120 Week 7 F /For WIZARD KIM

z06jl

Ch54-72.pdf

Home >Business & Finance homework help >Financial markets homework help >120 Week 7 F /For WIZARD KIM

Chapter 54: Conventional financing on a sale, and the buyer’s agent 359

After reading this chapter, you will be able to:

• undertake the duties of a transaction agent (TA) to police all facets of their buyer’s mortgage process;

• understand the adversarial relationship between a lender and buyer; and

• advise buyers of the financial advantage gained by submitting mortgage applications to multiple lenders.

Learning Objectives

Conventional financing on a sale, and the buyer’s agent

Chapter

The ability of a buyer or an owner to obtain financing is an integral component of most real estate transactions.

The submission of a mortgage application to a private or institutional lender is the catalyst which sets the machinery of the mortgage industry in motion.

The buyer’s agent owes their buyer the duty to ensure their buyer negotiates the best financial advantage available among mortgage lenders. As viewed and identified by lenders, the buyer’s agent is called a transaction agent (TA).

Role of the transaction agent (TA)

transaction agent (TA) The term lenders use to identify the buyer’s agent in a sales transaction, its closing contingent on the buyer obtaining a mortgage to fund the purchase price.

Loan Estimate

mortgage shopping worksheet

transaction agent (TA)

Uniform Residential Loan Application

For a further study of this discussion, see Chapter 37 of Real Estate Finance.

Key Terms

360 Real Estate Principles, Second Edition

The TA neither arranges nor makes a mortgage. Further, they are barred from receiving any compensation for referring the buyer to service providers or policing lender activity. Events related to the transaction serviced by the TA are covered solely by the broker fee negotiated on the sales transaction.

The duties imposed by agency law on the TA include:

• helping the buyer locate the most advantageous mortgage terms available in the market;

• oversight of the mortgage application submission; and

• policing the lender’s mortgage packaging process and funding conditions.

These TA activities ensure all documents needed to comply with the lender’s requests and closing instructions are in order. If not, funding cannot take place and closing the sales escrow is jeopardized.

A lender’s objectives and goals are diametrically opposed to those of the buyer – a debtor versus creditor relationship.

On the advice from their agents, buyers need to understand that the lender’s product – money – is always unpriced until the closing has taken place. This truth exists in spite of the Loan Estimate and interest rate disclosures that are given to the buyer within three business days following the lender’s receipt of the mortgage application. [See RPI Form 204-5]

The TA’s duties

Diametrically opposed interests

When applying for a conventional mortgage, a buyer has several types of lenders to choose from, including:

• portfolio lenders, such as banks, thrifts and credit unions;

• institutional lenders, such as insurance companies and trade association pensions; and

• warehousing lenders, such as mortgage bankers who resell the mortgage in the secondary mortgage market.

While portfolio and institutional lenders typically service their own mortgages, they often originate mortgages for immediate sale in a process called warehousing.

Warehoused mortgages are sold on the secondary mortgage market to investment pools, such as the Federal National Mortgage Association (Fannie Mae), the Federal Home Mortgage Corporation (Freddie Mac), the Government National Mortgage Association (Ginnie Mae) and Wall Street bankers.

The business of servicing mortgages is also bought and sold. This causes the mortgage to appear to be changing hands. Typically, the originating lender continues to service the mortgage when they sell the mortgage to an investor.

Sources of conventional financing

Chapter 54: Conventional financing on a sale, and the buyer’s agent 361

The buyer needs to understand the Loan Estimate is not a commitment to lend and is not a guarantee a mortgage on substantially the same terms will be funded. A lender at any time may change the mortgage terms then simply provide another, refreshed Loan Estimate. [See RPI Form 204-5]

Editor’s note — The new Loan Estimate and Closing Disclosure forms published by the Consumer Financial Protection Bureau (CFPB), which apply to all consumer mortgages, went into effect October 3, 2015. The new forms significantly simplify and streamline the mortgage lending process for homebuyers. [See RPI Form 204-5 and 402]

The Loan Estimate replaces both the initial Truth-in-Lending statement and the good faith estimate of costs (GFE). The Loan Estimate is provided within three business days of the lender’s receipt of the application, and provides the mortgage terms and details quoted by the lender. [See RPI Form 204-5]

The Closing Disclosure replaces both the old final Truth-in-Lending statement and the HUD-1 Settlement Statement. This form is provided within three business days of mortgage closing. It summarizes the “final” mortgage terms and details.1 [See RPI Form 402]

After their buyer’s offer has been accepted, it’s time for the buyer’s agent to assist their buyer with submitting a Uniform Residential Loan Application to multiple lenders. [See Chapter 55; see RPI Form 202 (FNMA 1003)]

Editor’s note – Instructions for the accurate completion of the Uniform Residential Loan Application are provided in Chapter 55.

As part of the TA’s advice and guidance in the mortgage application process, the TA instructs the buyer regarding:

• the expectations held and the role of each servicer or affiliate involved in the mortgage transaction, such as the lender’s mortgage representative, an appraiser, any mortgage broker involved, credit agencies, creditors of the buyer, etc.;

• what is going to take place during the application process, such as lender disclosures, payment of lender costs, funding requirements, etc.; and

• what to guard against, such as excuses and claims usually made by the lender to justify an increase in rates at the time of closing.

Documents the buyer needs to gather and submit to the lender to process the mortgage include:

• W-2s or other tax documents for the self-employed;

• recent bank statements; and

1 12 Code of Federal Regulations §§1026.19 et seq.

Loan Estimate An estimate of a buyer’s settlement charges and mortgage terms handed to the buyer on a standard form within three business days following the lender’s receipt of the mortgage application. [See RPI Form 204-5]

Before meeting with a lender

Uniform Residential Loan Application A standardized mortgage application completed by the buyer with the assistance of the transaction agent and the mortgage lender’s representative. [See RPI Form 202]

362 Real Estate Principles, Second Edition

A variety of state and federal loan programs exist, offering down payment assistance for low- to moderate-income buyers and first-time buyers, mortgage refinance or modification programs to distressed owners, and special programs for veterans.

Federal programs:

Federal Housing Administration (FHA)-insured mortgage: The FHA insures lenders against loss for the full amount of a mortgage. FHA-insured mortgages permit small cash down payments and higher loan-to-value ratio (LTV) requirements than mortgages originated by conventional lenders. [See Chapter 56]

U.S. Department of Veterans Affairs (VA) mortgage guarantee: The VA mortgage guarantee program assists qualified veterans or their surviving spouses to buy a home with zero down payment.

Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac) and Government National Mortgage Association (Ginnie Mae): Fannie Mae, Freddie Mac and Ginnie Mae are government-sponsored enterprises (GSEs) designed to help facilitate home purchases for low- to moderate-income buyers. Fannie Mae and Freddie Mac do not provide home mortgages directly. Instead, they purchase and package pools (tranches) of qualifying single family residence (SFR) mortgages originated by mortgage bankers, known as conforming mortgages, as mortgage-backed bonds (MBBs). They then sell the MBBs to Wall Street Bankers on the secondary mortgage market.

State programs:

California Housing Finance Agency (CalHFA): CalHFA administers several first-time homebuyer assistance programs, offering 30-year fixed rate mortgages with interest rates and fees typically lower than conventional financing.

California Department of Veterans Affairs (CalVet): CalVet provides a veteran with an ARM mortgage at a rate generally below market, low monthly payments and flexible credit standards, as compared to conventional financing or mortgages insured by the FHA or guaranteed by the VA.

California Department of Housing and Community Development (HCD): HCD programs fund local public agencies and private entities which produce affordable housing for rental or ownership.

Government financing programs at a glance

• recent pay-stubs to evidence the employment information represented by the buyer in section four of the mortgage application. [See Chapter 55; see RPI Form 202 (FNMA 1003)]

Lenders also verify other information in the application by requesting and reviewing:

• an appraisal report to establish the value of the property serving as security;

• verification of deposit or tax returns to establish the buyer’s income and assets; and

• a credit report to establish the buyer’s liabilities and propensity to repay the mortgage. [See Chapter 55; see RPI Form 202 (FNMA 1003)]

Chapter 54: Conventional financing on a sale, and the buyer’s agent 363

To best protect the buyer, applications are to be submitted to at least two lenders. The second application is insurance against lenders’ last minute changes to the rates and terms at the time of closing.

Without a backup application processed by another lender, the buyer is left with no opportunity to reject the lender’s changes.

Multiple government agencies promote the practice of submitting multiple applications. To assist the buyer with the task of comparing the products of two

Government supports multiple applications

Form 312

Mortgage Shopping Worksheet

364 Real Estate Principles, Second Edition

or more lenders, entities such as the California Department of Corporations, Freddie Mac, the Federal Reserve, and the Federal Trade Commission publish Mortgage Shopping Worksheets.

The Mortgage Shopping Worksheet published by Realty Publications, Inc. (RPI) is designed to be completed by the buyer with the assistance of the TA. The worksheet contains a list of all the mortgage variables commonly occurring on origination and during the life of the mortgage. [See Form 312 accompanying this chapter]

After submitting mortgage applications to two lenders and receiving the corresponding Loan Estimates, the buyer will possess all the information needed to fill out a Mortgage Shopping Worksheet for each lender. Once complete, the buyer and TA can clearly compare the terms offered by the competing lenders and if that lender remains competitive, close with that lender. [See Form 312]

Mortgage Shopping Worksheet A worksheet designed for use by buyers when submitting applications for a consumer mortgage to compare mortgages offered by different lenders based on a list of all the variables commonly occurring as costs at the time of origination and over the life of the mortgage. [See RPI Form 312]

It is the duty of the buyer’s transaction agent (TA) to ensure their buyer negotiates the best financial advantage available to them. Further, the TA ensures all documents needed to comply with the lender’s closing instructions are timely delivered and in order. The TA neither arranges nor makes a mortgage, but polices all facets of the mortgage process.

A buyer’s first step toward obtaining a mortgage is the submission of a standardized Uniform Residential Loan Application to a lender as a prospective borrower. The Uniform Residential Loan Application is designed to be completed by the buyer with the assistance of the TA and the lender’s mortgage representative.

To ensure competitive mortgage rates and terms, the TA needs to advise their buyer to submit separate mortgage applications to multiple lenders. By having mortgage applications with two or more lenders, the TA is able to direct the buyer to the lender who offers the superior set of mortgage costs, terms for payment and interest rates, and keep it that way through closing.

Loan Estimate ............................................................................... pg. 361 mortgage shopping worksheet ................................................ pg. 364 transaction agent (TA) ................................................................ pg. 359 Uniform Residential Loan Application ................................ pg. 361

Chapter 54 Summary

Chapter 54 Key Terms

Quiz 10 Covering Chapters 49-54 is located on page 615.

Chapter 55: The Uniform Residential Loan Application and post-submission activities 365

After reading this chapter, you will be able to:

• understand the components of the Uniform Residential Loan Application;

• guide your buyer on how to prepare the mortgage application; and

• advise on the lender disclosures required under the Real Estate Settlement Procedures Act (RESPA).

Learning Objectives

The Uniform Residential Loan Application and post-submission activities

Chapter

The Uniform Residential Loan Application prepared by the buyer with the assistance of their transaction agent (TA) provides the lender with necessary information about the buyer and the property which will secure the mortgage. It also gives the lender authorization to start the mortgage packaging process. [See Figure 1, RPI Form 202 (FNMA 1003)]

Fundamentals of the Uniform Residential Loan Application

balance sheet

buyer mortgage capacity

creditworthiness

debt-to-income ratio (DTI)

loan-to-value ratio (LTV)

mortgage package

Real Estate Settlement Procedures Act (RESPA)

transaction agent (TA)

Uniform Residential Loan Application

For a further study of this discussion, see Chapter 38 of Real Estate Finance.

Key Terms

366 Real Estate Principles, Second Edition

Generally, a mortgage is sought in a home sales transaction which is contingent on the buyer obtaining a mortgage to fund the purchase of the property, known as purchase-assist financing. However, a mortgage may also be needed for funding by:

• an owner of vacant land to construct a dwelling;

• a property owner to improve or renovate a property they currently own;

• a property owner to refinance an existing mortgage; or

• a tenant on a long-term lease who has agreed to make tenant improvements (TIs) to the property they rent.

As implied by its title, the Uniform Residential Loan Application is intended primarily for use on mortgages secured by residential properties.

However, as a generic mortgage application, it is used by mortgage brokers as an application for a mortgage funding any purpose and secured by any type of property. The Uniform Residential Loan Application contains all the information required for arranging all types of real estate mortgages. In practice, the type of property intended to be purchased by use of the mortgage funds is provided by the description of the property in the mortgage application.

The first section of the Uniform Residential Loan Application calls for the type of mortgage sought, such as conventional, VA or FHA-insured. The buyer also indicates:

• the total dollar amount of the mortgage requested;

• the anticipated interest rate, and whether it is to be fixed or adjustable;

• the periodic payment schedule (constant or graduated); and

• the amortization period (positive or negative). [See Figure 1, RPI Form 202 (FNMA 1003)]

The property under contract to secure the mortgage is identified and its intended use set forth in section two. Section two also states the purpose to be funded by the mortgage, such as purchase-assist or refinance. Also disclosed is the source of down payment funds and closing costs. [See Figure 1, RPI Form 202 (FNMA 1003)]

Information identifying the buyer, such as their name and social security number, is entered in section three. Space is left to insert any co-borrower information if the income, assets and liabilities of a co-borrower are to be considered for mortgage qualification purposes.

A separate form is used to disclose to the lender the applicant’s assets and liabilities if:

• the assets and liabilities result from separate property owned by a co- borrower;

transaction agent (TA) The term lenders use to identify the buyer’s agent in a sales transaction, its closing contingent on the buyer obtaining a mortgage to fund the purchase price.

Components of the Uniform

Residential Loan

Application

Buyer information

Chapter 55: The Uniform Residential Loan Application and post-submission activities 367

• the co-borrower is a necessary party to the transaction as the property encumbered is considered community property; or

• the co-borrower is a co-signer of the note as a primary borrower. [See Figure 2, RPI Form 209-3]

The buyer and co-borrower need to prepare a balance sheet if their assets and liabilities are sufficiently joined to make one combined statement viable. If not, each co-borrower is to prepare a separate asset and liabilities statement for individual consideration by the lender. [See Figure 2, RPI Form 209-3]

balance sheet An itemized, dollar- value presentation for setting an individual’s net worth by subtracting debt obligations (liabilities) from asset values. [See RPI Form 209-3]

Figure 1

Form 202

Uniform Residential Loan Application

For a full-size, fillable copy of this or any other form in this book that may be used in your professional practice, go to realtypublications.com/forms

368 Real Estate Principles, Second Edition

The buyer’s (and co-borrower’s) employment information necessary to identify their source of income is entered in section four of the Uniform Residential Loan Application.

Employment information includes:

• the employment currently held by the buyer;

• the buyer’s job title; and

Employment information

Figure 1

Form 202 Cont’d

Uniform Residential Loan Application

For a full-size, fillable copy of this or any other form in this book that may be used in your professional practice, go to realtypublications.com/forms

Chapter 55: The Uniform Residential Loan Application and post-submission activities 369

• years spent at that specific job and within that profession. [See Figure 1, RPI Form 202 (FNMA 1003)]

If the buyer is self-employed, they indicate this by checking the self-employed box. [See Figure 1, RPI Form 202 (FNMA 1003)]

Next, the buyer reports their monthly income and housing expenses in section five. [See Figure 1, RPI Form 202 (FNMA 1003)]

The buyer’s assets and liabilities are entered into section six. This discloses the buyer’s net worth. The information is pertinent since the buyer’s liabilities affect their ability to repay the mortgage. However, the buyer may not want to disclose all their assets. Thus, a balance needs to be struck between maintaining financial privacy and disclosing enough assets to get creditworthiness clearance so the mortgage will be funded. [See Figure 1, RPI Form 202 (FNMA 1003)]

Since the mortgage funds the acquisition of property, the buyer enters pricing details about the transaction in section seven, including the cost of repairs, alterations and improvements made to the property. [See Figure 1, RPI Form 202 (FNMA 1003)]

The buyer (and any co-borrower) declares any relevant miscellaneous creditworthiness issues in section eight of the mortgage application. This includes debt enforcement or debt avoidance the buyer has experienced. [See Figure 1, RPI Form 202 (FNMA 1003)]

The buyer signs the application (with any co-borrower) to acknowledge and agree to the numerous conditions, some of which are:

• the property will be occupied as represented in the application;

• the buyer will amend the application and resubmit it to the lender if the facts originally stated substantially change;

• the lender may sell/assign the mortgage to others, though the buyer will not be able to sell the property and delegate the mortgage responsibility to another person who acquires the property; and

• the lender is authorized to verify all aspects of the mortgage application as represented by the buyer. [See Figure 1, RPI Form 202 (FNMA 1003)]

A lender evaluating a mortgage package considers a buyer’s willingness and capacity to pay. To comply, borrowers applying for a consumer mortgage are evaluated by the lender for their ability-to-repay (ATR), part of Regulation Z (Reg Z), which implements TILA.1

Generally, the debt-to-income ratio (DTI) for conventional mortgages, also called the debt-to-income standard, limits the buyer’s:

• monthly payments for the maximum purchase-assist mortgage, including impounds for hazard insurance premiums and property taxes, to approximately 31% of the buyer’s monthly gross income; and

1 12 CFR 1026.43 et seq.

Additional components of the application

“Willing and able” to pay

debt-to-income ratio (DTI) Percentage of monthly gross income that goes towards paying debt.

370 Real Estate Principles, Second Edition

• long-term debt, plus the monthly payments, to approximately 41% of the buyer’s gross monthly income. [See RPI Form 229-1, 229-2 and 230]

Lenders use the DTI ratio to evaluate the buyer’s ability to make timely mortgage payments. This is referred to as buyer mortgage capacity. [See RPI Form 230]

The buyer’s willingness to make mortgage payments is evidenced by the credit report. The credit history demonstrates to the lender whether or not the buyer has a propensity to pay, called creditworthiness.

The DTIs can be adjusted depending on one or more compensating factors, such as if the buyer has:

• ample cash reserves;

• a low LTV; and

• spent more than five years at the same place of employment.

The Real Estate Settlement Procedures Act (RESPA) mandates lenders active in the secondary mortgage market to disclose all mortgage related charges on mortgages used to purchase, refinance or improve one-to-four unit residential properties.

buyer mortgage capacity A buyer’s ability to make mortgage payments based on their debt-to-income ratios (DTI).

creditworthiness An individual’s ability to borrow money, determined by their present income, wealth and previous debt payment history.

RESPA disclosures

Real Estate Settlement Procedures Act (RESPA) Legislation prohibiting brokers from giving or accepting referral fees if thebroker or their agent is already acting as a transaction agent in the sale of a one-to-four unit residential property which is being funded by a purchase-assist, federally-related consumer mortgage.

The typical conventional mortgage is a 30-year amortized mortgage with a fixed rate of interest.

The buyer’s monthly payment remains the same during the life of the fixed-rate mortgage. Fixed-rate mortgages offer greater long-term stability for the buyer than adjustable rate mortgages (ARMs) with their varying interest rates and payment schedules.

Financing options include:

• ARMs where the interest rate changes periodically based on an index for short- term consumer rates, plus a profit margin. ARMs cause the buyer’s monthly payment to periodically adjust;

• rate buy-downs where the buyer receives an initial interest rate which is periodically increased, along with the monthly payment, to a fixed rate within a few years, called a graduated payment mortgage (GPM);

• the length of the mortgage, which is typically 15 or 30 years, although some lenders offer mortgages with irregular terms;

• assumable mortgages allowing resale to a creditworthy buyer, with or without a rate adjustment [See Chapter 57];

• bi-weekly mortgages with payments made every two weeks to reduce the total amount of interest paid on the mortgage; and

• private mortgage insurance (PMI) where a qualifying buyer obtains a mortgage with less than a 20% down payment while paying a premium for insurance to cover the lender’s risk of loss created by the smaller down payment. [See Chapter 60]

Types of mortgages

Chapter 55: The Uniform Residential Loan Application and post-submission activities 371

Mortgage related charges include:

• origination fees;

• credit report fees;

• insurance costs; and

• prepaid interest.

