,000 loan at 7 percent interest for 30 payments years, the interest and principal payment would be $599.40 monthly. Most lenders also require payment of one-twelfth of the yearly taxes and insurance. This amount is kept in an escrow or reserve account from which the lender pays the taxes and insurance as they become due. The lender is then assured protection on the investment; for example, if the dwelling burns down, it is covered by insurance. Similarly, the taxes are paid, so there will be no tax foreclosure sale.
Partially Amortized Mortgages
The partially amortized mortgage requires periodic payments on the principal, but at the due date a balance remains because the principal has been only partially reduced. If a loan does not amortize out at the due date, the total unpaid sum is much larger than the regular monthly payment. In some situations the mortgagor may only make interest payments, with the full amount of the principal due at an agreed-upon time.
This results in a balloon payment. Balloon Notes are used when the lender prefers not to lend money for a long period of time. The mortgage is generally a 3- to 5-year fixed loan with an amortization schedule of 15 to 30 years. The mortgage holder is under no obligation to refinance the loan, so the borrower must find other means of financing when the balloon payment is due.
The equity an owner has in property represents the difference between the value of the difference between property and what is owed. A $60,000 property with a $50,000 mortgage represents value and debt equity of $10,000 for the owner. As the principal is paid off through the monthly amortized payments, equity increases. In the early years of the mortgage, equity build-up is slow because most of the payment is for interest. If there is more than one loan, equity is the difference between the total owed and the market value.
Interest charged or accepted by a money lender in excess of the amount allowed by law Illegal interests is considered usury and is illegal. Usury laws are not federal laws, but are set by state statutes. With the unprecedented rise of interest rates during the early l98Os, many states placed a moratorium on their usury laws, since many were originally lower than the national market for mortgage money. During the first three months of 1980, Congress placed a suspension order on all state usury laws. Designed to protect the borrower from paying excessive interest rates, the usury laws may indeed be a symbol of the past. Some states change the legally allowed rate as interest rates fluctuate.
Discount points are charged by money lenders to increase the yield on money lent to the borrower. Originally, discount amounts were based on the quality of the property, and the ability of the purchaser to borrow and repay. Today the amount is determined by market conditions.
If yields on mortgage loans are lower than yields on other investments, funds will be drawn away from the home mortgage market, and money for home mortgages will become scarce and more expensive. The fixed-rate mortgage lender has to determine the cost of doing business and allow for a reasonable profit to arrive at the yield needed to make the sale of a mortgage at a given discount economically sound.
One discount point is equal to 1 percent of the loan amount. Thus, if a lender charges two discount points on a $30,000 loan, the lender will be receiving 2 percent of $30,000, or $600. This will be paid to the lender at the time the loan closes. While most loans are paid off before the 30-year maturity, a general rule is that each discount point lowers the note rate by one-eighth of 1 percent. So the two discount points in the example would lower the interest rate by .25 percent. As the interest rate increases, the discount points are lower until you reach the market or “par” rate at which no points are charged.
Do not confuse discount points with the origination fee. The origination fee is paid by the borrower to the leader for the originating and processing of the new loan and is generally an additional 1 percent of the loan. Both the discount points and loan origination fee are considered prepaid interest and can be deducted on your income tax form.
Loan-to-Value Ratio (LTV)
The lender makes a loan on the property for a proportionate value of the real estate. If the property appraises for $40,000 and the purchaser is putting 20 percent down, the Percentage loaned loan-to-value ratio will be 80 percent of the $40,000, or $32,000. Needless to say, the greater the loan-to-value ratio, the greater the risk involved for the lending institution, since the down payment represents the borrower’s equity. Mortgages are made as high as 95 percent of LTV; however, the borrower must have excellent credit to qualify. The property must appraise at the purchase price. If not, the lender will only loan on 80 percent of the appraised value, and the buyer will need to pay the balance at closing if a PMI loan is used. However, if the property appraises higher than the purchase price, the lender wilt loan on the basis of the purchase price. The lender loans on whichever is lower, purchase price or appraised value.