RESPA is now administered and enforced by the Consumer Financial Protection Bureau (CFPB) — not the U.S. Department of Housing and Urban Development (HUD).

A RESPA-controlled lender provides the buyer with:

• a Loan Estimate of all mortgage terms quoted by the lender within three business days of the lender’s receipt of the buyer’s mortgage application [See RPI Form 204-5; see Chapter 54];2

• a special information booklet published by the CFPB to help the buyer understand the nature and scope of real estate settlement costs within three business days after the lender’s receipt of the buyer’s application;3

• a Closing Disclosure, which summarizes the “final” mortgage terms and details, provided by the lender at least three days before the consumer closes on the mortgage [See RPI Form 402];4 and

• a list of homeownership counseling organizations.

Editor’s note: A list of homeownership counseling organizations approved by HUD can be found at the CFPB’s website.

If the buyer is arranging financing through a mortgage broker, the broker, not the lender, provides a copy of the special information booklet to the buyer.5

However, the booklet does not need to be given to the buyer if the mortgage funds:

• the refinance of an existing mortgage;

• a closed-end mortgage in which the lender takes a subordinate lien;

• a reverse mortgage; and

• any federally related mortgage used to fund the purchase of other than a one-to-four unit residential property.6

Also, on ARMs, the lender informs the buyer not only of the interest rate, but also the index, margin and payment and interest rate floors and caps. [See RPI Form 320-1]

On the lender’s receipt of a mortgage application, the property is appraised. [See RPI Form 223-2 and 207; see Chapter 29]

2 12 CFR §1026.37

3 12 CFR §1026.19(g)

4 12 CFR §1026.19(f)(ii)

5 12 CFR §1024.6(a)(1)

6 12 CFR §1024.6(a)(3)

Property appraisal

• long-term debt, plus the monthly payments, to approximately 41% of the buyer’s gross monthly income. [See RPI Form 229-1, 229-2 and 230]

Lenders use the DTI ratio to evaluate the buyer’s ability to make timely mortgage payments. This is referred to as buyer mortgage capacity. [See RPI Form 230]

The DTIs can be adjusted depending on one or more compensating factors, such as if the buyer has:

• ample cash reserves;

• a low LTV; and

• spent more than five years at the same place of employment.

buyer mortgage capacity A buyer’s ability to make mortgage payments based on their debt-to-income ratios (DTI).

creditworthiness An individual’s ability to borrow money, determined by their present income, wealth and previous debt payment history.

RESPA disclosures

372 Real Estate Principles, Second Edition

The appraisal determines whether the property is of sufficient value to support the amount of financing the buyer requests. Essentially, the lender uses the appraisal to gauge whether the loan-to-value ratio (LTV) meets the lender’s standards. [See Chapter 29]

Generally, an acceptable LTV for conventional mortgages is 80% of the property’s value, requiring the buyer to make a minimum 20% down payment. A greater LTV compels the lender to require the buyer to obtain private mortgage insurance (PMI).

loan-to-value ratio (LTV) A ratio stating the outstanding mortgage balance as a percentage of the mortgaged property’s fair market value. The degree of leverage.

Figure 2

Form 209-3

Balance Sheet Financial Statement

For a full-size, fillable copy of this or any other form in this book that may be used in your professional practice, go to realtypublications.com/forms

Chapter 55: The Uniform Residential Loan Application and post-submission activities 373

Once a lender approves property based on an appraisal, a mortgage package is assembled and sent to a mortgage underwriter for review.

A mortgage approval issued by a lender is often conditioned on a buyer providing more information or taking corrective actions. For example:

• the physical condition of the property may need correction;

• title may need to be cleared of defects;

• derogatory entries on the buyer’s credit report may need to be eliminated; or

• the buyer’s long- or short-term debt is to be reduced.

Once conditions for funding are met and verified, the mortgage is classified as approved. Escrow calls for mortgage documents and funds, and on funding, the sales transaction is closed.

Agents need to remind themselves that the degree of risk each lender finds acceptable is different. More often than not, a lender exists who will make a mortgage of some amount and under some conditions to nearly any buyer. It is the business of lenders to do so.

mortgage package A collection of documents required to process a mortgage application and sent to a mortgage underwriting officer for review after receipt of the appraisal on the property offered as security.

Mortgage approval

The Uniform Residential Loan Application prepared by the buyer with the transaction agent (TA) supplies the lender with necessary information about the buyer and the property securing the mortgage. It also gives the lender authorization to start the mortgage packaging process.

The Uniform Residential Loan Application calls for the buyer, with the assistance of the mortgage representative and TA, to enter information such as:

• the type of mortgage sought;

• the identity of the property used to secure the mortgage;

• the buyer’s name and employment information;

• the buyer’s monthly income and housing expenses;

Chapter 55 Summary

374 Real Estate Principles, Second Edition

• the buyer’s assets and liabilities; and

• relevant miscellaneous creditworthiness issues to be disclosed to the lender.

A Real Estate Settlement Procedures Act (RESPA)-controlled lender needs to provide the buyer with a Loan Estimate of all mortgage related charges, a copy of the HUD-published special information booklet, a Closing Disclosure detailing all charges actually incurred and a list of homeownership counseling organizations.

Once a lender receives a mortgage application and any processing fee, the property is appraised to determine if it qualifies as security for the mortgage. If a lender approves the property based on an appraisal, a mortgage package is assembled and sent to an underwriter for review.

Once mortgage conditions are met and verified, the mortgage is classified as approved. Escrow calls for mortgage documents and funds. On funding, the sales transaction is closed.

balance sheet ................................................................................ pg. 367 buyer mortgage capacity .......................................................... pg. 370 creditworthiness .......................................................................... pg. 370 debt-to-income ratio (DTI) ......................................................... pg. 369 loan-to-value ratio (LTV) ........................................................... pg. 372 mortgage package ........................................................................ pg. 373 Real Estate Settlement Procedures Act (RESPA) ................. pg. 371 transaction agent (TA) ................................................................ pg. 366 Uniform Residential Loan Application ................................ pg. 366

Chapter 55 Key Terms

Quiz 11 Covering Chapters 55-61 is located on page 616.

Chapter 56: The FHA-insured home mortgage 375

After reading this chapter, you will be able to:

• understand how purchase-assist mortgages insured by the Federal Housing Administration (FHA) enable buyers to become owners;

• explain the minimum down payment and loan-to-value ratio (LTV) for FHA-insured financing;

• determine whether a buyer and property qualify for an FHA insured mortgage; and

• advise buyers on the use of an FHA Energy Efficient Mortgage to finance energy efficient improvements.

The FHA-insured home mortgage

Chapter

Consider a residential tenant who is solicited by a real estate agent to buy a home. The financial and tax aspects together with the social benefits of home ownership are compared to the corresponding benefits and mobility provided by renting their shelter.

The tenant indicates they are ready and willing to be owners of a home for their shelter. However, they have not accumulated enough cash reserves for the down payment needed to qualify for a mortgage they need to fund the purchase of a home.

Enabling tenants to become homeowners

Energy Efficient Mortgage (EEM)

Federal Housing Administration (FHA)- insured mortgage

fixed payment ratio

loan-to-value (LTV) ratio

mortgage insurance premium (MIP)

mortgage payment ratio

Real Estate Settlement Procedures Act (RESPA)

Key Terms

Learning Objectives

For a further study of this discussion, see Chapter 41 of Real Estate Finance.

376 Real Estate Principles, Second Edition

The agent assures the tenant that first-time homebuyers with little cash available for a down payment can buy a home by qualifying for a purchase- assist mortgage insured by the Federal Housing Administration (FHA).

By insuring mortgages made with less demanding cash down payment requirements, and with high loan-to-value (LTV) ratios of up to 96.5%, the FHA enables prospective buyers to become homeowners.

The FHA does not lend money to buyers. Rather, the FHA insures mortgages originated by approved direct endorsement lenders to qualified buyers who will occupy the property as their principal residence. For issuing insurance to the lender covering losses on a default, the buyer will pay premiums to FHA for the coverage.

To qualify for an FHA-insured fixed-rate mortgage, a first-time homebuyer is required to make a down payment of at least 3.5% of the purchase price. The interest rate on the underlying mortgage is negotiated between the buyer and the lender.1

If a buyer defaults on an FHA-insured mortgage, the FHA covers the lender against loss on the entire remaining balance of the mortgage. This is unlike private mortgage insurance (PMI) and insurance from the Veterans Administration (VA) which only insures a portion of the total mortgage amount.

After the lender acquires the property through foreclosure and conveys the property to the FHA, the FHA pays the lender the amount of the unpaid principal balance remaining on the mortgage.2

Before accepting a conveyance from the lender, the FHA requires the lender to confirm the property is in a marketable condition and has not suffered any waste. The FHA then sells the property to recoup the amount it paid to the lender.

Unlike conventional home mortgages where only a lender is involved, a buyer who takes out an FHA-insured mortgage with a lender is personally liable to the FHA for any loss the FHA suffers as a result of the homebuyer’s default.

When the FHA suffers a loss, the FHA can obtain a money judgment against the homebuyer for the difference between:

• the amount the FHA paid the lender; and

• the price received from the sale of the property.

California anti-deficiency mortgage laws do not apply to FHA-insurance coverage for lender claims on insured mortgages.3

1 24 Code of Federal Regulations §203.20

2 24 CFR §203.401

3 24 CFR §203.369

Federal Housing Administration (FHA)-insured mortgage A mortgage originated by a lender and insured by the FHA, characterized by a small down payment requirement, high loan-to-value (LTV) ratio and high mortgage insurance premiums (MIPs), typically made to first- time homebuyers.

Buyer liability on a default

Chapter 56: The FHA-insured home mortgage 377

The most commonly used FHA-insurance program is the Owner-occupied, One-to-Four Family Home Mortgage Insurance Program, Section 203(b). Buyers obtaining a Section 203(b) mortgage need to occupy the property as their primary residence.

For the privilege of making a small down payment, the buyer needs to pay a mortgage insurance premium (MIP) to the FHA. This essentially increases the annual cost of borrowing as the annual rate charged for MIP is added to interest payments. Together, the MIP and interest are the annual cost incurred to borrow FHA-insured funds for the purchase of a home.

FHA guidelines include:

• manual underwriting for homebuyers whose debt-to-income ratio (DTI) exceeds 43% and whose credit scores are below 620;

• 5% minimum down payments on FHA mortgages greater than $625,000; and

• MIP to continue through the life of the mortgage (previously it was cancelled once the homeowner reached a 78% LTV).

Further, an upfront premium, paid once at the time the mortgage is originated, is calculated as 1.75% of the funded mortgage amount.

The public policy rationale behind the FHA Section 203(b) program is based on the proposition homeowners are less of a financial burden on the government in their later years than life-time tenants.

The maximum FHA-insured mortgage available to assist a buyer in the purchase of one-to-four unit residential property is determined by:

• the type of residential property; and

• the county in which the property is located.

A list of counties and their specific mortgage ceilings is available from FHA or an FHA direct endorsement lender, or online from the Department of Housing and Urban Development (HUD) at http://www.hud.gov.

The FHA sets limitations on the amount of a mortgage it will insure. The limit is a ceiling set as a percentage of the appraised value of the property, called the loan-to-value ratio (LTV) .

The LTV ratio on an FHA-insurable mortgage is capped at a ceiling of 96.5% of the property’s fair market value. Thus, the minimum down payment is 3.5%.4

Additionally, even after including buyer-paid closing costs in the LTV calculations, the insurable mortgage amount cannot exceed the ceiling of 96.5% of the property’s appraised value.

4 HUD Mortgagee Handbook 4155.1 Rev-5 Ch-2 §A.2.b

One-to-four unit mortgage default insurance

mortgage insurance premium (MIP) The cost for default insurance incurred by a borrower on an FHA-insured mortgage set as a percent of the mortgage amount paid up front and an annual rate on the principal balance paid with monthly principal and interest for the life of the mortgage.

FHA-insured dollar limits by regions

Loan-to-value (LTV) ceilings and costs

loan-to-value ratio (LTV) A ratio stating the outstanding mortgage balance as a percentage of the mortgaged property’s fair market value. The degree of leverage.

378 Real Estate Principles, Second Edition

The maximum mortgage amount the FHA will insure is the LTV ratio’s percentage amount of the lesser of:

• the property’s sales price; or

• the appraised value of the property.5

Closing costs may not be used to help meet the 3.5% minimum down payment requirement. Also, closing costs are not deducted from the sales price before setting the maximum mortgage amount.6

The lender’s origination fee included as a closing cost is limited to 1% of the mortgage amount, excluding any competitive discount points and the 1.75% upfront MIP.

Either the buyer or seller may pay the buyer’s closing costs, called non- recurring closing costs. The lender may also advance closing costs on behalf of the buyer.

For a buyer to be creditworthy for an FHA-insured mortgage, the following debt-to-income (DTI) ratios need to be met:

• the buyer’s mortgage payment may not exceed 31% of the buyer’s gross effective income, called the mortgage payment ratio; and

• the buyer’s total fixed payments may not exceed 43% of the buyer’s gross effective income, called the fixed payment ratio.7

A buyer’s income consists of salary and wages. Social security, alimony, child support, and government assistance are factored into the buyer’s income to determine effective income. The buyer’s effective income before any reduction for the payment of taxes is referred to as gross effective income.

The maximum mortgage payment ratio of 31% of the gross effective income determines the maximum amount of principal, interest, taxes and insurance (fire and MIP) the buyer is able to pay on the mortgage. Collectively, this is called PITI.

Lenders use the maximum fixed payment ratio of 43% of the gross effective income. Applying this ratio, they determine whether a buyer can afford to incur the long-term debt of an FHA-insured mortgage in addition to all other long-term payments the buyer is obligated to pay.

When computing the fixed-payment ratio, the lender adds the buyer’s total mortgage payment to all the buyer’s recurring monthly obligations. This includes debts extending ten months or more, such as all installment loans, alimony and child support payments.8

5 HUD Mortgagee Handbook 4155.1 Rev-5 Ch-2 §A.2.a

6 HUD Mortgagee Handbook 4155.1 Rev-5 Ch-2 §A.2.d

7 HUD Handbook 4155.1 Rev-5 Ch-4 §F.2

8 HUD Handbook 4155.1 Rev-5 Ch-4 §C.4

Credit approval

mortgage payment ratio A debt-to-income ratio (DTI) used to determine eligibility for an FHA-insured mortgage limiting the buyer’s mortgage payment to 31% of the buyer’s gross effective income.

fixed payment ratio A debt-to-income ratio (DTI) used to determine eligibility for an FHA-insured mortgage limiting the buyer’s total fixed payment on all debts to 43% of the buyer’s gross income, also called the DTI back- end ratio.

Chapter 56: The FHA-insured home mortgage 379

However, even if the buyer’s ratios exceed FHA requirements, the mortgage may be approved if the buyer:

• makes a large down payment;

• has a good credit history;

• has substantial cash reserves; and

• demonstrates potential for increased earnings due to job training or education.

Taken together, these are referred to as compensating factors.9

The Real Estate Settlement Procedures Act (RESPA) requires any lender making an FHA-insured mortgage to deliver to the mortgage applicant a Loan Estimate published by the Consumer Financial Protection Bureau (CFPB) of costs paid to providers of services on the sale of a one-to-four unit residential property. [See RPI Form 204-5; see Chapter 54]

9 HUD Handbook 4155.1 Rev-5 Ch-4 §F.3

RESPA and TILA disclosures

Acceptable sources of cash down payment include:

• Savings and checking accounts: Lenders need to verify the account balance is consistent with the buyer’s typical recent balance and no large increase occurred just prior to the mortgage application. [See RPI Form 211]

• Gift funds: The donor of the gift needs to have a clearly defined interest in the buyer and be approved by the lender. Relatives or employer unions typically are acceptable donors. Gift funds from the seller or broker are kickbacks considered an inducement to buy and result in a reduction in the mortgage amount.

• Collateralized mortgages: Any money borrowed to make the down payment needs to be fully secured by the buyer’s marketable assets (i.e., cash value of stocks, bonds, or insurance policies), which may not include the home being financed. Cash advances on a credit card, for example, are not acceptable sources for down payment funds.

• Broker fees: If the buyer is also a real estate agent involved in the sales transaction, the fee received on the sale may be part of the buyer’s down payment.

• Exchange of equities: The buyer may trade property they own to the seller as the down payment. The buyer needs to produce evidence of value and ownership before the exchange will be approved.

• Sale of personal property: Proceeds from the sale of the buyer’s personal property may be part of the down payment if the buyer provides reliable estimates of the value of the property sold.

• Undeposited cash is an acceptable source of down payment funds if the buyer can explain and verify the accumulation of the funds. [HUD Handbook 4155.1 Rev-5 Ch-5 §B.1]

Acceptable source of cash down payment

380 Real Estate Principles, Second Edition

Lenders also deliver a Housing and Urban Development (HUD) information booklet. Both need to be delivered within three days after receiving the buyer’s application. [See Chapter 54]

Upon closing a sale, the lender delivers a Closing Disclosure published by the CFPB detailing all mortgage related charges incurred by the buyer and seller.10 [See RPI Form 402; see Chapter 54]

Mortgages insured by the FHA under Section 203(b) are subject to both disclosure requirements since they fund personal use mortgages and are federally related (RESPA).11

When a home is sold with the buyer taking title subject to an existing FHA- insured mortgage under some arrangement to pay for the seller’s equity, the seller is released from personal liability, if:

• they request a release from personal liability;

• the prospective buyer of the property is creditworthy;

• the prospective buyer assumes the mortgage; and

• the lender releases the seller from personal liability by use of an FHA- approved form.12

If the conditions for release from personal liability are not satisfied, the seller remains liable for any FHA loss on their insurance coverage for five years after the sale.13

However, if five years pass from the time the property is resold, the seller is then released from personal liability if:

• the mortgage is not in default by the end of the five-year period;

• the buyer assumes the mortgage with the lender; and

• the seller requests the release of liability from the lender.14

Homebuyers and homeowners have a way to finance energy efficient improvements under the FHA’s Energy Efficient Mortgage (EEM) program.

The underlying idea behind the EEM program is this: reduced utility charges allow applicants to make higher monthly mortgage payment to fund the cost of the energy efficient improvements.

Financeable energy efficient improvements funded under FHA’s program include:

• purchasing energy efficient appliances or heating and cooling systems;

• installing solar panels;

10 24 CFR §3500 et seq.

11 12 CFR §226.19

12 HUD Form 92210; 24 CFR §203.510(a); HUD Handbook 4155.1 Rev-5 Ch-7

13 12 USC §1709(r)

14 24 CFR §203.510(b)

Personal liability of the

seller

Energy efficiency

Energy Efficient Mortgage (EEM) An FHA-insured purchase-assist or refinance mortgage which includes the additional amount to cover the costs of constructing energy improvements on the mortgaged property.

Chapter 56: The FHA-insured home mortgage 381

• installing energy efficient windows;

• installing wall or ceiling installation; and

• completing repairs of existing systems to improve energy efficiency.

Under the EEM program, the costs of fundable energy improvements are added to the base FHA maximum mortgage amount on a purchase or refinance.15

Like most FHA mortgage programs, the EEM is not funded by the FHA. It is funded by a lender, and insured to guarantee repayment by the FHA.

An EEM may be used in connection with either an FHA-insured purchase or refinance mortgage (including streamline refinances), under the:

• “standard” 203(b) program for one-to-four unit residential properties;

• 203(k) rehabilitation program;

• 234(c) program for condominium projects; and

• 203(h) program for mortgages made to victims of presidentially declared disasters.16

Eligible property types include new and existing:

• one-to-four unit residential properties for the 203(b) and 203(k) programs;

• one-unit condominiums; and

• manufactured housing.17

15 HUD Mortgagee Letter 2009-18

16 HUD Handbook 4155.1 Chapter 6.D.2.a

17 HUD Handbook 4155.1 Chapter 6.D.2.a

The Federal Housing Administration (FHA) insures mortgages originated by approved direct endorsement lenders to qualified buyers to fund the purchase of their principle residence.

FHA-insured mortgages provide for a down payment as low as 3.5% and a higher loan-to-value (LTV) ratio than conventional mortgages. For the privilege of making a small down payment, the buyer pays a mortgage insurance premium (MIP) to the FHA, effectively increasing the annual cost of borrowing as an addition to interest.

If a buyer defaults on an FHA-insured mortgage, the FHA covers the lender against loss on the entire remaining balance of the mortgage.

The most commonly used FHA-insurance program is the Owner- occupied, One-to-Four Family Home Mortgage Insurance Program, Section 203(b).

Chapter 56 Summary

382 Real Estate Principles, Second Edition

Before the FHA will insure a mortgage, the lender needs to determine the buyer’s creditworthiness. For a buyer to be creditworthy for FHA mortgage insurance, the following debt-to-income ratios (DTI) need to be met:

• the buyer’s mortgage payment ratio may not exceed 31% of their gross effective income; and

• the buyer’s fixed payment ratio for all installment debts may not exceed 43% gross effective income.

Homebuyers and homeowners may finance energy efficient improvements under the FHA’s Energy Efficient Mortgage (EEM) program. With reduced utility charges, buyers and owners may make higher monthly mortgage payment to fund the cost of the energy efficient property improvements.

Energy Efficient Mortgage (EEM) ............................................ pg. 380 Federal Housing Administration (FHA)-insured mortgage ........................................................................................ pg. 376 fixed payment ratio..................................................................... pg. 378 loan-to-value (LTV) ratio ............................................................ pg. 377 mortgage insurance premium (MIP) ...................................... pg. 377 mortgage payment ratio ............................................................ pg. 378 Real Estate Settlement Procedures Act (RESPA) ................. pg. 380

Chapter 56 Key Terms

Quiz 11 Covering Chapters 55-61 is located on page 616.

Chapter 57: Carryback financing in lieu of cash 383

After reading this chapter, you will be able to:

• comprehend the financial benefits afforded to a seller and a buyer under seller carryback finance arrangements;

• identify the seller’s risks involved in carryback financing; and

• explain the tax advantages available to a seller for carrying back a portion of the sales price.

For a further discussion of this topic, see Chapter 26 of Real Estate Finance.

Carryback financing in lieu of cash

Chapter

When the availability of real estate mortgages tightens, a seller hoping to locate a buyer amenable to the seller’s asking price needs to consider seller financing.

Seller financing is also known as:

• an installment sale;

• a credit sale;

• carryback financing; or

• an owner-will-carry (OWC) sale.

Seller financing supports the price

all-inclusive trust deed (AITD)

nonrecourse

portfolio category income

private mortgage insurance (PMI)

seller financing

Learning Objectives

Key Terms

384 Real Estate Principles, Second Edition

Seller financing occurs when a seller carries back a note executed by the buyer to evidence a debt owed for purchase of the seller’s property. The amount of the debt is the remainder of the price due after deducting:

• the down payment; and

• the amount of any existing or new mortgage financing used by the buyer to pay part of the price.

On closing, the rights and obligations of real estate ownership held by the seller are shifted to the buyer. Concurrently, the seller carries back a note and trust deed taking on the rights and obligations of a secured creditor.

Editor’s note —California brokers and agents who make, offer or negotiate residential mortgages for compensation are required to obtain a Mortgage Loan Originator (MLO) license endorsement on their California Bureau of Real Estate (CalBRE) license. A residential mortgage is a consumer purpose loan secured by a one-to-four unit residential property.

Thus, offering or negotiating carryback financing triggers the MLO license endorsement only if the broker or agent receives additional compensation for the act of offering or negotiating the carryback, beyond the fee collected for their role as seller’s agent or buyer’s agent.

The seller who offers a convenient and flexible financing package to prospective buyers makes their property more marketable and defers the tax bite on their profits.

Qualified buyers who are rational are willing to pay a higher price for real estate when attractive financing is available. This holds regardless of whether financing is provided by the seller or a mortgage lender. For most buyers, the primary factors when considering their purchase of a property is the amount of the down payment and the monthly mortgage payments.

Buyer willingness is especially apparent when the rate of interest on the carryback financing is in line with or below the rates lenders are charging on their purchase-assist mortgages. The lower the interest rate, the higher the price may be.

For buyers, seller carryback financing generally offers:

• a moderate down payment;

• competitive interest rates;

• less stringent terms for qualification and documentation than imposed by lenders; and

• no origination (hassle) costs.

In a carryback sale, the amount of the down payment is negotiable between the buyer and seller without the outside influences a traditional mortgage broker and borrower has to contend with.

seller financing A note and trust deed executed by a buyer of real estate in favor of the seller for the unpaid portion of the sales price on closing. Also known as an installment sale, credit sale or carryback financing.

Marketing property: the

seller will carry

Flexible sales terms for the

buyer

Chapter 57: Carryback financing in lieu of cash 385

Additionally, a price-to-interest rate tradeoff often takes place in the carryback environment. The buyer is usually able to negotiate a lower-than- market interest rate in exchange for agreeing to the seller’s higher-than- market asking price.

Taxwise, it is preferable for a seller to carry back a portion of the sales price, rather than be cashed out when taking a significant taxable profit.

The seller, with a reportable profit on a sale, is able to defer payment of a substantial portion of their profit taxes until the years in which principal is received. When the seller avoids the entire profit tax bite in the year of the sale, the seller earns interest on the amount of the note principal that represents taxes not yet due and payable.

If the seller does not carry a note payable in future years, they will be cashed out and pay profit taxes in the year of the sale (unless exempt or excluded).

What funds they have left after taxes are reinvested in some manner. These after-tax sales proceeds will be smaller in amount than the principal on the carryback note. Thus, the seller earns interest on the net proceeds of the carryback sale before they pay taxes on the profit allocated to that principal.

The tax impact the seller receives on their carryback financing is classified as portfolio category income.

On closing the sale, the seller financing may be documented in a variety of ways. Common arrangements include:

• land sales contracts;

• lease-option sales;

• sale-leasebacks; and

• trust deed notes, standard and all-inclusive.

Legally, the note and trust deed provides the most certainty. Further, they are the most universally understood of the various documents used to structure seller financing. In this arrangement, carryback documentation consists of:

• a promissory note executed by the buyer in favor of the seller as evidence of the portion of the price remaining to be paid for the real estate before the seller is cashed-out [See RPI Form 421]; and

• a trust deed lien on the property sold to secure the debt owed by the buyer as evidenced by the note. [See RPI Form 450]

The note and trust deed are legally coupled, inseparable and function in tandem. The note provides evidence of the debt owed but is not filed with the County Recorder. The trust deed creates a lien on property as the source for repayment of the debt in the event of a default.

Tax benefits and flexible sales terms

portfolio category income Unearned income from interest on investments in bonds, savings, income property, stocks and trust deed notes.

The closing documents needed for the carryback

386 Real Estate Principles, Second Edition

Form 303

Foreclosure Cost Sheet

In addition, when the seller carries back a note executed by the buyer as part of the sales price for property containing four-or-fewer residential units, a financial disclosure statement is to be prepared. This statement is prepared by the broker who represents the person who first offers or counteroffers on terms calling for a carryback note.1 [See RPI Form 300]

1 Calif. Civil Code §2956

Chapter 57: Carryback financing in lieu of cash 387

A carryback seller assumes the role of a lender at the close of the sales escrow. This includes all the risks and obligations of a lender holding a secured position in real estate – a mortgage. The secured property described in the trust deed serves as collateral, the seller’s sole source of recovery to mitigate the risk of loss on a default by the buyer on the note or trust deed.

Another implicit risk of loss for secured creditors arises when the property’s value declines due to deflationary future market conditions or the buyer committing waste. The risk of waste, also called impairment of the security, is often overlooked during boom times.

However, a decline in property value during recessionary periods due to the buyer’s lack of funds poses serious consequences for the seller when the buyer defaults on the payment of taxes, assessments, insurance premiums or maintenance of the property.

Also, the seller needs to understand a carryback note secured solely by a trust deed lien on the property sold is nonrecourse paper. Thus, the seller will be barred from obtaining a money judgment against the buyer for any part of the carryback debt not satisfied by the value of the property at the time of foreclosure – the unpaid and uncollectible deficiency.2

However, as with any mortgage lender, if the risk premium built into the price, down payment, interest rate and due date on the carryback note is sufficient, the benefits of carryback financing level out or outweigh the risks of loss. [See RPI Form 303]

2 Calif. Code of Civil Procedure §580b

Carryback risks for the seller

nonrecourse A debt secured by real estate, the creditor’s source of recovery on default limited solely to the value of their security interest in the secured property.

Seller financing, also known as carryback financing, occurs when the seller carries back a note for the unpaid portion of the price remaining after deducting the down payment and the amount of the mortgage the buyer is assuming.

Carryback financing offers considerable financial and tax advantages for both buyers and sellers when properly structured. A carryback seller is able to defer a meaningful amount of profit taxes, spreading the payment over a period of years. Further, a seller who offers a convenient and flexible financing package makes their property more marketable.

For buyers, seller carryback financing generally offers a moderate down payment, competitive interest rates, less stringent terms for qualification than those imposed by lenders and no origination costs.

A carryback seller takes on the role of a lender in a carryback sale, with all the risks and obligations of a lender holding the seller’s secured

Chapter 57 Summary

388 Real Estate Principles, Second Edition

position on title. As with any creditor, if the risk premium built into the rate and terms of the carryback note is sufficient, the benefits of carryback financing outweigh the risks of loss.

all-inclusive trust deed (AITD) ............................................... pg. 467 nonrecourse ................................................................................. pg. 387 portfolio category income ....................................................... pg. 385 private mortgage insurance (PMI) ........................................ pg. 465 seller financing .......................................................................... pg. 384

Chapter 57 Key Terms

Quiz 11 Covering Chapters 55-61 is located on page 616.

Chapter 58: Usury and the private lender 389

After reading this chapter, you will be able to:

• determine which lending arrangements are subject to or exempt from usury restrictions on interest rates;

• identify extensions of credit on property sales as excluded from usury restrictions;

• discern when the usury threshold rate applies; and • explain the penalties imposed on a non-exempt private lender on

violations of usury law.

Usury and the private lender

Chapter

When a mortgage is made, the lender charges the borrower interest for use of the money during the period lent.

However, the amount of interest a private, non-exempt lender can charge is regulated by statute and the California Constitution. Collectively, these are referred to as usury laws.1

Today, the remaining goal of usury laws is the prevention of loan-sharking by private lenders. Loan-sharking involves charging interest at a higher rate than the ceiling-rate established by the usury laws. These mortgages are categorized as usurious.2

1 Calif. Constitution, Article XV; Calif. Civil Code §§1916-1 through 1916-5

2 CC §1916-3(b)

Broker arranged mortgages avoid usury

usury A limit on the lender’s interest rate yield on nonexempt real estate mortgages.

exempt debt

excluded debt

restricted real estate loans

treble damages

usury

Key Terms

Learning Objectives

For a further study of this discussion, see Chapter 43 of Real Estate Finance.

390 Real Estate Principles, Second Edition

Adopted in 1918 as a consumer protection referendum, the first California usury laws set the maximum interest rate at 12% for all lenders — no exceptions.

During the Great Depression, California legislation exempted certain types of lenders from usury restrictions. The exemptions were implemented with the intent to open up the mortgage market.3

These exemptions to usury laws remain in place today and more have been added. For example, in 1979, mortgages made or arranged in California by real estate brokers were exempted from usury restrictions.

Other types of lenders exempted from usury law restrictions include:

• savings and loan associations (S&Ls);

• state and national banks;

• industrial mortgage companies;

• credit unions and pawnbrokers;

• agricultural cooperatives;

• corporate insurance companies; and

• personal property brokers.4

Exemptions successfully opened the market by increasing the availability of funds. In turn, interest rates were soon driven lower due to increased competition.

When a borrower pays interest on a mortgage, they are paying rent to the lender for use of its money for a period of time. The money lent is fully repaid during or at the end of the period.

Normally, the amount of interest charged is a fixed or adjustable percentage of the amount of money loaned.

Though interest is commonly paid with money, interest may also be paid by the borrower by providing the lender with personal property, goods or services. The many types of consideration given by the borrower for the lender making a mortgage become part of the lender’s yield on the mortgage—interest.5

Thus, interest includes the value of all compensation a lender receives for lending money, whatever its form, excluding reimbursement or payment for mortgage origination costs incurred and services rendered by the lender.6

If the use of the proceeds of a mortgage is earmarked primarily for personal, family, or household use by the borrower, the maximum annual interest rate is 10% per annum.7

3 Cal. Const. Art. XV

4 Cal. Const. Art. XV

5 CC §1916-2

6 CC §1915

7 Calif. Const. Art. XV §1(1)

Usury exemptions

spur competition

Interest paid with goods

and services

Setting the interest rate

Chapter 58: Usury and the private lender 391

Mortgages made to fund the improvement, construction, or purchase of real estate when originated by a non-exempt private lender are subject to a different usury threshold rate, which is the greater of:

• 10% per annum; or

• the applicable discount rate of the Federal Reserve Bank of San Francisco (FRBSF), plus 5%.

Two basic classifications of private mortgage transactions exist relating to interest rates private lenders may charge on real estate mortgages:

• brokered real estate mortgages; and

• restricted or non-brokered real estate mortgages.

Brokered real estate mortgages are exempt from usury restrictions and fall into one of two categories:

• mortgages made by a licensed real estate broker acting as a principal for their own account as the private lender who funds the mortgage; or

• mortgages arranged with private lenders by a licensed real estate broker acting as an agent in the mortgage transaction for compensation.

Restricted real estate mortgages are all mortgages made by private party lenders which are neither made nor arranged by a broker.

Editor’s note — Private lenders include corporations, limited liability companies, partnerships and individuals. These entities are not exempt from usury limitations unless operating under an exempt classification, such as a personal property broker or real estate broker.

The most common restricted mortgage involves private party lenders, unlicensed and unassisted by brokers, who make secured or unsecured mortgages.

Private party transactions involving the creation of a debt which avoid usury laws break down into two categories:

• exempt debts, being debts which involve a mortgage or a forbearance on a mortgage and are broker-made or arranged; and

• excluded debts, being debts which do not involve a mortgage.

The most familiar of the excluded “non-mortgage” type debts is seller carryback financing. [See Chapter 57]

Carryback notes executed by the buyer in favor of the seller are not loans of money. They are credit sales, also called installment sales. A seller may carry back a note at an interest rate in excess of the usury threshold rate. The rate exceeding the usury law threshold is enforceable since the debt is not a mortgage. Thus, carryback notes are not subject to usury laws.

Usury law and real estate mortgages

restricted real estate loans All mortgages made by private party lenders which are neither made nor arranged by a real estate broker.

Exceptions for private parties

exempt debt Private party transactions exempt from usury laws involving the origination of a mortgage secured by real estate and made or arranged by a real estate broker.

excluded debt Extensions of credit by sellers of real estate creating a debt obligation in sales transactions which avoid usury laws.

392 Real Estate Principles, Second Edition

The most common penalty imposed on a non-exempt private lender in violation of usury law is the forfeiture of all interest on the mortgage. Thus, the lender is only entitled to a return of the principal advanced on the mortgage. All payments made by the borrower are applied entirely to principal reduction, with nothing applied to interest.8

The lender may also have to pay a usury penalty of treble damages.9

Treble damages are computed at three times the total interest paid by the borrower during the one year period immediately preceding their filing of a suit and during the period of litigation until the judgment is awarded.

An award of treble damages is typically reserved for a lender the court believes took grossly unfair advantage of an unwary borrower.10

A borrower who knew at all times a loan interest rate was usurious is not likely to be awarded treble damages. Also, a lender who sets a usurious rate in complete ignorance of the illegality of usury would not be additionally penalized with treble damages.

8 Bayne v. Jolley (1964) 227 CA2d 630

9 CC §1916-3

10 White v. Seitzman (1964) 230 CA2d 756

Penalties for usury

treble damages A usury penalty computed at three times the total interest paid by the borrower during the one year period immediately preceding their filing of an action on a non- exempt private lender mortgage.

The amount of interest a private, non-exempt lender can charge a borrower is regulated by the California Constitution and statutes, collectively called usury laws.

Mortgages made or arranged by a California real estate broker are exempt from usury restrictions. Further, sales transactions involving the extension of credit by a seller are not subject to usury laws.

Non-exempt mortgages made to fund the improvement, construction, or purchase of real estate are subject to an interest restriction of 10% annually or the current discount rate of the Federal Reserve Bank of San Francisco plus 5%, whichever is greater.

Penalties for violating usury law include the forfeiture of all interest on a usurious mortgage. Lenders who are found to have taken grossly unfair advantage can also be penalized with treble damages.

exempt debt ................................................................................... pg. 391 excluded debt ................................................................................ pg. 391 restricted real estate loans ........................................................ pg. 473 treble damages ............................................................................. pg. 392 usury ............................................................................................... pg. 389

Chapter 58 Summary

Chapter 58 Key Terms

Quiz 11 Covering Chapters 55-61 is located on page 616.

Chapter 59: A lender’s oral promises as commitments 393

After reading this chapter, you will be able to:

• identify the unenforceability of a lender’s oral or unsigned mortgage commitment; and

• better your buyer’s chance of closing with the best rates and terms possible by submitting mortgage applications to at least two lenders.

Learning Objectives

For a further study of this discussion, see Chapter 39 of Real Estate Finance.

A lender’s oral promises as commitments

Chapter

Consider an owner planning to make improvements to their industrial property. The owner applies for a mortgage to upgrade the facilities, add equipment and construct additional improvements. The owner has a long- standing business relationship with a lender, having borrowed from it in the past.

The mortgage officer processing the mortgage orally assures the owner it will provide permanent long-term financing to refinance the short-term financing the owner will use to fund the improvements. Nothing is put to writing or signed. Relying on the lender’s oral assurances, the owner enters into a series of short-term mortgages and credit sales arrangements to acquire equipment and improvements.

The mortgage officer visits the owner’s facilities while improvements are being installed and constructed. The lender orally assures the owner they will provide long-term financing again.

mortgage commitment Key Terms

No responsibility for oral or conditional promises

394 Real Estate Principles, Second Edition

On completion of the improvements, the owner makes a demand on the lender to fund the permanent financing. However, the lender refuses. The owner is informed the lender no longer considers the owner’s business to have sufficient value as security to justify the financing.

The owner is unable to obtain permanent financing with another lender. Without amortized long-term financing, the business fails for lack of capital. The business and property are eventually lost through foreclosure to the holders of the short-term financing. The owner seeks to recover money losses from the lender, claiming the lender breached its commitment to provide financing.

Can the owner recover for the loss of their business and property from the lender?

No! The lender never entered into an enforceable mortgage commitment. Nothing was placed in writing or signed by the lender which unconditionally committed the lender to specific terms of a mortgage.

Even though the lender orally assured the owner multiple times a mortgage will be funded, and despite the owner’s reliance on their pre-existing business relationship with the lender, the owner cannot rely on the lender’s oral commitment.1

The only other course of action the buyer may take is to purchase a written mortgage commitment, paying for the assurance funds will be provided on request.

However, these commitments are always conditional, never absolute. The lender is allowed to deny a mortgage even after delivering a written mortgage commitment in exchange for a commitment fee without liability if they refuse to fund.

Once a lender signs a written agreement, it is bound to follow it. The preceding scenario is an example of the reason lenders rarely enter into signed written promises regarding a mortgage application. When they do, they need to do nothing more than the limited federally mandated nonbinding disclosures on single family residence (SFR) mortgages under Regulation Z (Reg Z), also known as the Truth-in-Lending Act (TILA). [See Chapter 54]

Lenders customarily process applications and prepare mortgage documents. However, these documents are at all points only signed by the buyer. The lender orally advises the buyer whether the mortgage has been approved, but signs nothing that binds it.