The Promissory Note
In real estate financing the borrower signs a promissory note in which the promise is to repay debt made to pay the specified debt at a rate and time specified in the note. The note is backed by a mortgage that pledges the property as security for the loan.
The note and mortgage may be incorporated into a single document, but technically they are two legal instruments. The note must state the terms of payment, the due date, and interest rate and sometimes will include a prepayment penalty. Since lenders often sell their loans to the secondary mortgage market, a standardized form is used in all states.
A mortgage is an instrument that pledges property as collateral for a debt. To pledge properly as property without giving up possession is referred to as hypothecating the property. There are two parties to the mortgage — the mortgagee and the mortgagor. The mortgagee (the creditor) is the person or lender to whom the mortgage has been given as security. This interest can be assigned to another and occurs when the mortgage is sold to the secondary mortgage market.
The mortgagor (debtor) is the owner of the property put up as security. The mortgagor is also referred to as the obligor and possesses all the rights of ownership but must live up to the terms of the mortgage that has been given to the mortgagee. The note set forth above is backed by the mortgage that pledges the property as security for the loan, This pledge gives the lender security while permitting the mortgagor use of the property. if the borrower does not make the payments as agreed, the creditor has the right to seize and sell the property through foreclosure to satisfy the debt. Thus, the mortgagor is not paying on a mortgage but on a note (a promise to pay.) A mortgage note is a negotiable or nonnegotiable instrument and, as such, can be bought or sold.
Section 18 says that if the owner defaults in payment, the lender can immediately Acceleration clause take possession of the premises. This clause, called the acceleration clause, is recited in deeds of trust, mortgages, and land contracts. It permits the lender or creditor to declare the entire sum due and payable upon certain default by the debtor. The legality of the call clause, as it is commonly known, has been upheld for loans issued by federally chartered savings and loans.
DEED OF TRUST
Some states use deeds of trust as the security instrument rather than a mortgage.
A deed of trust is a conditional deed to secure money for the payment of a debt involving three parties to the instrument. The borrower transfers the property to a trustee, who holds it for the benefit of the lender until the debt is repaid in full. Upon full payment, the reconveyance clause requires the trustee to reconvey the property to the borrower.
Remember, the purpose of a trust deed is to secure the loan. Widely used in some parts of the country, a deed of trust (or trust deed) is considerably easier to foreclose on than a mortgage. The lender does not hold title, only the right to request the trustee to hold a foreclosure sale in the event of a default in payment. If the trustee is not an authorized public trustee, the law states the foreclosure must proceed through the courts in the same manner as a routine mortgage foreclosure There are three parties to a deed of trust:
- the trustor (the owner or borrower);
- the trustee (a trustee; a disinterested third party); and
- the beneficiary (the lender).
The secondary mortgage market is the market for the sale of securities or bonds collateralized by the value of mortgage loans. The mortgage lender, commercial banks, or specialized firm will group together many loans and sell grouped loans as securities called collateralized mortgage obligations (CMOs). The risk of the individual loans is reduced by that aggregation process. These securities are collateralized debt obligations (CDOs), also known as mortgage-backed securities (MBS). The CMOs are sometimes further grouped in other CDOs. Mortgage delinquencies, defaults, and decreased real estate values can make these CDOs difficult to evaluate.
The Assumption Clause
If a loan is assumed by new owners, the assumption clause in the deed says that the buyers are obligating themselves to pay off the loan. This transfers the responsibility of payment onto the buyers. In case of default, the Lender will expect the new owners to fulfill existing mortgage their promise. If they do not do so, the original owners are still primarily liable since their names are on the promissory note. However, if the sellers obtain a release of liability from the lender, the sellers’ obligation ends when the title is transferred. If the clause in the deed states that the buyers are purchasing the property “subject to the existing loan” the buyers acknowledge the existing loan, promise to pay, but are only secondarily liable. Assumption clauses are usually found only in VA and FHA loans.