The first and only act committing the lender is its actual funding of the mortgage — at the time of closing.

Thus, the lender-borrower relationship is one of power, not one of an open market arrangement. Lending is an asymmetrical power relationship.

1 Kruse v. Bank of America (1988) 202 CA3d 38

mortgage commitment A lender’s commitment to make a mortgage, enforceable only when written, unconditional and signed by the lender for consideration.

Escape from an oral commitment

Chapter 59: A lender’s oral promises as commitments 395

Until the lender delivers funds and a closing has occurred, the lender can back out of its oral or unsigned written commitment at any time without liability.

When a lender breaches its oral commitment to lend, the buyer’s reliance on anything less than an unconditional written mortgage commitment is not legally justified — even though the buyer had no realistic choice other than to rely on the lender’s oral promises.

In order to prepare a buyer for the mortgage application process, agents need to advise their buyer of the likely scenarios they will encounter. Thus, the informed buyer is best able to anticipate and defend themselves when confronted with unscrupulous eleventh-hour changes.

Always advise buyers seeking a purchase-assist mortgage to “double app”; that is, submit mortgage applications to a minimum of two lenders as recommended by the U.S. Department of Housing and Urban Development (HUD) and the California Bureau of Real Estate (CalBRE). [See RPI Form 312]

Multiple competitive applications keep lenders vying for your buyer’s business up to the very last minute – the ultimate moment of funding, when commitments truly are commitments. [See Chapter 54]

Agents provide protection for their buyers

A lender’s oral or unsigned mortgage commitment is unenforceable by a buyer. A mortgage commitment is only enforceable when it is placed in writing and signed by the lender, unconditionally committing the lender to the specific terms of a mortgage for consideration.

Lenders customarily process applications and prepare mortgage documents. However, these documents are signed only by the buyer. The first and only act committing the lender is its actual funding of the mortgage which occurs at the time of closing. Thus, until the lender delivers funds and a closing has occurred, the lender can back out of its oral commitment at any time without liability.

To better your buyer’s chance of closing with the best rate and terms possible, counsel them to submit applications for a mortgage to at least two institutional lenders. A second application with another institution gives the buyer additional leverage in mortgage negotiations needed at closing.

mortgage commitment ............................................................. pg. 394

Chapter 59 Summary

Chapter 59 Key Terms

Quiz 11 Covering Chapters 55-61 is located on page 616.

Notes:

Chapter 60: Private mortgage insurance 397

After reading this chapter, you will be able to:

• advise your buyers who have a down payment less than 20% about the availability of private mortgage insurance (PMI) on conventional mortgages with loan-to-value ratios (LTVs) exceeding 80%; and

• review the qualification and approval process for obtaining PMI with buyers.

Private mortgage insurance

Chapter

Private mortgage insurance (PMI) indemnifies a lender against losses on a mortgage when a borrower defaults.1

The lender’s recoverable losses include:

• principal on the debt;

• any deficiency in the value of the secured property; and

• foreclosure costs.

PMI insurers are unrelated to government-created insurance agencies, such as the Federal Housing Administration (FHA) and the Veterans Administration (VA), which also insure or guarantee mortgages made to qualified borrowers. [See Chapter 56]

1 Calif. Insurance Code §12640.02

private mortgage insurance (PMI) Default mortgage insurance coverage provided by private insurers for conventional loans with loan-to-value ratios higher than 80%.

Protecting the lender from loss

lender-paid mortgage insurance (LPMI)

loan-to-value ratio (LTV)

private mortgage insurance (PMI)

Key Terms

Learning Objectives

For a further study of this discussion, see Chapter 42 of Real Estate Finance.

398 Real Estate Principles, Second Edition

PMI is not mortgage life insurance, which pays off the insured mortgage in the event a borrower dies, becomes disabled, or loses their health or income.

PMI insures the lender for losses incurred up to a percentage of the mortgage amount. In turn, the mortgage amount represents a percentage of the property’s value, called the loan-to-value ratio (LTV).

Typically, mortgages insured by PMI are covered for losses on amounts exceeding 67% of the property’s value at the time the mortgage is originated.

The buyer usually pays the PMI premiums, not the lender (although the lender is the insured and holder of the policy).

However, some lenders and PMI insurers offer a lender-paid mortgage insurance (LPMI) program. If issued by the PMI insurer, the lender pays the mortgage insurance premium and charges the borrower a higher interest rate on their principal payments.

Premium rates are set as a percentage of the mortgage balance and are calculated in the same manner as interest.

If the buyer is current on PMI payments and has not taken out other mortgages on their property, the buyer may terminate their PMI coverage when the equity in their property reaches 20% of its value at the time the mortgage was originated. Once the buyer reaches 22% equity, PMI is automatically cancelled (unless the mortgage is a piggyback 80-10-10).

Furthermore, the buyer may cancel PMI two years after the mortgage is recorded if the LTV for the mortgage balance is 75%. The lender may agree to a higher LTV for cancellation.

When PMI may be cancelled as agreed, the lender may not charge advance PMI payments unless the borrower has:

• incurred more than one late penalty in the past 12 months; or

• been more than 30 days late on one or more payments on the note.2

Premiums charged by PMI insurers do not include an up-front fee on origination like FHA, only an annual fee calculated as a percentage of the mortgage balance and payable monthly with principal and interest payments.

Depending on the policies of the insurer, the buyer needs to meet PMI qualification standards such as:

• a minimum credit score of upwards of 680;

• a debt-to-income ratio between 41% and 45%;

2 Calif. Civil Code §2954.12(a)(3)

Private mortgage insurance coverage

loan-to-value ratio (LTV) A ratio stating the outstanding mortgage balance as a percentage of the mortgaged property’s fair market value. The degree of leverage.

Who pays for PMI?

lender-paid mortgage insurance (LPMI) Default mortgage insurance provided by private insurers in which the lender pays the mortgage insurance premium and recovers the cost through a higher interest rate.

Buyer and property

standards

Chapter 60: Private mortgage insurance 399

• two months principal, interest, taxes and insurance (PITI) payments in cash reserves;

• employment full time during the past two years, a current pay stub, written verification by employer (VOE form), and telephone confirmation of employment at closing, unless self-employed;

• if self-employed, financial statements for the two prior years and year- to-date, plus IRS tax returns;

• all documents and title vestings to be in the name of the buyer as an individual;

• limit to three mortgages under PMI coverage in the name of the buyer;

• completion of a homeowners’ course of education on mortgage debt obligations;

• no bankruptcy within four years, unless excused by extenuating circumstances; and

• no prior foreclosure under a mortgage.

The PMI investigation and documentation takes place after submission of a mortgage application. It is generally limited to verification of all the buyer’s representations on the application. The availability of PMI coverage for different types of California real estate is limited. Only properties classified as single family residences (SFRs) may receive PMI.

Most PMI contracts do not authorize the insurer to seek indemnity from the borrower for claims made on the policy by the lender. This is distinct from FHA or VA insurance programs which place homeowners at a risk of loss for a greater amount than their down payment.

Most insured mortgages are purchase-money mortgages made to buyer- occupants to acquire their principal residence. Purchase money mortgages are nonrecourse obligations, with recovery on the mortgage limited to the value of the real estate.3

However, if the mortgage is recourse, as is the case of a refinance, the lender’s right to seek a deficiency judgment may be assigned to the PMI insurer. Pursuing a money judgment to collect from the borrower for a deficiency in the value of the property requires a judicial foreclosure action. [See Chapter 70]

In the case of fraud on recourse or nonrecourse mortgages, the PMI insurer is not barred by anti-deficiency statutes from recovering losses. Thus, they may enforce collection of their losses against the borrower for misrepresentations, such as the property’s value, job status, etc.

To qualify for PMI, the buyer needs to be a natural person and take title as the vested owner of the property.

3 Calif. Code of Civil Procedure §580b

Defaulting borrower and PMI recourse

The PMI credit check

400 Real Estate Principles, Second Edition

The lender, when qualifying the buyer for a mortgage to be covered by PMI, relies on the more restrictive PMI insurer’s requirements regarding the buyer’s:

• liquid assets after closing;

• debt-to-asset ratio;

• debt-to-income ratio; and

• regard for financial obligations.

A buyer required to qualify for PMI before a lender funds a mortgage undergoes an in-depth risk analysis based on the PMI insurer’s eligibility requirements.

At a minimum, the buyer is required to submit documents for review by the PMI insurer, including:

• a copy of the mortgage application;

• a credit report current within 90 days and covering a minimum of two years; and

• an appraisal of the real estate to be purchased.

However, the PMI carrier may also require additional documentation to verify the mortgage transaction fulfills the insurer’s underwriting requirements, such as verification the buyer will occupy the property and a copy of the signed purchase agreement.

The buyer’s credit rating and disposable income need to clearly support their ability to make the monthly payments on the low down payment mortgage.

Private mortgage insurance (PMI) indemnifies a lender for loss on a mortgage secured by an interest in real estate when a borrower whose down payment is less than 20% defaults.

If the buyer is current on PMI payments and has taken out no other mortgages on their property, the buyer may terminate their PMI coverage when the equity in their property reaches 20% of its value at the time the mortgage was originated. Once the buyer reaches 22% equity, PMI is automatically cancelled.

The lender making a conventional mortgage to fund the purchase of a principal residence when the mortgage will exceed 80% of the property value requires the buyer to meet the qualifications for PMI coverage, not just the lender’s qualifications.

lender-paid mortgage insurance (LPMI) ............................... pg. 398 loan-to-value ratio (LTV) ............................................................ pg. 398 private mortgage insurance (PMI) .......................................... pg. 397

Chapter 60 Summary

Chapter 60 Key Terms

Quiz 11 Covering Chapters 55-61 is located on page 616.

Chapter 61: The promissory note 401

After reading this chapter, you will be able to:

• understand a signed promissory note is evidence of the existence of an underlying debt, not the debt itself;

• recognize the linkage between a promissory note and a trust deed; and

• identify the different types of promissory notes and debt repayment arrangements they are used to evidence.

Learning Objectives

The promissory note

Chapter

Most real estate sales hinge on financing some portion of the purchase price. A buyer promises to pay a sum of money, in installments or a single payment at a future time, to a lender who funds the sales transaction. Alternately, the buyer may make payments to the seller under a carryback financing arrangement.

Given in exchange for property or a loan of money, the promise to pay evidences a debt owed by the buyer and payable to the seller or lender to whom the promise is made.

Evidence of the debt

adjustable rate mortgage (ARM)

all-inclusive trust deed (AITD)

applicable federal rate (AFR)

balloon payment

graduated payment mortgage (GPM)

installment note

promissory note

reconveyance

straight note

usury

For a further discussion of this topic, see Chapter 5 of Real Estate Finance.

Key Terms

402 Real Estate Principles, Second Edition

The promise to pay is set out in a written document called a promissory note. A promissory note represents an underlying debt owed by one person to another.

The signed promissory note is not the debt itself, but evidence the debt exists.

The buyer, called the debtor or payor, signs the note and delivers it to the lender or carryback seller, called the creditor.

The note can be either secured or unsecured. If the note is secured by real estate, the security device used is a trust deed. When secured, the debt becomes a voluntary lien on the real estate described in the trust deed.

Notes are categorized by the method for repayment of the debt as either:

• installment notes; or

• straight notes.

The installment note is used for debt obligations with constant periodic repayments in any amount and frequency negotiated.

Variations of the installment note include:

• interest-included; and

• interest-extra.

Finally, notes are further distinguished based on interest rate calculations, such as:

• fixed interest rate notes, commonly called fixed rate mortgages (FRMs); and

• variable interest rate notes, commonly called adjustable rate mortgages (ARMs).

An interest-included installment note with constant periodic payments produces a schedule of payments. The schedule contains diametrically varying amounts of principal and interest from payment to payment. Principal reduction on the mortgage increases and interest paid decreases with each payment made on the mortgage. [See Form 420 accompanying this chapter]

Each payment is applied first to the interest accrued on the remaining principal balance during the period between payments, typically monthly. The remainder of the payment is applied to reduce the principal balance of the debt for accrual of interest during the following period before the next payment is due.

Interest-included installment notes may either:

• be fully amortized through constant periodic payments, meaning the mortgage is fully paid at the end of the term; or

promissory note A document given as evidence of a debt owed by one person to another. [See RPI Form 421 and 424]

The promissory

note installment note A note calling for periodic payments of principal and interest, or interest only, until the principal is paid in full by amortization or a final balloon payment. [See RPI Form 420, 421 and 422]

straight note A note calling for the entire amount of its principal to be paid together with accrued interest in a single lump sum when the principal is due. [See RPI Form 423]

Installment note, interest

included

Chapter 61: The promissory note 403

• include a final/balloon payment after a period of installment payments, called a due date.

Interest-extra installment notes call for a constant periodic payment of principal on the debt. In addition to the payment of principal, accrued interest is paid concurrently with the principal installment.

balloon payment Any final payment on a note which is greater than twice the amount of any one of the six regularly scheduled payments immediately preceding the date of the final/ balloon payment. [See RPI Form 418-3 and 419]

Installment note, interest extra

Form 420

Note Secured by Deed of Trust

Installment — Interest included

404 Real Estate Principles, Second Edition

The principal payments remain constant until the principal amount is fully paid or a due date calls for a final balloon payment. Accordingly, the interest payment decreases with each payment of principal since the interest is paid on the remaining balance. [See RPI Form 422]

Thus, unlike an interest-included note, the amount of each scheduled payment of principal and interest on an interest-extra note is a declining amount from payment to payment.

A straight note calls for the entire amount of its principal to be paid in a single lump sum due at the end of a period of time. No periodic payments of principal are scheduled, as with an installment note. [See RPI Form 423]

Interest usually accrues unpaid and is due with the lump sum principal installment. Thus, this form of real estate financing is sometimes referred to as a sleeper trust deed. Occasionally, the interest accruing is paid periodically during the term of the straight note, such as monthly payments of interest only with the principal all due at the end of a fixed period of time.

The straight note is typically used by bankers for short-term mortgages since a banker’s short-term note is not usually secured by real estate. In real estate transactions, the note evidences what is generally called a bridge loan, a short term obligation.

While the installment note and the straight note are common, variations on the interest rate and repayment schedules contained in the installment and straight notes are available to meet the specific needs of the lender and borrower.

The variations include the:

• adjustable rate mortgage (ARM);

• graduated payment mortgage (GPM);

• all-inclusive trust deed (AITD); and

• shared appreciation mortgage (SAM).

The ARM, as opposed to an FRM, calls for periodic adjustments to the interest rate. Thus, the amount of scheduled payments fluctuates from time to time. The interest rate varies based on movement in an agreed-to index, such as Cost-of-Funds index for the 11th District Federal Home Loan Bank.

The ARM provides the lender with periodic increases in its yield on the principal balance during periods of rising and high short-term interest rates.

When an upward interest adjustment occurs, the note’s repayment schedule calls for an increase in the monthly payment to maintain the original

Straight notes

Payment variations

adjustable rate mortgage (ARM) A variable interest rate note, often starting out with an introductory teaser rate, only to reset at a much higher rate in a few months or years based on a particular index. [See RPI Form 320-1]

Adjustable rate

mortgage

Chapter 61: The promissory note 405

amortization period. If the amount of the original monthly payment is retained without an increase to reflect an increase in the interest rate, the mortgage term is extended or negative amortization occurs.

GPM provisions, in which the payment increases gradually from an initial low base level, are in demand when interest rates or home prices rise too quickly and ARM mortgages are disfavored. A graduated payment schedule allows buyers time to adjust their income and expenses in the future. A GPM often has a variable interest rate.

For example, the GPM provision allows low monthly payments on origination. The payments are gradually increased over the first three- to five-year period of the mortgage, until the payment amortizes the mortgage over the desired number of remaining years.

However, any accrued monthly interest remaining unpaid each month is added to the principal balance resulting in negative amortization. The negative amortization causes the unpaid interest to bear interest as though it were principal, called compounding.

The AITD variation of a note is used more often in carryback transactions than money lending. AITDs become popular in times of recession, increasing long-term rates and tight credit. The property is subject to one or more trust deed mortgages with lower than current mortgage rates, though the opposite can be the case.

The AITD “wraparound” note typically calls for the buyer to pay the carryback seller constant monthly installments of principal and interest. The carryback seller then pays the installments due on the underlying (senior) trust deed note from the payments received on the AITD note.

The SAM repayment schedule variation is designed to help sellers attract buyers during times of tightening mortgage money. Usually, the real estate sales volume is in a general decline, followed in a year by a drop in prices. The SAM is an example of a split-rate note. [See Figure 1, RPI Form 430]

Under a SAM note, the buyer pays an initial fixed interest rate, called a “floor” or “minimum” rate. The floor rate charged is typically two-thirds to three-fourths of the prevailing market rate, but not less than the applicable federal rate (AFR) for reporting imputed interest.

In return, the carryback seller receives part of the property’s appreciated value as additional interest, called contingent interest, when the property is sold or the carryback SAM is due.

graduated payment mortgage (GPM) A mortgage providing for installment payments to be periodically increased by predetermined amounts to accelerate the payoff of principal.

Graduated payment mortgage

All-inclusive trust deed note

Shared appreciation mortgage

applicable federal rate (AFR) Rates set by the Internal Revenue Service for carryback sellers to impute and report income at the minimum interest when the note rate on the carryback debt is a lesser rate.

406 Real Estate Principles, Second Edition

Figure 1

Form 430

Shared Appreciation Note

Installment — Contingent Interest Extra

A note documents the terms for repayment of a mortgage or the unpaid portion of the sales price carried back after a down payment, including:

• the amount of the debt;

• the interest rate;

• the periodic payment schedule; and

• any due date.

The dollar amount of the note carried back by a seller on an installment sale as evidence of the portion of the price remaining to be paid is directly influenced by whether the carryback is:

• an AITD note; or

• a regular note.

The face amount of an AITD note carried back by a seller will always be greater than had a regular note been negotiated in any given sales transaction. The AITD note is for the difference remaining after deducting the down payment from the purchase price. Thus, the AITD note includes the principal amount of the wrapped mortgages. However, a regular note is only for the amount of the seller’s equity remaining after deducting from the purchase price the down payment and the principal balance due on the existing trust deed notes taken over by the buyer.

Financial aspects

all-inclusive trust deed (AITD) A note entered into by the buyer in favor of the seller to evidence the amount remaining due on the purchase price after deducting the down payment, an amount inclusive of any specified mortgage debts remaining of record with the seller retaining responsibility for their payment. Also referred to as a wraparound mortgage or overriding mortgage. [See RPI Form 421]

Chapter 61: The promissory note 407

California’s usury law limits the interest rate on non-exempt real estate mortgages to the greater of:

• 10%; or

• the discount rate charged by the Federal Reserve Bank of San Francisco, plus 5%.1 [See Chapter 58]

In most carryback transactions, the buyer gives the seller a trust deed lien on the real estate sold as security for payment of the portion of the price left to be paid.

The trust deed is recorded to give notice and establish priority of the seller’s security interest in the property.2

A trust deed alone, without a monetary obligation for it to attach to the described property, is a worthless trust deed for there is nothing to be secured. Although the note and trust deed executed by a buyer in favor of the seller are separate documents, a trust deed is only effective as a lien when it provides security for an existing promise to pay or perform any lawful act that has a monetary value.3

Even though they are separate documents, the note and trust deed are for the same transaction and are considered one contract to be read together.4

The promissory note, once signed by the borrower and delivered to the lender, represents the existence of a debt.5

When a secured debt has been fully paid, the trust deed securing the debt is removed from title to the secured property, a process called reconveyance.6

1 Calif. Constitution, Article XV

2 Monterey S.P. Partnership v. W.L. Bangham, Inc. (1989) 49 C3d 454

3 Domarad v. Fisher & Burke, Inc. (1969) 270 CA2d 543

4 Calif. Civil Code §1642

5 Calif. Code of Civil Procedure §1933

6 CC §2941

Interest rate limitations on mortgages

usury A limit on the lender’s interest rate yield on nonexempt real estate loans.

The trust deed

Satisfaction of the debt

reconveyance A document executed by a trustee named in a trust deed to release the trust deed lien from title to real estate, used when the secured debt is fully paid. [See RPI Form 472]

408 Real Estate Principles, Second Edition

A promissory note is a document given as evidence of a debt owed by one person to another. To be enforceable, the promissory note needs to be signed by the payor and delivered to the lender or carryback seller on closing the sale.

A note may be secured or unsecured. If the note is secured by real estate, the security device used is a trust deed, commonly called a mortgage. When secured, the debt evidenced by the note becomes a voluntary lien on the real estate described in the trust deed that references the note. Even though they are separate documents, the note and trust deed are for the same transaction and are considered one contract to be read together.

Notes are categorized by the method for repayment of the debt as either installment notes or straight notes. The installment note is used for debts paid periodically in negotiated amounts and at negotiated frequencies. A straight note calls for the entire amount of its principal to be paid together with accrued interest in a single lump sum when the principal is due.

An interest-included installment note produces a schedule of constant periodic payments which amortize the mortgage principal. Interest- extra installment notes call for a constant periodic payment of principal on the debt. In addition to the payment of principal, accrued interest is paid separately, typically concurrent with payment of the principal installment.

Variations exist on the interest rate and repayment schedules contained in installment and straight notes.

When a debt secured by a trust deed lien on real estate has been fully paid, the lien is removed from title, a process called reconveyance.

adjustable rate mortgage (ARM) ............................................. pg. 404 all-inclusive trust deed (AITD) ............................................... pg. 406 applicable federal rate (AFR) ................................................... pg. 405 balloon payment ....................................................................... pg. 403 graduated payment mortgage (GPM) .................................... pg. 405 installment note ......................................................................... pg. 402 promissory note .......................................................................... pg. 402 reconveyance .............................................................................. pg. 407 straight note ................................................................................ pg. 402 usury .............................................................................................. pg. 407

Chapter 61 Key Terms

Chapter 61 Summary

Quiz 11 Covering Chapters 55-61 is located on page 616.

Chapter 62: Late charges and grace periods 409

After reading this chapter, you will be able to:

• determine the provisions and conduct needed for a lender or carryback seller to establish their right to collect a late charge;

• differentiate late charge arrangements based on the type of property securing repayment, and whether the loan was arranged by a broker; and

• understand how late charges are enforced and calculated.

Learning Objectives

Late charges and grace periods

Chapter

Promissory notes contain a late charge provision. The late charge provision imposes an additional charge if payment is not received by the lender when due or within a grace period.

To establish the right to enforce collection of a late charge, the following conditions need to be met by the lender or carryback seller:

• a late charge provision exists in the note [See Form 418-1 accompanying this chapter];

• a scheduled payment is delinquent;

• a notice of amounts due is delivered to the lender or carryback seller assessing the late charge and demanding its payment;

Elements of a late charge

late charge A fee imposed as an additional charge under a provision in a promissory note, lease or rental agreement when payments are not received by their due date or during a grace period.

balloon payment

brokered loan

grace period

late charge Key Terms

For a further discussion of this topic, see Chapter 12 of Real Estate Finance.

410 Real Estate Principles, Second Edition

• the dollar amount of the late charge is within the limits set by applicable statutes and reasonableness standards; and

• accounting requirements for semi-annual and annual reports have been complied with.

The failure of an owner to pay a late charge is a non-material breach of the note and trust deed. As a non-material breach, the failure to pay late charges cannot be the sole monetary basis for initiating a foreclosure by recording a notice of default (NOD).

grace period The time period following the due date for a payment during which payment received by the lender or landlord is not delinquent and a late charge is not due. [See RPI Form 550 §4.3 and 552 §4.7]

Form 418-1

Late Payment Provisions

Chapter 62: Late charges and grace periods 411

Distinctions exist in the treatment of late charges permitted for private lender loans as compared to charges permitted for seller carryback paper.

For private lenders, late charges on loans secured by single family residences (SFRs) are treated differently than when they are secured by other types of property. Also, the amount of the late charge a private lender may impose is further controlled by whether or not the loan was made or arranged by a broker.

Late charge provisions included in notes used by institutional lenders are generally non-negotiable. This non-negotiable status is due primarily to lender adherence to established uniformities, such as ceilings set by statute or pooling arrangements in the secondary mortgage money market.

However, the inclusion of late charge provisions in notes carried back by sellers or originated by private lenders are not automatic as boilerplate language but are left to negotiations.

Before a late charge provision is included in a note, the charge needs to be agreed to. When a late charge is referenced in a carryback note provision agreed to in a purchase agreement, escrow is instructed to include the applicable late charge provision in the note prepared for signatures. [See RPI Form 150 §8.1]

For a late charge provision to be complete, it needs to include:

• the amount of the late charge;

• the duration of any grace period following the due date before a payment received by the lender is delinquent; and

• a requirement for notice from the lender to impose the late charge and demand its payment. [See Form 418-1]

The reasonable amount of monetary losses collectible as a late charge include:

• the actual out-of-pocket expenses incurred in a reasonable collection effort; and

• the lost use of the principal and interest (PI) portion of the delinquent payment.

To collect a late charge for the delinquent payment on a note secured by any type of real estate, the carryback seller or private lender is to notify the owner of the charge and make a demand for its payment.

The negotiation of late charge provisions

The provision and the late charge amount

Collectable losses

Late charge notice

412 Real Estate Principles, Second Edition

Private lenders are to give notice and make a demand for the late charge in a timely manner by use of either:

• a billing statement or notice sent for each payment prior to its due date stating the late charge amount and the date on which it will be incurred; or

• a written statement or notice of the late charge amount due concurrent with or within ten days after mailing a notice to cure a delinquency.1

The notice of amounts due or the billing statement is to include the exact amount of the late charge or the formula used to calculate the charge.2

If the private lender fails to initiate collection of the late charge, the lender waives its right to collect a late charge on that payment. However, failure to comply with the late charge notice requirements on a delinquency does not waive the private lender’s right to enforce the late charge provision on future delinquencies.3

In regards to carryback notes, if, on receipt of a delinquent payment, the carryback seller fails to make a demand for payment of the late charge, they waive their right to collect a late charge on that installment.4

Ten days is the minimum grace period allowed for a private lender secured by an owner-occupied SRF, even if the homeowner agrees to a shorter grace period, or no grace period is agreed to.5

The late charge amount on a private lender loan which is not made or arranged by a broker and is secured by an owner-occupied SFR is limited to the greater of:

• 6% of the delinquent PI installment; or

• $5.6

Mailing the installment within the grace period does not qualify the payment as timely paid. The payment needs to be actually received by the carryback seller, lender or collection agent no later than the last day of the grace period.7

When a licensed real estate broker makes or arranges a loan as or for a private lender, the 6% limit for late charges established for loans secured by owner- occupied SFRs does not apply. Further, reasonableness standards do not apply as well. Instead, statutes control.8

1 CC §2954.5(a)

2 CC §2954.5(a)

3 CC §2954.5(e)

4 Calif. Code of Civil Procedure §2076; CC §1501

5 CC §2954.4(a), (b)

6 CC §2954.4(a), (e)

7 Cornwell v. Bank of America National Trust and Savings Association (1990) 224 CA3d 995

8 CC §2954.4(e)

Late charge grace periods

on private lender

mortgages

Made or arranged by

brokers

Chapter 62: Late charges and grace periods 413

For private lender loans made or arranged by a real estate broker, called a brokered loan, and secured by any type of real estate, the late charge is limited to the greater of:

• 10% of the delinquent principal and interest payment; or

• $5.9 [See Form 418-1 §2.2]

Also, if the private lender loan made or arranged by a broker contains a due date for a final/balloon payment, a late charge may be assessed on the final/balloon payment if it is not received within ten days after its due date. [See Form 418-1 §2.4]

Like an owner-occupied SFR loan, an installment on a private lender loan made or arranged by a broker on any type of property is not late if it is received by the lender within ten days after the installment is due.10

For a private lender loan secured by an owner-occupied SFR, or one made or arranged by a broker and secured by any type of property, the private lender cannot charge more than one late charge per delinquent monthly installment, no matter how many months the payment remains delinquent.11

Refusal or failure of an owner to pay a late charge when demanded does not justify a call of the loan or initiation of foreclosure by itself.12

No lender or carryback seller is entitled to foreclose on an owner who has tendered all installments which are due, but has failed to pay outstanding late charges. Collection of late charges when no other monetary breach exists needs to be enforced by means other than foreclosure.

Additionally, a private lender making a loan on any type of real estate is required to furnish the owner with a semi-annual accounting for the total amount of late charges due and unpaid during the accounting period.13

For late charges on a carryback note secured by property improved with only a one-to-four unit residence, the carryback seller needs to also provide the owner with an annual accounting statement detailing any late charges due and unpaid during the entire year.14

9 Calif. Business and Professions Code 10242.5(a)

10 Bus & P C §10242.5(b)

11 CC §2954.4(a); Bus & P C §10242.5(b)

12 Baypoint Mortgage Corporation v. Crest Premium Real Estate Investments Retirement Trust (1985) 168 CA3d 818

13 CC §2954.5(b)

14 CC §2954.2(a)

brokered loan A private lender loan made or arranged by a real estate broker.

One charge per delinquency

Enforcement of the late charge

414 Real Estate Principles, Second Edition

To establish the right to enforce collection of a late charge:

• a late charge provision needs to exist in the note;

• a scheduled payment needs to be delinquent;

• a notice of amounts due has been delivered to the owner;

• the dollar amount of the late charge is within the limits set by applicable statues and reasonableness standards; and

• accounting requirements for semi-annual and annual reports have been complied with.

For a late charge provision to be complete, it needs to include:

• the amount of the late charge;

• the duration of any grace period; and

• a requirement for notice from the trust deed holder to impose the late charge and make a demand for its payment.

The late charge amount on a private lender loan which is not made or arranged by a broker and is secured by an owner-occupied SFR is limited to the greater of 6% of the delinquent principal and interest payment or $5.

For private lender loans made or arranged by a real estate broker and secured by any type of real estate, the late charge is limited to the greater of 10% of the delinquent principal and interest payment or $5.

balloon payment ........................................................................ pg. 413 brokered loan ............................................................................... pg. 413 grace period .................................................................................. pg. 410 late charge .................................................................................... pg. 409

Chapter 62 Summary

Chapter 62 Key Terms

Quiz 12 Covering Chapters 62-67 is located on page 617.

Chapter 63: Prepayment penalties 415

After reading this chapter, you will be able to:

• understand how prepayment penalties were historically used by lenders to prevent the loss of interest;

• determine whether a prepayment penalty is prohibited under the Dodd-Frank Wall Street Reform and Consumer Protection Act; and

• advise on the enforceability of a prepayment penalty provision in a note secured by a trust deed containing a due-on clause.

Learning Objectives

Prepayment penalties

Chapter

Consider an owner of real estate who wants to pay off some or the entire principal on a mortgage before it is due by its terms. However, the owner has previously agreed to an additional charge the lender may levy to reduce or pay off the debt, called a prepayment penalty.

The prepayment penalty agreement is included in the promissory note. It is not a provision in the trust deed, since it relates to the payment of the debt, not the care and maintenance of the real estate.

The unscheduled prepayment of any principal on a debt before it is due is ironically considered a privilege, since the borrower wants to deleverage and is now able to pay off their lender. If a prepayment penalty provision is agreed to in the note, a lender can charge the owner on each exercise of the

Debt reduction — a costly privilege

prepayment penalty A provision in a note giving a lender the right to levy a charge against a borrower who pays off the outstanding principal balance on a loan prior to expiration of the prepayment provision. [See RPI Form 418-2]

Dodd-Frank Wall Street Reform and Consumer Protection Act

due-on clause

prepayment penalty Key Terms

For a further discussion of this topic, see Chapter 10 of Real Estate Finance.

416 Real Estate Principles, Second Edition

Form 418-2

Prepayment of Principal Provisions

privilege. The owner may be charged whether the reduction is a portion or all of the principal remaining on the debt. [See Form 418-2 accompanying this chapter]

Historically, prepayment penalties were used by lenders to prevent the loss of interest until the funds were re-lent to another borrower.

Prepayment penalties became regulated in 2010 under the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Enforceable penalties

Dodd-Frank Wall Street Reform and Consumer Protection Act A 2010 enactment of significant changes to U.S. financial regulation in response to the 2007 financial crisis.

Chapter 63: Prepayment penalties 417

Prepayment penalties are prohibited on mortgage loans which are not qualified mortgages.

A qualified mortgage is any consumer loan secured by an owner- or non- owner-occupied one-to-four unit residential property.

Further, prepayment provisions are also prohibited on qualified mortgages which have:

• an adjustable rate of interest; or

• an annual percentage rate (APR) exceeding the average prime offer rate in a comparable residential mortgage loan by set quotas.

Prepayment penalties on qualified mortgages cannot exceed:

• 3% of the outstanding balance on the mortgage during the 1st year of payment following the recording of the mortgage;

• 2% of the outstanding balance on the mortgage during the 2nd year of payment;

• 1% of the outstanding balance on the mortgage during the 3rd year of payment; and

• 0% after the first three years following the recording of the mortgage.

Further, a SFR secured lender on the payoff of a consumer mortgage may only charge a prepayment penalty if:

• the prepayment penalty does not extend beyond three years after the date of the mortgage’s closing;

• the prepayment penalty provision is not included in the terms of any refinancing by the same lender of the mortgage paid off;

• at closing, the borrower’s total monthly payments on installment debts are less than 50% of their verified gross income; and

• the monthly payments do not change or adjust during the first four- year period after closing. [12 Code of Federal Regulations §§1026.32(d) (6)-(7)]

Prepayment penalty provisions in all notes secured by a trust deed containing a due-on clause and encumbering an owner-occupied, one-to-four unit residential property are unenforceable if the lender or carryback seller:

• calls the mortgage due for a transfer in violation of the due-on clause;

• starts foreclosure to enforce a call under the due-on clause; or

• fails during the pendency of the sale of property subject to the mortgage to approve, within 30 days of receipt of the completed credit application from a qualified buyer, the assumption of the mortgage or carryback note.1

However, a seller carrying back a note secured by a one-to-four unit residential property can bar prepayment only for the calendar year of sale, if they have not already carried back more than four notes in the same year.2

1 12 Code of Federal Regulations §591.5(b)(2), (3)

2 CC §2954.9(a)(3)

Due-on clause and prepayment penalties

due-on clause A trust deed provision used by lenders to call the loan immediately due and payable, a right triggered by the owner’s transfer of any interest in the real estate, with exceptions for intra-family transfers of their home.

privilege. The owner may be charged whether the reduction is a portion or all of the principal remaining on the debt. [See Form 418-2 accompanying this chapter]

Historically, prepayment penalties were used by lenders to prevent the loss of interest until the funds were re-lent to another borrower.

Prepayment penalties became regulated in 2010 under the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Enforceable penalties

Dodd-Frank Wall Street Reform and Consumer Protection Act A 2010 enactment of significant changes to U.S. financial regulation in response to the 2007 financial crisis.

418 Real Estate Principles, Second Edition

Prepayment penalties were historically used by lenders in an effort to prevent the loss of interest until the funds were re-lent to another borrower.

A property owner’s right to prepay principal to reduce their debt or payoff and release the trust deed lien on their property is established by the terms of the promissory note. Further, prepayment penalties are regulated by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Dodd-Frank Wall Street Reform and Consumer Protection Act .................................................................................................. pg. 417 due-on clause ............................................................................... pg. 417 prepayment penalty .................................................................. pg. 415

Chapter 63 Summary

Chapter 63 Key Terms

Quiz 12 Covering Chapters 62-67 is located on page 617.

Chapter 64: Balloon payment notices 419

After reading this chapter, you will be able to:

• understand what constitutes a final/balloon payment on a note; • calculate the amount of a final/balloon payment; and • advise on the requirements for the contents and delivery of a

final/balloon payment notice.

Balloon payment notices

Chapter

A final/balloon payment is any final payment on a note in an amount greater than twice the amount of any of the six regularly scheduled payments immediately preceding the balloon payment date.1

Final/balloon payment notes contain due date provisions calling for an accelerated final payoff of the principal in a lump sum amount before the note balance has been fully amortized through periodic payments. Further, a note has a balloon payment if it contains a call provision giving the carryback seller or lender the right to demand final payment at any time or after a specified time.2

Consumer mortgages are contrasted with business mortgages based on the purpose for which the funds are intended to be used.

A consumer mortgage both:

• funds a personal, family or household purpose; and

1 CC §§2924i(d)(1), 2957(b)

2 CC §§2924i(d)(2), 2957(c)

Notes containing a balloon payment

Limitations on final/balloon payments in consumer mortgages

balloon payment call provision

Learning Objectives

Key Terms For a further discussion of this topic, see Chapter 13 of Real Estate Finance.

420 Real Estate Principles, Second Edition

• is secured by a one-to-four unit residential property, whether or not occupied by the borrower or their family.3

Final/balloon payments in consumer mortgages have become rare due to Regulation Z (Reg Z) rules. Mortgage lenders making consumer mortgages are mandated by Reg Z to qualify the borrower under ability-to-repay rules (ATR).

If the mortgage complies with Reg Z qualified mortgage (QM) standards the mortgage is presumed compliant with ATR rules.

However, to be classified as a QM, the mortgage needs to be fully amortized in substantially equal regular installments, a rule eliminating the inclusion of a final/balloon payment provision.

Some mortgages with due dates require a final/balloon payment notice.

A 90/150-day due date notice provision is required in notes containing a final/balloon payment provision with a term exceeding one year if:

• the note is carried back by a seller and secured by a trust deed on one- to-four residential units; or

• the note evidences a loan secured by a trust deed on an owner-occupied, one-to-four unit residential property.

A due date notice is not required, unless agreed to by both parties, on transactions including:

• carryback mortgages secured by any type of real estate other than a one-to-four unit residential property, whether or not owner-occupied;

• lender mortgages secured by any type of real estate other than owner- occupied, one-to-four residential units;

• open-ended credit secured by any type of real estate, such as a home equity line of credit (HELOC); and

• construction loans for any type of improvements.4

The due date notice is used to remind the owner of the secured property of a note’s final/balloon payment. The notice, while a reminder, gives the owner an opportunity to refinance or pay off the note.

Carryback sellers and lenders need to deliver the notice to the buyer or owner of the property:

• personally; or

• by first-class certified mail to the property owner’s last known address.

The notice needs to be given at least 90 days, but not more than 150 days, before the due date.5

3 12 Code of Federal Regulations §1026.2(a)(19)

4 CC §2924i(b)(1), (3)

5 CC §§2924i(c), 2966(a)

Final/balloon payment

notice and due dates

Delivery and contents of the notice

call provision A provision in a note giving the mortgage holder the right to demand full payment at any time or after a specified time or event, also called an acceleration clause. [See RPI From 418-3]

Chapter 64: Balloon payment notices 421

If the notice is not timely delivered, the final due date is extended until 90 days after proper notice is given. No other terms of the note are affected. Thus, the accrual of interest and the schedule of periodic payments remain the same during the extended due date period.6

The failure to deliver the notice does not invalidate the note or lessen the property owner’s obligation to continue making the regular periodic payments. Non-delivery of the notice merely extends the date by which the owner is obligated to pay off the note.

If the owner defaults on a payment during the due-date extension period, the noteholder may initiate foreclosure.