The wraparound mortgage is two or more mortgages consolidated into one payment. This mortgage may allow the buyers to purchase with a small down payment and the added benefit of a low-interest-rate first mortgage. The sellers receive all of their cash at the time of closing. The lender wraps new money around an existing assumable mortgage loan. If in the future the borrowers have the cash available, they could pay off the new money and resort to the original, low-interest mortgage. If the mortgage contains a due-on-sale clause, it cannot be wrapped.
Wrap mortgages are used when interest rates are high, allowing the buyer to take advantage of the lower rate existing mortgage without having to come up with a large down payment as in the case of a loan assumption.
Adjustable Rate Mortgages (ARMs)
In the late I970s the variable rate mortgage became the first vehicle that allowed for interest rates to be moved up or down on home mortgages. This allowed the yield to the lender to be kept close to the market interest rates being paid to depositors. This loan was followed by the renegotiable rate mortgage in 1980, which permitted adjustments every one, three, and five years to correlate with market conditions. The Federal Home Loan Bank Board (FHLBB) sanctioned the adjustable rate mortgage (ARM) in 1981, and in 1988 the board set guidelines that must be conformed to in all federal transactions.
Like the variable rate mortgage, the adjustable rate offers protection to the mortgagee because it allows the mortgagee to vary the interest rate in the future, The interest rate may be adjusted up or down depending on the current cost of funds (called an index), usually one-year US. Treasury securities (referred to as T-bills). Thus, with an adjustable rate mortgage, the yield to the lender may be kept close to market interest rates. The lender adds a profit margin to the index, which varies from 2 percent to 3 percent. This margin compensates the lender for any risk involved in making the loan and allows for a reasonable profit. If the rate is increased, the monthly payments do not necessarily increase; however, negative amortization is possible. A way to avoid increased payments is to extend the life of the loan up to a maximum of one-third of the original term. The time will not be extended, however, to a point that would reduce the payments.
The adjustment period is the time during which the interest rate can be changed. Usually this is one year, although three or five years also are used. The longer time span is an advantage to the borrower if market rates are increasing and, conversely, if rates are declining, the borrower would prefer the shorter time span.
The amount that the interest rate may change is limited by rate caps. Federal law mandates that the lenders reveal the interest cap rate. The periodic cap rate is the amount that the rate may increase at any given time. The aggregate cap rate is the upper limit to which the rate can raised over the full term of the loan.
Acquisition of Title Insurance.
Good and marketable title with only acceptable encumbrances will be called for by most real estate contracts and required by the lending institution which will make the loan in order to provide the proceeds to purchase the property covered by the contract. The lender will normally take a deed of trust covering the property as collateral for the loan. Assurance of good and marketable title basically takes the form of either a title certificate prepared by an attorney or a commitment by a title insurance company to insure the title against encumbrances with certain exceptions. This title insurance will cover the lender, but can cover the owner/purchaser if the owner wants to pay an additional premium in order to obtain protection by the title insurance. Title insurance policies insure against loss or damage (not exceeding the face amount of the policy), including attorneys’ fees and expenses incurred by reason of the following:
- Title to the property being vested other than as stated in the policy;
- A defect in the title such as an improper acknowledgment in a deed;
- Lack of a right to access to and from the land; and
- The unmarketability of the title.
The above elements are the basic matters insured against, but policies generally contain more coverage, depending upon the needs of the insured.
Title insurance is a one premium agreement to indemnify a policyholder for losses caused by both on-record and off-record defects found in the title to the insured property or defects to the interest of a party like a mortgagee, in amounts not exceeding the face amount of the policy, and which defects were in existence on the date the policy was issued. A title policy in favor of a mortgagee will insure the priority of the mortgagee’s lien, as well as the mortgagee’s legal interest in the property. Coverage will extend as long as the policyholder holds title to the property, or a lien against the property in the case of a mortgagee’s policy. Coverage even extends beyond ownership by the insured in situations where the insured is asked to make good on deed warranties given by the policyholder and covered by the policy, even if the policyholder is several owners removed from the present owner in the chain of title.