6 CC §§2924i(e), 2966(b)

Form 419

Notice of Balloon Payment Date

422 Real Estate Principles, Second Edition

The dollar amount of the final/balloon payment in a carryback transaction needs to be computed and disclosed to the buyer:

• first in a Seller Carryback Disclosure Statement handed to both the buyer and seller as an attachment to the purchase agreement, or for further approval before the close of escrow subject to cancellation on reasonable disapproval [See RPI Form 300];7 and

• again in a written due date notice delivered at least 90 days, but not more than 150 days, before the final/balloon payment is enforced by the carryback seller. [See Form 419 accompanying this chapter]

Additionally, the carryback note prepared by escrow includes a statutory provision calling for the final/balloon payment due date notice.8 [See RPI Form 418-3 §2.1]

7 2924i (e)

8 2966

A final/balloon payment is any payment on a note which is an amount greater than twice the amount of any of the six regularly scheduled payments immediately preceding the date of the final/balloon payment.

Final/balloon payments in consumer mortgages have become rare due to Regulation Z (Reg Z) rules, as they are prohibited in most qualified mortgages (QMs).

A 90/150-day due date notice provision is required in certain mortgages with terms exceeding one year and containing a final/balloon payment provision. Carryback sellers and lenders need to deliver the final/balloon payment notice to the buyer or owner of the property personally or by first-class certified mail to the property owner’s last known address. The notice needs to be given at least 90 days, but not more than 150 days, before the due date.

A lender or carryback seller may not foreclose if the buyer fails to make a final/balloon payment unless timely notice of the upcoming payoff was given. If the notice is not delivered on time, the final due date of the loan is extended until 90 days after proper notice is given. Non-delivery of the notice extends the date by which the owner is obligated to pay off the note but does not affect any other terms of the note.

balloon payment ........................................................................ pg. 420 call provision ............................................................................... pg. 420

Chapter 64 Summary

Chapter 64 Key Terms

Quiz 12 Covering Chapters 62-67 is located on page 617.

Chapter 65: Trust deed characteristics 423

After reading this chapter, you will be able to:

• understand how a trust deed voluntarily imposes a lien for a debt on an ownership interest real estate;

• identify the three parties and their roles under a trust deed; and • take steps to have a trust deed removed from title to a property.

Learning Objectives

For a further discussion of this topic, see Chapter 14 of Real Estate Finance.

Trust deed characteristics

Chapter

Financing involves a borrower who signs and delivers a promissory note to a lender or seller as evidence of the debt owed for money lent or credit extended. However, the promissory note itself is only a promise to pay as agreed. It is not a guarantee or other assurance the debt evidenced by the note will actually be repaid.

A guarantee is an agreement entered into by a person who is not the borrower under the note, known as a guarantor. The guarantee agreement obligates the guarantor to be responsible for the borrower’s performance. In essence, the guarantor agrees to buy the note in the event the borrower defaults. [See RPI Form 439]

In real estate loan transactions, lenders want assurance the debt owed by the borrower will be repaid. Thus, lenders who fund real estate transactions or provide refinancing require borrowers to provide the real estate involved as collateral to secure the performance of the borrower’s promise to pay if they default on repayment.

A security device and a lien

promissory note A document given as evidence of a debt owed by one person to another. [See RPI Form 421 and 424]

guarantee An assurance that events and conditions will occur as presented by the agent.

beneficiary

deed-in-lieu of foreclosure

guarantee

promissory note

reconveyance

trustee

Key Terms

424 Real Estate Principles, Second Edition

To secure payment of the debt by a parcel of real estate, the security device used is a trust deed agreement. The trust deed is always the preferential method used to impose a lien on real estate. [See Figure 1, RPI Form 450]

The lien gives the lender or carryback seller the right to foreclose on the real estate when the borrower defaults. The trust deed, by its words, purports to convey legal title to a neutral person, called a trustee. In law, the title is not transferred. Instead, a lien is created to encumber the owner’s title and establish the property as security for the debt.

By the use of the trust artifice, title to the property is theoretically held by a trustee as a middleman. In other words, title is held in trust on behalf of the owner and for the benefit of the lender or carryback seller.

If the borrower or owner defaults on the note, the trustee is instructed by the lender to sell the property at a public auction to satisfy the debt.

A trust deed lien arrangement consists of:

• an identification of the parties;

• a description of the real estate liened as security;

• an identification of the primary money obligation, usually evidenced by a note, which brought about the need for security;

• the terms of the lender’s security interest which is the encumbrance on the property, limited to setting out the rights and obligations of the borrower and the lender solely in regard to the real estate; and

• the borrower’s signature and notary acknowledgments. [See Form 450]

The trust deed identifies three parties, each of whom has distinctly separate roles in the secured transaction:

• the borrower/owner (trustor) who voluntarily imposes the trust deed lien on their property;

• the middleman (trustee) who holds the power of sale over the property; and

• the lender or carryback seller (beneficiary) who benefits from the trust deed lien encumbering the property.

The trustor who signs and delivers a trust deed to a lender or carryback seller is the owner of the real estate interest encumbered. Delivery is accomplished by recording the trust deed with the county recorder, which perfects its priority on title.

The owner creating a trust deed encumbrance on real estate usually is the borrower of money or buyer of the property in a seller financed credit sale.

The owner’s real estate interest which is encumbered can be less than the entire fee interest, such as:

• a fractional co-ownership;

• leasehold interest;

trustee One who holds title to real estate in trust for another.

Parties to the trust deed

Chapter 65: Trust deed characteristics 425

• life estate in the property;

• beneficial interests of creditors in existing trust deeds;

• equitable ownership rights under land sales contracts; and

• purchase rights under options to buy.

For example, a condominium owner can encumber their long-term leasehold interest, even though some other person is the fee owner of the real estate.1

1 Calif. Civil Code §§783, 1091, 2947

Figure 1

Form 450

Deed of Trust and Assignment of Rents

For a full-size, fillable copy of this or any other form in this book that may be used in your professional practice, go to realtypublications.com/forms

426 Real Estate Principles, Second Edition

The trust deed lien created by the owner of a fractional interest in the real estate attaches only to the owner’s interest in the property. It does not attach to the interests of any co-owners.2

If community property is encumbered, both spouses need to consent to the encumbrance of the community real estate interest, with the exception of attorney fees agreements in divorce proceedings.3

Despite the wording in the trust deed stating the trustor “hereby grants and conveys to trustee...the following real property...”, the trustee receives no ownership or security interest in the real estate. Further, the trustee holds no legal right to any interest in the property.

The trustee merely receives the authority to carry out the activities vested in the trustee by the power-of-sale provision in the trust deed lien held by the beneficiary (lender).4

Under the trust deed, the trustee’s sole responsibilities concerning the prop- erty are to:

• auction the property at a public sale on notice from the beneficiary; and

• reconvey title to the trustor (owner) and release the beneficiary’s lien on instructions from the beneficiary or the trustor.

Thus, the owner’s possessory right to the property is never transferred to the trustee under a trust deed. The trustor, as the owner of the real estate, remains free to occupy, sell, lease or further encumber their property, subject to the existing trust deed lien. Any person other than the owner of the real estate may serve as trustee. This includes the beneficiary of the trust deed, be they the lender or carryback seller.5

Some private lenders name their attorney or broker as the trustee. Frequently, title and escrow companies unknowingly play the role of trustee in a particular transaction by virtue of the lender’s use of general trust deed forms distributed by title companies.

Under a trust deed lien, the trustee is non-existent until the beneficiary elects to foreclose or release its security interest in the property. The trustee’s conduct is in nearly all aspects completely controlled by statutes.6

When the trustee is called on by the beneficiary to carry out its duty to foreclose or reconvey, the trustee is required to act impartially. A trust deed lien does not create a trust relationship between the parties to the trust deed. The trustee is regarded as a common agent and bears a responsibility to both the beneficiary and the trustor to absolutely follow the strict statutory foreclosure scheme.7

2 Caito v. United California Bank (1978) 20 C3d 694

3 Calif. Family Code §1102

4 Lupertino v. Carbahal (1973) 35 CA3d 742

5 More v. Calkins (1892) 95 C 435

6 Garfinkle v. Superior Court of Contra Costa County (1978) 21 C3d 268; CC §2924 et seq.

7 Kerivan v. Title Insurance and Trust Company (1983) 147 CA3d 225

The trustee’s authority

No possessory

right transferred

Chapter 65: Trust deed characteristics 427

The beneficiary, such as a lender or carryback seller, is the entity entitled to the performance of the promised activity referenced in the trust deed as the purpose for obtaining the security. This is generally the repayment of debt evidenced by a note.

The beneficiary, like the trustee, receives no ownership interest in the property. But unlike the trustee, the beneficiary holds an interest in the property in the form of a lien.

Thus, the beneficiary has the power to instruct the trustee (who may be the beneficiary) to sell the secured property on behalf of the beneficiary. In turn, the trustee has authority from both the trustor and the beneficiary under the power-of-sale provision in the trust deed to sell the property in conformance with the statutory scheme at the direction of the beneficiary.8

A trust deed ceases to exist when its purpose as security for a debt ends. Thus, once the beneficiary (lender or carryback seller) receives the full amount of money they are entitled to under the note and trust deed, any later claim of a security interest by the beneficiary is invalid.

Removing the trust deed from the title to the property on ending the debt relationship between the owner and the creditor is accomplished in one of three ways:

• foreclosure by issuance of a trustee’s deed or sheriff’s deed [See RPI Form 475];

• full repayment by reconveyance [See RPI Form 472]; or

• mutual agreement by a deed-in-lieu of foreclosure. [See RPI Form 406]

Foreclosure of the trust deed lien is accomplished by a public auction at a trustee’s sale or sheriff’s sale, the proceeds of which are applied to the debt.

If the price bid at the foreclosure sale is insufficient to fully satisfy the note, the foreclosure sale terminates the trust deed lien on the property. The foreclosure sale cancels the trust deed’s effect on the title on issuance of the trustee’s or sheriff’s deed.

Full repayment of the debt requires the beneficiary to cause the trust deed to be reconveyed. Once the debt is fully repaid by the trustor, the beneficiary delivers the original note to the trustee, together with a request for a reconveyance of title. In turn, the trustee records a reconveyance of the trust deed. [See RPI Form 472]

On a request for reconveyance, the trustee will demand identification of the beneficiary and require the original note be marked as paid. After recording the reconveyance, the trustee will deliver the note to the owner at the owner’s request.

Unless the recorded trust deed lien expires earlier, the lien expires and is no

8 Prob C §§16000, 16420(a)(1)

The beneficiary is the lienholder

beneficiary One entitled to the benefits of properties held in a trust or estate, with title vested in a trustee or executor.

Extinguishing the relationship

deed-in-lieu of foreclosure A deed to real property accepted by a lender from a defaulting borrower to avoid the necessity of foreclosure proceedings by the lender. [See RPI Form 406]

reconveyance A document executed by a trustee named in a trust deed to release the trust deed lien from title to real estate, used when the secured debt is fully paid. [See RPI Form 472]

Request for reconveyence

428 Real Estate Principles, Second Edition

The trust deed agreement is the preferential method used to impose a lien on real estate. The trust deed identifies three parties:

• the owner, called the trustor;

• the middleman, called the trustee; and

• the lender or carryback seller, called the beneficiary.

The trustee holds no legal right to any interest in the property. The trustee has the limited authority to carry out the activities vested in the trustee by the power-of-sale provision in the trust deed lien held by the beneficiary.

On the instruction from the beneficiary, the trustee’s sole responsibilities concerning the property are to:

• auction the property at a public sale; or

• reconvey title to the trustor and release the beneficiary’s lien.

The beneficiary, such as a lender or carryback seller, is the entity entitled to the performance of the promised activity referenced in the trust deed, such as the repayment of debt evidenced by a note. The beneficiary holds an interest in the property in the form of a lien.

The trust deed ceases to exist when its purpose as security for a debt ends. Removing the trust deed from the title to the property on ending the debt relationship is accomplished in one of three ways:

• foreclosure by issuance of a trustee’s deed or sheriff’s deed;

• full repayment by reconveyance; or

• mutual agreement by a deed-in-lieu of foreclosure.

beneficiary ................................................................................... pg. 427 deed-in-lieu of foreclosure ....................................................... pg. 427 guarantee ...................................................................................... pg. 423 promissory note .......................................................................... pg. 423 reconveyance .............................................................................. pg. 427 trustee ............................................................................................ pg. 424

Chapter 65 Summary

Chapter 65 Key Terms

longer enforceable by any means after the later of: • ten years after the final maturity date contained in the recorded trust

deed; or

• 60 years after the recording of the trust deed if the final maturity date cannot be ascertained from the recorded trust deed.9

9 CC §882.020

Quiz 12 Covering Chapters 62-67 is located on page 617.

Chapter 66: Assumptions: formal and subject-to 429

After reading this chapter, you will be able to:

• identify four procedures for a buyer to take over mortgage financing which encumbers a seller’s property;

• understand the use of a beneficiary statement to confirm the amount and terms of an existing mortgage;

• determine the nonrecourse nature of a purchase-money mortgage; and

• advise a seller on the steps to be taken to reduce their risk of loss on a buyer’s takeover of a recourse mortgage.

Learning Objectives

Assumptions: formal and subject-to

Chapter

assumption agreement

beneficiary statement

due-on clause

nonrecourse

novation

purchase-money mortgage

recourse mortgage

subject-to transaction

Key Terms

On the sale of real estate, financing the seller has in place as an existing encumbrance on the property may be taken over by a buyer when acquiring ownership under one of four procedures:

• a formal assumption agreement between the lender and the buyer;

• a subject-to assumption agreement between the seller and the buyer;

• a subject-to transfer of ownership to a buyer without an assumption agreement of any type; and

• a novation agreement between the lender, seller and buyer.

Mortgage takeover by a buyer

For a further study of this discussion, see Chapter 23 of Real Estate Finance.

430 Real Estate Principles, Second Edition

A subject-to transaction is initially structured by use of a financing provision in a purchase agreement. The provision calls for the amount of an existing mortgage to be part of the purchase price the buyer is to pay for the property. The financing provision further states the buyer is to take title to the property subject to the existing mortgage. [See RPI Form 150 §§5 and 6]

The seller’s representation of the terms and condition of the mortgage is confirmed by the buyer during escrow on escrow’s demand and receipt of the lender’s beneficiary statement. [See RPI Form 415]

The buyer relies on the beneficiary statement for future payment schedules, interest rates and the principal balance on the mortgage they are taking over from the seller.

Some buyers acquire their ownership rights under unrecorded sales documents, such as lease-option agreements or land sales contracts. This is done in an effort to avoid detection of a change in ownership by the lender.

Thus, the seller and buyer avoid conveyances, escrow, title insurance, and other customary transfer activities until the buyer originates new financing or negotiates an assumption of the existing mortgage. These unrecorded sales transactions do, however, trigger due-on clauses and reassessments. [See Chapter 67]

On a subject-to transaction when mortgage rates charged are comparable to or lower than the note rate on the seller’s existing mortgage:

• a beneficiary statement is ordered to confirm the mortgage amount and its terms;

• the change of ownership conveyance is recorded and insured; and

• the conveyance is promptly brought to the lender’s attention so they cannot accept payments and then later call the mortgage when rates rise, claiming the transfer went undisclosed.

Conversely, when interest rates are rising or high compared to the note rate on an existing mortgage, the lender is often not notified of a subject-to sales transaction.

However, the lender can enforce its due-on clause and call the mortgage on its future discovery of any sale, regardless of how the sale was structured.

The concern of the seller on either a subject-to or an assumption of the seller’s mortgage is whether personal liability exists on the mortgage. Mortgage liability depends on whether the mortgage is:

• a recourse mortgage, meaning the lender may pursue the seller for a loss due to a deficiency in the value of the secured property, but only if the lender forecloses judicially; or

• a nonrecourse mortgage, meaning the lender may not pursue the seller for a loss on the mortgage when the property has insufficient value to satisfy the outstanding debt.

The subject-to

transaction beneficiary statement A document issued by a mortgage holder on request noting future payment schedules, interest rates and balances on a mortgage assumed by an equity purchase (EP) investor. [See RPI Form 415]

Unrecorded sales

documents due-on clause A trust deed provision used by lenders to call the loan immediately due and payable, a right triggered by the owner’s transfer of any interest in the real estate, with exceptions for intra-family transfers of their home.

subject-to transaction A sale of mortgaged property calling for the buyer to take title subject to the mortgage, the principal balance being credited toward the purchase price paid. Compare with formal assumption. [See RPI Form 156 §5]

Nonrecourse mortgage debt

nonrecourse A debt secured by real estate, the creditor’s source of recovery on default limited solely to the value of their security interest in the secured property.

Chapter 66: Assumptions: formal and subject-to 431

A seller has no liability for the lender’s losses on a purchase-money mortgage taken over by a buyer under any procedure.

Purchase-money mortgages include:

• seller carryback financing on the sale of any type of real estate which becomes the sole security for the carryback note;

• a mortgage which funded the purchase of an owner-occupied, one-to- four unit residential property;1 and

• a mortgage made for the construction of an owner-occupied, single family residence (SFR).

A lender as the holder of a purchase-money mortgage has no recourse to the borrower on a default, and is limited to foreclosing and selling the secured property as the sole source of recovery for any amounts remaining unpaid on the mortgage.2

On the take-over of a purchase-money mortgage by a buyer, the mortgage retains its original nonrecourse purchase-money characteristic, regardless of whether the buyer takes title subject-to or assumes the mortgage.3

Thus, a non-occupying buyer who takes over a purchase-money mortgage under any procedure is entitled to anti-deficiency protection. In contrast, purchase-assist mortgage financing originated by a non-occupying buyer of any type of residential property, including one-to-four unit residential property, is a recourse mortgage.

Recourse mortgages are all mortgages not classified as purchase-money mortgages, as reviewed above. When property is sold and title is conveyed to a buyer subject-to an existing recourse mortgage, the seller remains liable for any deficiency on the recourse mortgage if the buyer fails to pay and the lender forecloses.4

Further, unless the buyer enters into an assumption agreement with either the seller or the lender, a subject-to buyer is not liable to either the seller or the lender for a drop in the property’s value below the mortgage balance, unless the buyer commits waste.5

However, when the buyer and lender enter into an assumption agreement which significantly modifies the terms of the recourse mortgage without the seller’s consent, the seller is not liable for the mortgage.6

A seller can take steps to reduce their risk of loss on a buyer’s takeover of a recourse mortgage. To do so, the seller includes a provision in the purchase agreement requiring the buyer to enter into an assumption agreement with the seller.

1 Calif. Code of Civil Procedure §580b 2 CCP §580b 3 Jackson v. Taylor (1969) 272 CA2d 1 4 Braun v. Crew (1920) 183 C 728 5 Cornelison v. Kornbluth (1975) 15 C3d 590; CC §2929 6 Braun, supra; CC §2819

purchase-money mortgage Nonrecourse mortgage financing provided by a lender as purchase- assist funding for the purchase of a one-to- four unit residential property the buyer is going to occupy, or a seller carryback note and trust deed as an extension of credit to a buyer of any type of real estate which is secured solely by the property sold. Anti- deficiency mortgage.

recourse mortgage A mortgage debt in which a lender may pursue collection from a property owner for a loss due to a deficiency in the value of the secured property to fully satisfy the debt if the lender forecloses judicially.

Recourse real estate mortgages

Buyer-seller assumption

432 Real Estate Principles, Second Edition

The buyer-seller assumption agreement is a promise given by the buyer to the seller to perform all the terms of the mortgage taken over by the buyer on the sale. It is agreed to in the purchase agreement and prepared in escrow. [See Form 431 accompanying this chapter]

The assumption agreement gives the seller the right to collect from the buyer the amount of any deficiency judgment a recourse lender might be awarded against the seller in a judicial foreclosure. To be enforceable, the assumption agreement is required to be in writing.7

Although the buyer’s promise to pay the mortgage under a buyer-seller assumption agreement is given to the seller, the buyer also becomes liable under the agreement to the recourse lender under the legal doctrine of equitable subrogation.8 [See Form 431 §6]

Even though the buyer takes over the primary responsibility for the recourse mortgage, the seller remains secondarily liable to the lender. The seller’s risk of loss arises when the buyer fails to pay the recourse mortgage and there is a lack of market value remaining in the property to cover the mortgage amount.9

Unlike the subject-to seller, the seller under the buyer-seller assumption agreement is entitled to be indemnified, meaning held harmless by the buyer for any losses the seller later incurs due to their continued liability on the mortgage taken over by the buyer.

Sales negotiations calling for the buyer to enter into an assumption agreement with the seller may also call for the buyer to secure the assumption agreement by a performance trust deed carried back by the seller as a lien on the property sold. [See RPI Form 432 and 451]

With a recorded trust deed held by the seller to secure the buyer’s promise to pay the lender as agreed in the assumption agreement, any default by the buyer allows the seller to:

• demand the buyer to tender the entire balance remaining due on the assumed mortgage, subject to the buyer’s right to reinstate the delinquencies; and

• proceed with foreclosure under the performance trust deed to recover the property and cure the default on the mortgage assumed by the buyer.

A buyer-seller assumption, like a subject-to transaction, does not alter the lender’s right to enforce its due-on clause on discovery of the conveyances.

A lender may enter into an agreement with both the buyer and the seller for the buyer’s assumption of the mortgage and a release of the seller’s liability. In

7 CC §1624

8 Braun, supra

9 Everts v. Matteson (1942) 21 C2d 437

assumption agreement A promise given by a buyer to the seller or an existing mortgage holder to perform all the terms of the mortgage taken over by the buyer on the sale. [See RPI Form 431 and 432]

Indemnified for losses

Novation

Chapter 66: Assumptions: formal and subject-to 433

exchange, the lender charges a fee together with a demand for a modification of mortgage interest rate and terms of repayment. This agreement is called a novation or substitution of liability.

On a buyer-lender assumption of a mortgage secured by an owner-occupied, one-to-four unit residential property, the lender is required to release the seller from liability for the mortgage assumed by the buyer.10

A novation agreement is comparable to the existing lender originating a new mortgage with the buyer, except the trust deed executed by the seller remains of record and the note remains unpaid.

10 12 Code of Federal Regulations §591.5(b)(4)

novation An agreement entered into by a mortgage holder, buyer and seller to shift responsibility for a mortgage obligation to the buyer by an assumption and release the seller of liability.

Form 431

Assumption Agreement - Unsecured and Subrogated

434 Real Estate Principles, Second Edition

Existing financing encumbering a property may remain of record and be taken over by a buyer under a subject-to transfer, a formal assumption, a subject-to assumption or a novation agreement.

A subject-to transaction is structured by a provision in a purchase agreement calling for the principal amount of an existing mortgage to be part of the purchase price paid for the property. The lender may enforce its due-on clause by calling the mortgage on its later discovery of the sale, regardless of how the sales transaction is structured.

A seller is not liable for a deficiency in property value to satisfy the mortgage on foreclosure of a nonrecourse purchase-money debt taken over under any procedure by the buyer. On a recourse mortgage, the seller can reduce their risk of loss on a buyer’s takeover of the mortgage by negotiating for the buyer to enter into an assumption agreement with the seller.

A buyer-seller assumption does not alter the lender’s right to enforce its due-on clause on discovery but does give the seller the right to recover from the buyer any losses they may have incurred due to the lender’s losses on a default and foreclosure.

The lender can enter into an agreement with both the buyer and seller for the buyer’s assumption of the mortgage and a release of the seller’s liability on the mortgage, called a novation. A novation agreement is comparable to the existing lender originating a new mortgage with the buyer, except the trust deed executed by the seller remains of record and the note remains unpaid.

assumption agreement ............................................................ pg. 432 beneficiary statement .............................................................. pg. 430 due-on clause .............................................................................. pg. 430 nonrecourse ................................................................................. pg. 430 novation ....................................................................................... pg. 433 purchase-money mortgage ..................................................... pg. 431 recourse mortgage ...................................................................... pg. 431 subject-to transaction ............................................................... pg. 430

Chapter 66 Summary

Chapter 66 Key Terms

Quiz 12 Covering Chapters 62-67 is located on page 617.

Chapter 67: Due-on-sale regulations 435

After reading this chapter, you will be able to:

• understand the nature of a due-on clause in trust deeds as a restriction on the mobility of an owner’s title and pricing in times of rising interest rates;

• explain ownership activities which trigger due-on enforcement by mortgage holders;

• apply the exemptions barring mortgage holders from due-on enforcement; and

• negotiate a limitation or waiver of a mortgage holder’s due-on rights.

Due-on-sale regulations

Chapter

A burden on the use and mobility of ownership is created by the existence of the due-on clause buried within all trust deeds held by lenders and carryback sellers.

The occurrence of an event triggering due-on enforcement automatically allows the mortgage holder to:

• call the mortgage, demanding the full amount remaining due to be paid immediately, also known as acceleration; or

• recast the mortgage, requiring a modification of the mortgage’s terms as a condition for the mortgage holder’s consent to a transfer, called a waiver by consent.

Mortgage holder interference is federal policy

acceleration

due-on clause

waiver agreement

Learning Objectives

Key Terms

For a further discussion of this topic, see Chapter 22 of Real Estate Finance.

436 Real Estate Principles, Second Edition

In times of stable or falling interest rates, mortgage holders usually permit assumptions of mortgages at the existing note rate, unless a prepayment penalty clause exists. Mortgage holders have no financial incentive to recast mortgages, or call and relend the funds at a lower rate when interest rates are dropping. [See Chapter 63]

However, in times of steadily rising rates, mortgage holders seize any event triggering the due-on clause to increase the interest yield on their portfolio. They employ title companies to advise them on recorded activity affecting title to the properties they have mortgages on. Once the due-on clause is triggered, the mortgage holder requires the mortgage to be recast at current market rates as a condition for allowing an assumption, lease or further encumbrance of the property by the owner.

Thus, real estate ownership encumbered by due-on trust deeds becomes increasingly difficult to transfer as interest rates rise. This tends to imprison owners in their home as they are unable to sell and relocate without accepting a lower price.

Due-on clauses are most commonly known as due-on-sale clauses. However, “due-on clause” is a more accurate term. A sale is not the only event triggering the clause. Still, as the name “due-on-sale” suggests, the primary event triggering the mortgage holder’s due-on clause is a sale of property which is subject to the mortgage holder’s trust deed lien.

The due-on clause is triggered not only by a transfer using a grant deed or quitclaim deed, but by any conveyance of legal or equitable ownership of real estate, recorded or not. [See RPI Form 404 and 405]

Examples include a:

• land sales contract [See RPI Form 168];

• lease-option sale [See RPI Form 163]; or

• other wraparound carryback devices, such as an all-inclusive trust deed (AITD). [See RPI Form 421]

The due-on clause is also triggered by:

• a lease with a term over three years; or

• a lease for any term when coupled with an option to buy.1

This interference addresses owners of commercial income property which they lease to user tenants. Typically, the owners want long-term leases which run more than three years in their term. Here, the leasing periods have to be held to three year each, the initial term, and each extension of the periods of occupancy under a lease agreement. Otherwise, the mortgage holder can call the mortgage if the initial period is more than three years, or when exercised the extension of the lease term is for more than three years.

1 12 Code of Federal Regulations §591.2(b)

Economic recessions

and recoveries

acceleration A demand for immediate payment of all amounts remaining unpaid on a loan or extension of credit by a mortgage lender or carryback seller.

Due-on-sale

Due-on-lease

Chapter 67: Due-on-sale regulations 437

A senior mortgage holder may call a mortgage due on completion of the foreclosure sale by a junior mortgage holder on any type of real estate. A trustee’s deed on foreclosure is considered a voluntary transfer by the owner, since the power of sale authority in the junior trust deed was agreed to by the owner of the real estate.

The due-on clause is not only triggered by the voluntarily agreed-to trustee’s sale. It is also triggered by any involuntary foreclosure, such as a tax lien sale.2

Federal regulations allow due-on enforcement on any transfer of real estate which secures the lien, whether the transfer is voluntary or involuntary.3

Transfers of real estate which trigger due-on enforcement include the inevitable transfer resulting from the death of a vested owner. However,

2 Garber v. Fullerton Savings and Loan Association (1981) 122 CA3d 423 (Disclosure: the legal editor of this publication was an attorney in this case.)

3 12 CFR §591.2(b)

Due-on- foreclosure

Due-on-death exceptions

Trust deed called or recast at the mortgage holder’s option

Events triggering the due-on clause

Sale:

• transfer of legal title (grant or quitclaim deed);

• land sales contract or holding escrow;

• court-ordered conveyance; or

• death.

Lease:

• lease for more than three years; or

• lease with an option to buy.

Further encumbrance:

• creation or refinance of a junior lien; or

• foreclosure by junior lienholder.

Transfers not triggering due-on enforcement (owner-occupied, four-or-less residential)

• creation of junior lien where owner continues to occupy;

• transfers to spouse or child who occupies;

• transfer into inter vivos trust (owner obtains mortgage holder’s consent and continues to occupy);

• death of a joint tenant; or

• transfer on death to a relative who occupies.

Sidebar

It has recently come to our attention...

438 Real Estate Principles, Second Edition

as with due-on enforcement triggered by further encumbrances, narrow exceptions apply to the death of an owner who occupied a one-to-four unit residential property.

For example, the transfer of a one-to-four unit residential property to a relative on the death of the owner-occupant does not trigger the due-on clause. However, this is conditioned on the relative becoming an occupant of the property.4

Also, where two or more people hold title to one-to-four unit residential property as joint tenants, the death of one joint tenant does not trigger due- on enforcement.

However, at least one of the joint tenants, whether it was the deceased or a surviving joint tenant, needs to have occupied the property when the mortgage was originated. Conversely, occupancy is not required for a surviving joint tenant who qualifies for the joint tenancy exception.5

In all other transfers, the death of a vested owner, joint tenant or other co- owner triggers the mortgage holder’s due-on clause.

Federal due-on regulations bar due-on enforcement on the transfer of one-to- four unit residential property to a spouse after a divorce, so long as the spouse occupies the property.6

However, if the acquiring spouse chooses to lease the residential property for any period of time rather than occupy it, the mortgage holder may call or recast the mortgage.

The due-on clause is not triggered by an owner’s transfer of their one-to-four unit residential property to a spouse or child who occupies the property.7

This inter-family transfer exception applies only to transfers from an owner to a spouse or child. Any transfer from a child to a parent triggers due-on enforcement.

An owner wishing to enter into a transaction to sell, lease or further encumber their real estate without mortgage holder interference needs to first negotiate a limitation or waiver of the mortgage holder’s due-on rights.

4 12 CFR §591.5(b)(1)(v)(A)]

5 12 CFR §591.5(b)(1)(iii)

6 12 CFR §591.5(b)(1)(v)(C)

7 12 CFR §591.5(b)(1)(v)(B)

Divorce and inter-family

transfers

Waiver by negotiation

and by conduct

Chapter 67: Due-on-sale regulations 439

Lenders and carryback sellers are allowed to enforce due-on sale clauses in trust deeds on most transfers of any interest in any type of real estate. The occurrence of an event which triggers due-on enforcement automatically allows the mortgage holder to call or recast the mortgage. In times of rising rates, mortgage holders seize any event triggering the due-on clause to increase the interest yield on their portfolio.

The due-on clause is triggered by any conveyance of legal or equitable ownership of real estate, such as a sale. A due-on clause is also triggered by:

• a lease with a term over three years;

• a lease for any term when coupled with an option to purchase;

• further encumbrance of a non-owner-occupied, one-to-four unit residential property; and

• on completion of the foreclosure sale by a junior mortgage holder or carryback seller on any type of real estate.

Further, transfers of real estate resulting from the death of a vested owner also trigger due-on enforcement, with some narrow exceptions based on occupancy of residential property.

Exceptions to due-on enforcement exist. Due-on enforcement based on the further encumbrance of an owner-occupied, one-to-four unit residential property is not permitted. Similarly, the due-on clause is not triggered by an owner’s transfer of property to a spouse or child who then occupies the property, or on the transfer of one-to-four unit residential property to a spouse after a divorce if the spouse occupies the property.

An owner wishing to sell, lease or further encumber their real estate without mortgage holder interference needs to first negotiate a limitation or waiver of the mortgage holder’s due-on rights.

Chapter 67 Summary

Waiver agreements are trade-offs. In return for waiving or agreeing to limit the exercise of its due-on rights in the future, the mortgage holder demands consideration such as:

• additional points if an origination;

• additional security;

• principal reduction;

• increased interest;

• a shorter due date; or

• an assumption fee.

waiver agreement An agreement in which a mortgage holder consents to the owner’s present or future transfer of an interest in the mortgaged property as a waiver of the mortgage holder’s due- on rights. Also known as an assumption agreement. [See RPI Form 431 and 432]

440 Real Estate Principles, Second Edition

Quiz 12 Covering Chapters 62-67 is located on page 617.

acceleration ................................................................................. pg. 436 due-on clause ............................................................................... pg. 436 waiver agreement ...................................................................... pg. 439

Chapter 67 Key Terms

Chapter 68: Reinstatement and redemption 441

After reading this chapter, you will be able to:

• understand how a property owner or junior lienholder terminates foreclosure proceedings by reinstating or redeeming a mortgage;

• distinguish the timeframes an owner has to cure a default and reinstate the mortgage from periods for trustee’s notices, postings and advertising periods;

• advise a client on their financial options when faced with foreclosure; and

• recognize defaults curable only by redemption.

Learning Objectives

Reinstatement and redemption

Chapter

acceleration

future advances

power-of-sale provision

redemption

reinstatement

For a further study of this discussion, see Chapter 47 of Real Estate Finance.

Trust deeds securing a debt obligation contain a boilerplate provision authorizing mortgage holders to call due and payable all amounts remaining unpaid after a material default on the trust deed, called an acceleration clause. Similarly, the trust deed under its power-of-sale provision authorizes the trustee to initiate a non-judicial foreclosure sale of the property on a declaration of default and instructions to foreclose from the beneficiary.

Under the power-of-sale provision, the trustee records a notice of default (NOD) to initiate the trustee’s foreclosure procedures when instructed by the beneficiary to do so. As a result of the tandem effect of the acceleration clause

Nullifying the mortgage holder’s call during foreclosure

Key Terms

442 Real Estate Principles, Second Edition

when an NOD is recorded, all sums remaining to be paid on the note and trust deed become due and immediately payable, subject to the owner’s and junior lienholder’s reinstatement rights.

After an NOD is recorded and prior to five business days before the trustee’s sale, the owner can terminate the foreclosure proceedings by paying:

• the delinquent amounts due on the note and trust deed as described in the NOD and foreclosure charges, called reinstatement;1 or

• the entire amount due on the note and trust deed, plus foreclosure charges, called redemption.2

A trust deed on which a foreclosure has been initiated is reinstated when the beneficiary receives:

• all amounts referenced as delinquent in the NOD, including principal, interest, taxes and insurance (collectively known as PITI), assessments, and advances;

• installments that become due and remain unpaid after the recording of the NOD;

• any future advances made by the beneficiary after the recording of the NOD to pay taxes, senior liens, assessments, insurance premiums, and to eliminate any other impairment of the security; and

• costs and expenses incurred by the mortgage holder to enforce the trust deed, including statutorily limited trustees fee’s or attorney fees.3

After an NOD is recorded, an owner or junior lienholder may bring current any monetary or curable default stated in the NOD prior to five business days before the trustee’s sale, called the reinstatement period. If the sale is postponed, the reinstatement period is extended, ending the day before the fifth business day prior to the postponed sale date.4 [See Figure 1]

Until the NOD is recorded by a trustee, the beneficiary is compelled to accept the tender of all delinquent amounts noticed in the NOD.

After recording the NOD, the mortgage holder’s trustee needs to allow three months to pass before advertising and posting notice of the date of the trustee’s sale.5 [See Figure 1]

The trustee needs to begin advertising and post a Notice of Trustee’s Sale (NOTS) at least 20 days before the date of the sale. The property may be sold by the trustee no sooner than the twenty-first day after advertising begins and the posting of notice occurs.6 [See Figure 1]

1 Calif. Civil Code §2924c

2 CC §2903

3 CC §2924c(a)(1)

4 CC §2924c(e)

5 CC §2924

6 CC §2924f(b)

After the NOD is recorded

acceleration A demand for immediate payment of all amounts remaining unpaid on a loan or extension of credit by a mortgage lender or carryback seller.

power-of-sale provision A trust deed provision authorizing the trustee to initiate a non-judicial foreclosure sale of the described property on instructions from the beneficiary.

redemption A property owner or junior lienholder’s right to clear title to property of a mortgage lien prior to the completion of a trustee’s sale or following a judicial foreclosure sale by paying all amounts due on the mortgage debt, including foreclosure charges.

Chapter 68: Reinstatement and redemption 443

Additionally, if the billing address for the owner is different than the address of a residential property in foreclosure, the NOTS needs to be accompanied by a notice to the occupants regarding their rights during and after foreclosure.7 [See RPI Form 573]

The owner in foreclosure is not allowed to delay the trustee’s sale by requesting a postponement.8

Thus, the owner or junior lienholder has approximately 105 days after recording the NOD to cure the default and reinstate the note and trust deed. Doing so avoids a full payoff or foreclosure of the property.

To determine the last day for reinstatement of the note and trust deed, consider a trustee’s sale scheduled for a Friday. Count back five business days beginning with the first business day prior to the scheduled Friday sale. Since weekends are not business days, the fifth day counting backward from the scheduled trustee’s sale is the previous Friday (if no holidays exist).

7 CC §2924.8

8 CC §2924g

reinstatement A property owner or junior lienholder’s right to reinstate a mortgage and cure any default prior to five business days before the trustee’s sale by paying delinquent amounts due on the note and trust deed, plus foreclosure charges.

Reinstatement of the note and trust deed

Trustee’s Notices

* NOD = Notice of Default

** NOTS = Notice of Trustee’s Sale

Owner’s Right to Cure

Reinstatement Period

Redemption Period

Three Month Period 20 Day Advertising

Period

• no less than 3 months and 10 days • pay off mortgage holder’s demand and

trustee’s fees and costs

• five business days before trustee’s sale • pay off mortgage holder’s demand and

trustee’s fees and costs • a unit in a CID has an additional 90 days

after the trustee’s sale foreclosing on an HOA assessment lien to redeem the unit

• trustee’s fees due • trustee’s fee increase

D el

a y

i n

R ec

o rd

in g

N O

D R

ec o

rd ed

D a

y o

f Tr

u st

ee ’s

S a

N O

TS R

ec o

rd ed

Periods for Notices and Reinstatement Figure 1 Periods for Notice and Reinstatement

444 Real Estate Principles, Second Edition

Thus, the very last day to reinstate the mortgage is on the Thursday eight calendar days before the trustee’s sale.

The mortgage holder’s failure to identify or include the dollar amount of all known defaults in the NOD does not invalidate the NOTS. Further, the mortgage holder may enforce payment of any omitted defaults by recording another, separate NOD.9

On reinstatement of the note and trust deed, the NOD is rescinded by the trustee, removing the recorded default from the title to the property.10

Any call due to a default is eliminated when the note and trust deed have been reinstated. Upon reinstatement, the owner continues their ownership of the property as though the mortgage had never been in default.

Failure to cure a default before the reinstatement period expires allows a trust deed holder to require the owner to redeem the property prior to completion of the trustee’s sale by:

• paying all sums due under the note and trust deed; and

• reimbursing the costs of foreclosure.

The owner’s right of redemption runs until the trustee completes the bidding and announces the property has been sold. Any owner, junior lienholder, or other person with an interest in the property may satisfy the debt and redeem the property prior to the completion of the trustee’s sale.11

To redeem the property, the owner or junior lienholder is required to pay:

• the principal and all interest charges accrued on the principal;

• permissible penalties;

• foreclosure costs; and

• any future advances made by the foreclosing mortgage holder to protect its security interest in the property.

Unless all amounts due on the note and trust deed resulting from the owner’s default are paid in full during the redemption period, the owner will lose ownership to the property at the trustee’s foreclosure sale.