The title insurance company or the attorney providing the certificate will have a title search done of the records of the County Courthouse where all documents relating to land titles are to be recorded. Title is checked by taking a chain of title back a certain number of years, usually 32 years in many states. The certificate of title given by an attorney as a result of this search is a certificate to the effect that the attorney has made the examination of the title, and that, based on what he has found, fee simple title is vested in the seller free and clear of any encumbrances other than those he notes as exceptions, such as utility easements, restrictive covenants, and prior mineral reservations.
As stated earlier, normally a lending institution will require that title insurance be purchased in order to insure that the seller has good title and that the deed of trust received by the lender constitutes a first lien on the property superior to all other liens. The lender is therefore the insured. The buyer can also get insurance covering him, but his policy will be separate from the policy covering the lender. The advantage of title insurance over a certificate of title is one of economics in the sense of economical security. A title certificate from an attorney to the buyer and to the lender, if done correctly, is generally the only protection that is necessary. However, if a mistake is made, and it is deemed to be a negligent mistake, the attorney can be subject to malpractice exposure. If title insurance had been procured, the lender or the owner could simply file a claim on the policy when the title defect becomes evident, and the title insurance company will then either clear the defect or pay the beneficiaries of the policy (e.g., the owners and the lender) the amount of any loss up to the maximum policy limits. It is comforting to know that you can go against a title insurance company if a defect later arises, rather than having to sue the attorney who prepared the certificate for malpractice. Also, title insurance insures some things that are not shown by the public record, such as forgery of a deed, the lack of mental capacity of a grantor, or the misindexing or misfiling of a document by the recorder.
Prior to issuing the policy, the title insurance company will either rely on its own staff to search the chain of title or an attorney “approved” by the title company who will give the title company his certificate of title based on his search of the chain of title. A Commitment for Title Insurance is then issued.
The Commitment describes the transaction that is being insured and obligates the title insurance to issue a title policy if the parties to the transaction comply with the terms and provisions of the Commitment. It also defines the state of the title as of the time of the examination of title, states the amount of coverage to be provided, and specifically describes the requirements that the parties will have to meet (i.e., conditions precedent) in order to obligate the title insurance company to issue the policy.
The Commitment is composed of a cover along with at least three schedules and a page setting forth certain stipulations and conditions. The cover is a standard pre-printed document committing the company to issue title insurance upon satisfaction of certain conditions. The Commitment is generally limited to six months after its issuance. This time period can be extended by agreement between the proposed insured and the title company.
Schedule A shows the following:
- The effective date of the Commitment. This date is important since it starts the six month period of effectiveness as well as identifies the latest date upon which the title was searched.
- Whom the owner of the policy will be, i.e., whether the insured will be the owner, the mortgagee, or both.
- The amount of coverage.
- The owner of the property.
- A description of the property. If the description is very long, an exhibit may be used.
Schedule B-1 of the Commitment contains the requirements which must be met before the title company will issue the policy, for example:
- execution and recording of instrument granting title to be insured.
- payment of the consideration (i.e., proceeds of a sale or disbursement of the proceeds of a loan).
- payment of the title insurance premium.
- payment of all taxes which are currently due.
- payment of any contractors or others that have done work on the property.
- satisfaction, cancellation and release of any lien to be paid from the sales/loan proceeds.
Schedule B-2 contains the exceptions to title. Normally these are matters that cannot, or will not, be removed by paying off a lien or correcting a document.
The inside back cover of the Commitment sets forth the Standard Exceptions for Owner’s Policy and Conditions and Stipulations.
A mortgagee’s policy normally consists of a cover and two schedules. The front cover contains the policy number and the coverage afforded by the policy. Regarding the coverage against “unmarketabiliy of the title,” this does not guarantee the policyholder that a buyer can be found for the property or that the value of the property will not decrease. However, it does cover situations in which the state of the title is sufficiently in question that a reasonable purchaser would refuse to purchase the property or that a title insurer would refuse to insure the property.
Any change in the policy is done by way of endorsement. Some endorsements clarify the basic coverage provided by a policy at the time it is issued. Others reflect changes in the policy as a result of changes in circumstances such as a release of part of the collateral from a mortgage. Some of the more common endorsements are listed as follows:
- An Access Endorsement provides that the property has free access to a particular street or highway.
- A Comprehensive Endorsement. The comprehensive endorsement is one of the most commonly requested endorsements to a loan policy and provides protection against loss or damage sustained by reason of any inaccuracies in the assurances that:
- there are no covenants, conditions, or restrictions under which the lien of the mortgage could be divested, subordinated or extinguished, or its validity, priority or enforceability impaired; and that unless specifically excepted in Schedule B:
- there are no violations of any enforceable covenants, conditions, restrictions or setback lines shown in the public record;
- any instrument shown in Schedule B as containing covenants, conditions or restrictions does not also (A) establish an easement, (B) provide for a lien for liquidated damages, (C) provide for a private charge or assessments, or (D) provide for an option to purchase, right of first refusal or prior approval of a future purchaser or occupant; and
- there are not any encroachments of existing improvements onto adjoining land, nor any encroachment from adjoining land onto the land described in Schedule A.
The comprehensive endorsement also covers loss or damage resulting from:
- Any future violation of covenants, conditions or restrictions occurring prior to the acquisition of title by the insured provided the violation results in:
- impairment or loss of the lien of the insured mortgage; or
- loss of title if the insured shall acquire title in satisfaction of the indebtedness secured by the insured mortgage;
- damage to existing improvements, including lawns, shrubbery or trees:
- which are located on or encroach upon an easement resulting from the exercise of the rights to maintain the easement for the purpose for which it was granted; or
- resulting from the future exercise of any right to use the surface of the land to extract minerals excepted from the description of the land;
- a final court order requiring the removal of any existing improvements because of any encroachment thereof onto adjoining land; and a final court order denying the right to maintain existing improvements because of a violation of covenants, conditions, restrictions or setback lines shown in the public records.
A Contiguity Endorsement insures against gaps between tracts comprising a commercial parcel which is being insured.
A Doing Business Endorsement protects against loss or damage as a result of the insured’s failure to qualify to do business in the subject state as required by state law.
An Environmental Protection Lien Endorsement provides coverage for certain state and /or federal liens relating to liability for hazardous waste removal costs, where such liens have been placed of record prior to the date of the policy.
A Fairway Endorsement: Pursuant to this endorsement, a title company cannot raise as a defense to a claim the fact that an insured partnership has dissolved since issuance of the policy and been replaced by a successor.
A First Loss Endorsement normally applies to a situation in which the mortgagee policy covers several separate and distinct properties. If a claim affects only one property, the insured lender is not required by this endorsement to exhaust its other remedies before filing a claim as to that single property.
A Last Dollar Endorsement: Sometimes, pursuant to an agreement between the title company and the insured, a loan policy will be issued in an amount less that the face amount of the mortgage. This endorsement supersedes the policy provision which reduces the face amount as the mortgage is paid off.
A Revolving Credit Endorsement provides the lender with coverage for obligatory future advances, such as in a home equity loan. The endorsement also provides coverage for changes in interest rates according to a formula agreed on in the loan documents.
A Survey Endorsement is usually used in conjunction with an agreement by the title company to insure the survey description even if it is not exactly the same as the latest record description.
A Zoning Endorsement insures that the property is zoned in a certain way and that a certain use can be made of the property. Along with coverage for land use, they provide coverage for building restrictions such as setback requirements, building height, and number of parking spaces
A Mineral Endorsement provides coverage for losses occasioned by damages to improvements during the removal of sub-surface minerals and petroleum deposits by the mineral owner.
The Short Form policy is designed for loans secured by one to four family residences in subdivisions located in municipalities. It consists of a single page with Schedules A and B on the front and back respectively. No mineral right or survey exceptions are allowed and the policy affirmatively insures against loss or damage by reason of any violation, variation, encroachment or adverse circumstance affecting the title which would be disclosed by a survey. These policies are very popular with lenders since they are short and easy to understand. They also insure over a lot of things which probably should be exceptions to coverage.
COMMERCIAL FINANCING DOCUMENTS
In a commercial, as opposed to a residential loan, there are several other document that one needs to be familiar with.
Loan Commitment Agreement.
Many lenders use a loan agreement to set forth the basic terms of the loan. Sometimes such a document will also contain certain financial covenants that must be kept during the life of the loan. Some lenders prefer a commitment letter, which is what I prefer. Covenants can be put in the deed of trust.
Assignment of Leases and Rents.
This document assigns specific leases on the property which is security for the loan as well as a blanket assignment of all future leases. The Borrower/Owner retains the right to collect rents until a default in the Loan occurs. Upon default, the Lender has the right to collect the rent and apply it to the debt. The Assignment is obviously a collateral assignment as opposed to an absolute assignment.
This is a blanket assignment of all present and future leases and rents. It purports to be an absolute assignment rather than a collateral assignment. Some attorneys believe that this type of assignment gives the Lender some advantages if the borrower files for bankruptcy. The Borrower/Owner is give a “license” to collect the rents so long as there is no default. Even though the leases and rents are normally assigned in the deed of trust, lenders seem to feel more comfortable with a separate assignment.
Security Agreement. (Appendix D).
A UCC Security Agreement is also normally contained in the deed of trust, but again, lenders seem to feel more comfortable with a separate security agreement. Unless equipment, inventory, and/or personal property of some value are actually collateral for the loan, such an agreement seems to be unnecessary other than to cover future fixtures not financed by the Lender.
UCC-1 Financing Statement. (Appendix E).
This is a fixture filing exhibit to cover any fixtures that will later be placed on the property and financed by the Borrower with another lender or the seller.
Environmental Indemnity Agreement. (Appendix F)
Lenders are requiring these agreements in all major loans regardless of the type of property that is covered by the deed of trust. Such an agreement can be put in the deed of trust, but again, lenders feel more secure with a separate agreement. Also, having a separate agreement eliminates any question of the survival of the agreement after the deed of trust has been satisfied and therefore “extinguished.”
Certificate of Borrower. (Appendix G).
This document requires an official of the borrower to make certain representations, under oath. While these representations may already be in a corporate resolution or in covenants of one of the loan documents, a company official is less likely to “bend” the truth on a document he swears to as opposed to an unsworn document like a loan application or a copy of a corporate resolution.
Tenant Acceptance. (Appendix H).
The main purpose of this agreement is to assure the lender that leases on the property are in full force and effect and not in default. It is difficult to get these signed, particularly prior to closing. However, don’t let the borrower wait until after closing to get them signed. The borrower has no incentive then.
Subordination, Non-Disturbance and Attornment Agreement.
The main purpose of this document is to subordinate the lease to the deed of trust, and have the tenant agree to be bound by the lease to a new owner in the event of foreclosure. Also, the tenant agrees to allow the lender to cure any defaults by the borrower/landlord. This instrument is generally recorded while the tenant acceptance is not. It is also difficult to get these instruments signed, particularly prior to closing. Again, don’t let the borrower wait until after closing to get them
Certification of No Material Change and No Damage.
This document is particularly useful when an out-of-state lender has not had the opportunity to inspect the property
Rent Roll Certification.
I don’t know that this document is necessary if all the tenant acceptance letters are executed prior to closing. However, the second paragraph does assure the lender that no oral promises have been made to any tenant contrary to the tenant’s
Loan Closing Statement.
Loan Closing Statements for commercial generally aren’t as complicated as a HUD-1 Settlement Statement in a residential closing. It may be helpful to use a HUD-1 form for a commercial loan closing, particularly if there will be a lot of disbursements from the loan proceeds.
Certificate of Secretary.
The most important documents attached to this certificate are the certificate of good standing and the corporate or partnership resolutions authorizing the loan and designating the officers who are to execute the loan documents.
Resolution of the Board of Directors of Borrower.
This is a sample of the type of resolution the board of directors or partners will need to approve in order to authorize the transaction and designate the officers/partners who will sign the loan documents.