When the owner fails to meet their obligations regarding the care, use and maintenance of the secured real estate, the owner is in default under the waste provision in the trust deed. The default on the trust deed exists even though the owner may be current on all payments called for in the note.

Other activities are considered a default on the trust deed, such as the owner’s failure to pay:

• property taxes;

9 CC §2924

10 CC §2924c(a)(2)

11 CC §2903

Redemption

Mortgage holder

remedies on a default

Chapter 68: Reinstatement and redemption 445

The owner’s alternatives

Aside from reinstatement and redemption, an owner of property has several other options when faced with losing their property through foreclosure:

1. Refinance — The owner obtains a new mortgage to pay off the one in default.

2. Foreclosure consultant — The owner seeks the services of a financial advisor or investment counselor, called a foreclosure consultant. For a fee, a foreclosure consultant will:

• prevent a mortgage holder from enforcing or accelerating the note;

• help the owner reinstate the mortgage or receive an extension of the reinstatement period; or

• arrange a mortgage or an advance of funds for the owner. [CC §2945.1(a)]

A property owner grappling with foreclosure can obtain similar services at no cost from a mortgage counselor subsidized by the federal government.

3. Deed-in-lieu — The owner deeds the property directly to the mortgage holder in exchange for cancelling the secured debt.

4. Litigate — The owner disputes the validity of the foreclosure by filing an action, restraining and enjoining the foreclosure.

5. Bankruptcy — The owner files for bankruptcy protection which automatically stays the foreclosure until a release of the stay is obtained by the mortgage holder from the court. [11 United States Code §362(a)]

Unless the owner can make up the de fault or have the mortgage amount “crammed down” as part of the reorganization plan, bankruptcy only delays the inevitable foreclosure. Once the automatic stay is lifted, the foreclosure sale may take place no sooner than seven calendar days later. [CC §2924g(d)]

6. Sale — The owner sells the property before the trustee’s sale.

A recorded notice of default (NOD) needs to state the owner has the right to sell their property which is in foreclosure. [CC §2924c(b)]

In an effort to protect owners from being unlawfully deprived of the equity in their property when selling the property during the foreclosure period, special requirements exist for purchase agreements between owners and equity purchase investors on owner-occupied, one-to-four unit residential property in foreclosure. [CC §1695 et seq; see Chapter 70]

However, selling property in foreclosure is difficult for the owner, due to time constraints and the difficulty of finding a buyer able to meet the financing needs to assume or payoff existing mortgages, cure defaults and correct the deferred maintenance on the property.

7. Walk — The owner simply vacates the property when the mortgage holder completes foreclosure.

This is an economically viable alternative for an owner with little or no cash investment in the property, especially if payments saved during continued occupancy exceed the cash invested and the mortgage balance exceeds the property’s value.

446 Real Estate Principles, Second Edition

• hazard insurance premiums;

• assessments; and

• amounts due on senior trust deed liens.

A trust deed holder may advance funds to cure a default on the trust deed or preserve the value of the property. The amount of the advance is then added to the debt owed by authority of the trust deed’s future advances provision. The trust deed holder may then demand the immediate repayment of the advance from the owner.

A property owner’s ability to reinstate a mortgage by curing a default depends on the trust deed provision in default.

For example, an owner of real estate encumbered by a trust deed fails to pay property taxes. The trust deed mortgage holder records an NOD, specifying the delinquent property taxes as the owner’s default under the trust deed.

Can the property owner reinstate the mortgage and retain the property by eliminating the default?

Yes! The default is monetary, entitling the owner to reinstate the mortgage by simply paying the delinquent property taxes, and the trustee’s fees and charges incurred in the foreclosure proceeding.

Some trust deed defaults do not allow debt to be reinstated. Reinstatement of the note on those defaults is only available if agreed to by the mortgage holder. Defaults triggering a call and requiring redemption of the property by a payoff of the entire debt without the ability to reinstate the trust deed include:

• a breach of a due-on clause;

• a waste provision; or

• a violation of law provision in the use of the property.

future advances A trust deed provision authorizing a mortgage holder to advance funds for payment of conditions impairing the mortgage holder’s security interest in the mortgaged property, such as delinquent property taxes, assessments, improvement bonds, mortgage insurance premiums or elimination of waste. [See RPI Form 450 §2.5]

Trust deed defaults and

reinstatement

Defaults cured only by

redemption

Chapter 68: Reinstatement and redemption 447

Trust deeds contain a boilerplate acceleration provision authorizing mortgage holders to call the mortgage after a material default on the trust deed. Similarly, the trust deed’s power-of-sale provision authorizes the beneficiary to instruct the trustee to initiate a non-judicial foreclosure sale of the property.

After the NOD has been recorded and prior to five business days before the trustee’s sale, the owner may terminate the foreclosure proceedings by paying:

• the delinquent amounts due on the note and trust deed, plus foreclosure charges, called reinstatement; or

• the entire amount due on the note and trust deed, plus foreclosure charges, called redemption.

The owner or junior lienholder has approximately 105 days after recording the NOD to cure the default and reinstate the note and trust deed. Doing so avoids a full payoff or foreclosure sale of the property.

On reinstatement of the note and trust deed, the NOD is rescinded by the trustee, removing the recorded default from the title of the property. The owner continues their ownership of the property as though the trust deed had never been in default.

A property owner’s ability to reinstate a trust deed by curing a default depends on the trust deed provision in default.

Failure to cure a default before the reinstatement period expires allows a trust deed holder to require the owner to redeem the property and avoid the trustee’s sale by:

• paying all sums due under the note and trust deed; and

• reimbursing the costs of foreclosure prior to completion of the trustee’s sale.

The owner’s right of redemption exists until the trustee completes the bidding and announces the property has been sold.

Other activities are considered a default on the trust deed, such as the owner’s failure to maintain the property, called waste, or failure to pay:

• property taxes;

• hazard insurance premiums;

• assessments; or

• amounts due on senior trust deed liens.

A trust deed holder may advance funds to cure a default on the trust deed and then add the advance to the debt owed. The trust deed holder may then demand the immediate repayment of the advance from the owner.

Chapter 68 Summary

448 Real Estate Principles, Second Edition

acceleration ................................................................................. pg. 442 future advances .......................................................................... pg. 446 power-of-sale provision ........................................................... pg. 442 redemption .................................................................................. pg. 442 reinstatement ............................................................................. pg. 443

Chapter 68 Key Terms

Quiz 13 Covering Chapters 68-72 is located on page 618.

Chapter 69: Trustee’s foreclosure procedures 449

After reading this chapter, you will be able to:

• advise on an owner’s rights during the different periods in the trustee foreclosure process;

• understand the pre-foreclosure workout process mandated for one-to-four unit residential property; and

• counsel buyers and owners on the procedures for a trustee’s sale, including advertising, postponing, and accepting bids.

Learning Objectives

Trustee’s foreclosure procedures

Chapter

bona fide purchaser (BFP)

Declaration of Default and Demand for Sale

full credit bid

nonjudicial foreclosure

notice of default (NOD)

power-of-sale provision

pre-foreclosure workout

recourse mortgage

rescind

surplus funds

trustee

trustee’s sale guarantee

Key Terms

For a further study of this discussion, see Chapter 49 of Real Estate Finance.

A lender or carryback seller holding a note secured by a trust deed in default has two foreclosure methods available to enforce collection of the secured debt. These two foreclosure methods are:

• a judicial foreclosure sale, also called a sheriff’s sale [See Chapter 70];1 or

• a nonjudicial foreclosure sale, also called a trustee’s sale.2

1 Calif. Code of Civil Procedure §726

2 Calif. Civil Code §2924

Power-of-sale provision

nonjudicial foreclosure When property is sold at a public auction by a trustee as authorized under the power-of- sale provision in a trust deed.

450 Real Estate Principles, Second Edition

The key to the trust deed holder’s ability to nonjudicially foreclose by a trustee’s sale on the secured real estate is the power-of-sale provision contained in the trust deed. [See Figure 1]

Other security devices used to create a lien on real estate to secure a debt which may also contain a power-of-sale provision include:

• a land sale contract [See RPI Form 165];3

• a lease-option sale [See RPI Form 163 §19];

• a UCC-1 financing statement;4 or

• the conditions, covenants and restrictions (CC&Rs) of a homeowners’ association (HOA) for collection of assessments.5

The grant of the power-of-sale provides a private contract remedy for the recovery of money. The power-of-sale is voluntarily agreed to by the owner of the secured property, authorizing the secured creditor on a default to hold a nonjudicial foreclosure sale by public auction.6

However, if the note evidences a recourse debt with a remaining balance exceeding the fair price of the mortgage holder’s security position in real estate, the mortgage holder may choose a judicial foreclosure. A judicial foreclosure allows the lienholder to seek a money judgment for any deficiency in the property’s value to satisfy the debt. [See Chapter 70]

However, by foreclosing under the power-of-sale provision, the lienholder avoids a costly (and potentially time consuming) court action for judicial foreclosure.

Editor’s note — When a mortgage holder completes a nonjudicial foreclosure by trustee’s sale, they cannot later obtain a deficiency judgment against the owner of the secured real estate. Alternatively, the owner cannot redeem the property after the mortgage holder’s trustee’s sale as they can after a judicial foreclosure sale. [See Chapter 70]

A trust deed is a security device which imposes a lien on real estate. The trust deed creates a fictional trust which appears to “hold title” to the secured real estate for the benefit of the lienholder.

Thus, a trust deed has three parties:

• at least one trustor (the owner(s) of the secured real estate);

3 Petersen v. Hartell (1985) 40 C3d 102

4 Lovelady v. Bryson Escrow, Inc. (1994) 27 CA4th 25

5 CC §1367

6 CC §2924

power-of-sale provision A trust deed provision authorizing the trustee to initiate a non-judicial foreclosure sale of the described property on instructions from the beneficiary.

Who conducts the

sale

GRANTS TO TRUSTEE IN TRUST, WITH POWER OF SALE

3.6 TRUSTEE’S SALE — On default of any obligation secured by this Deed of Trust and acceleration of all sums due. Beneficiary may instruct Trustee to proceed with a sale of the secured property under the power of sale granted herein, noticed and held in accordance with Calif. Civil Code §2924 et seq.

Figure 1

Excerpt from Form 450

Long Form Trust Deed and Assignment of Rents

Long Form Trust Deed and Assignment of Rents – Securing a Promissory Note

Chapter 69: Trustee’s foreclosure procedures 451

• a trustee who need not be named; and

• at least one beneficiary (a lender, carryback seller, HOA or other lienholder).

The trustee’s sale is conducted by the trustee who is either:

• named in the trust deed; or

• appointed by the beneficiary of the trust deed at the time the beneficiary initiates the foreclosure process.

A broker, attorney, trust deed service, subsidiary of the lender, or the lender itself may be appointed at any time as the trustee.

The trustee begins foreclosure by recording a notice of default (NOD). The trustee ends the process on delivery of the trustee’s deed and disbursement of any sales proceeds.7 [See Figure 2, RPI Form 471]

Generally, trust deeds are prepared and distributed by title or escrow companies naming their corporation as the trustee. However, a trust deed or other security device does not need to name the trustee at all. The beneficiary later simply appoints a trustee to handle the NOD or reconveyance. [See RPI Form 450]

Also, the beneficiary may appoint a substitute trustee to replace the trustee named in the trust deed.

Before recording an NOD on a trust deed securing a purchase-assist mortgage on a borrower’s principal residence, a mortgage holder needs to conduct a pre-foreclosure workout with the owner.

At least 30 days prior to recording an NOD, the mortgage holder needs to contact the borrower to:

• assess the borrower’s financial situation;

• explore options for the borrower to avoid foreclosure;

• advise the borrower of their right to an additional meeting within 14 days to discuss their financial options;

• provide borrowers with the toll-free Department of Housing and Urban Development (HUD) phone number to find a HUD-certified housing counseling agency; and

• in the event personal or phone contact cannot be made, the mortgage holder is to exercise due diligence through further attempts to contact the borrower.

If the mortgage holder is unable to make contact with the borrower, the mortgage holder sends the borrower a certified letter, return receipt requested, containing a toll-free number with access to a representative during business hours.

7 Bank of America National Trust & Savings Association v. Century Land & Water Co. (1937) 19 CA2d 194

trustee One who holds title to real estate in trust for another.

notice of default (NOD) The notice filed to begin the nonjudicial foreclosure process. Generally, the NOD is filed following three or more months of delinquent mortgage payments.

Pre- foreclosure workout prior to NOD

pre-foreclosure workout Negotiations between a mortgage holder and defaulting property owner with the purpose of exploring options to avoid foreclosure.

Long Form Trust Deed and Assignment of Rents – Securing a Promissory Note

452 Real Estate Principles, Second Edition

A trustee’s actions under a power-of-sale provision are strictly controlled by California statutes. To successfully complete a trustee’s foreclosure sale, the trustee and beneficiary of the trust deed are to adhere to the procedures fully detailed in the foreclosure statutes for handling a trustee’s sale.8

The foreclosure process has three stages:

1. the notice of default (NOD) is recorded and mailed;

2. the notice of trustee’s sale (NOTS) is recorded, posted and mailed; and

3. the trustee’s sale of the real by auction, trustee’s deed and distribution of sales proceeds

8 Garfinkle v. Superior Court of Contra Costa County (1978) 21 C3d 268

The stages of foreclosure

For a full-size, fillable copy of this or any other form in this book that may be used in your professional practice, go to realtypublications.com/forms

Figure 2

Form 471

Notice of Default with Substitution of Trustee

Chapter 69: Trustee’s foreclosure procedures 453

While the trustee is concerned about the three stages for processing the foreclosure, the owner of the real estate and the beneficiary are concerned primarily with two different periods of time which control payment of the debt:

• the reinstatement period, which runs from the recording of the NOD and ends prior to five business days before the trustee’s sale; and

• the redemption period, which also runs from the recording of the NOD but ends with the completion of the trustee’s sale of the secured property. [See Chapter 68]

When a trust deed is in default and the beneficiary has chosen to foreclose, the beneficiary delivers a Declaration of Default and Demand for Sale to the trustee.

The declaration contains instructions directing the trustee to initiate foreclosure on the secured real estate as authorized under the power-of-sale provision contained in the trust deed. [See Figure 2, RPI Form 471]

Even though the trustee may have received the beneficiary’s declaration of default, the trustee’s foreclosure process and the periods imposing rights and obligations do not begin until the trustee or beneficiary records a notice of default (NOD).9

Once the NOD is recorded, the trustee is to strictly follow statutory notice requirements. To be assured the required notices are served on all the proper persons, the trustee orders a trustee’s sale guarantee from a title company before or at the time the NOD is recorded. [See Chapter 69]

The trustee’s sale guarantee provides coverage to the trustee for failure to serve notices on any party due to an omission of that person’s identity in the guarantee.

When ordering a trustee’s sale guarantee from a title insurance company, the trustee instructs the title company to record the NOD in the office of the county recorder in the county where the real estate is located.10

The NOD contains statutorily mandated statements which sets forth the monetary default on the note or other obligation secured by the trust deed.11

The NOD does not need to state the actual amounts of the monetary defaults on the recurring obligations. However, the NOD needs to state the nature of the present defaults on the note and the trust deed.12

To determine the amount needed to cure the default, the NOD directs the owner seeking to reinstate the trust deed or redeem the property to contact

9 System Investment Corporation v. Union Bank (1971) 21 CA3d 137

10 CC §2924

11 CC §2924c(b)(1)

12 CC §2924c(a)(1)(B)

Trustee’s sale guarantee

Declaration of Default and Demand for Sale A document delivered to the trustee under a power of sale provision by the mortgage holder instructing the trustee to initiate foreclosure on the secured real estate by recording a notice of default (NOD).

trustee’s sale guarantee A policy issued by a title insurance company to a trustee before or at the time the notice of default is recorded providing coverage for the trustee should they fail to serve notices on any party of record due to an omission in the guarantee.

The notice of default and election to sell

454 Real Estate Principles, Second Edition

the trustee. Thus, the trustee insulates the beneficiary from all direct contact with the owner or junior lienholder after the date the NOD is recorded until canceled or a trustee’s sale takes place.

Within 10 business days after recording the NOD, two copies of the NOD are mailed to:

• the owner of the property;

• the administrator of a deceased owner’s estate; and

• each person who has recorded a request to receive a copy of the NOD.13

Within one month after recording the NOD, the trustee sends a copy of the NOD by registered or certified mail and another copy by first-class mail to holders of a recorded interest in the secured property.

Any person interested in obtaining a copy of the NOD who will not automatically receive the notice records a request for NOD. The request for NOD assures the interested person they will be notified of the default. [See RPI Form 412]

A trustee or person depositing the NOD into the mail to give notice to others is to prepare a proof of service and include a copy of the form with the NOD in each mailing.14

A trustee or beneficiary may begin noticing the date set for the sale of a property on the day following three months after the NOD is recorded.15

The date the sale will be held may be set for any business day, Monday through Friday, between the hours of 9 a.m. and 5 p.m.16

In general practice, a date down of the trustee’s sale guarantee issued to the trustee is ordered out from the title company the day before or on the day the title company records the NOTS.

The date down notifies the trustee of any interests recorded on the title to the property after the NOD is recorded. However, the trustee is not required to give notice of the impending trustee’s sale to any person who recorded an interest in the property after the NOD was recorded.17

The trustee prepares an NOTS which contains:

• the trustee’s name or their agent’s name, street address and telephone number (or toll-free number if located out of state);

• the street address or common designation of the secured property;

• the county assessor’s parcel number of the secured property;

13 Estate of Yates v. West End Financial Corporation, Inc. (1994) 25 CA4th 511; CC §2924b(b)(1)

14 CC §2924b(e)

15 CC §2924

16 CC §2924g(a)

17 CC §2924b(c)(1)

Delivering the NOD

The notice of trustee’s sale

Chapter 69: Trustee’s foreclosure procedures 455

• the dollar amount of the debt in default, including reasonably estimated advances for hazard insurance premiums, property taxes due and foreclosure costs; and

• a statutory statement informing the owner they are in default.18 [See RPI Form 474]

Further, if the mortgage secured by the trust deed was negotiated in Spanish, the trust deed may contain a request for a Spanish-language NOD. The trustee is then obligated to serve the owner an NOD translated into Spanish.19

At least 20 calendar days before the trustee’s sale, the trustee sends two copies of the NOTS to each party the trustee previously sent the NOD.20

To ensure the sale at a public auction is properly advertised, the notice requirements for the NOTS are more comprehensive than the notice requirements for the NOD.

In addition to mailing the notice to all interested parties of record, the trustee performs all of the following at least 20 calendar days prior to the sale:

• post a copy of the NOTS in one public place in the city of the sale, or if the sale is not to be held in a city, the judicial district in which the property is to be sold;

• post a copy of the NOTS in a conspicuous place on the property to be sold; and

• start publishing a copy of the NOTS once a week for three consecutive calendar weeks in a newspaper of general circulation in the city where the property is located.21

A trustee’s sale is a public auction by private agreement where the property is sold to the highest bidder.22

The trustee’s sale is held in the county where the secured real estate is located.23

Before the auction begins, the trustee may:

• demand all prospective bidders to show evidence of their financial ability to pay as a precondition to recognizing their bids; and

• hold the prospective bidders’ amounts to be bid.24

A bidder at auction can tender their bid amount in U.S. dollars in the form of:

• cash;

• a cashier’s check drawn on a state or national bank;

18 CC §2924f

19 CC §2924c(b)(1)

20 CC §2924b(c)(3)

21 CC §2924f(b)(1)

22 CC §2924h

23 CC §2924g(a)

24 CC §2924h(b)(1)

Delivering the NOTS

Sold to the highest bidder

456 Real Estate Principles, Second Edition

• a check issued by a state or federal thrift, savings and loan association (S&L), savings bank or credit union; or

• a cash equivalent designated by the trustee in the NOTS, such as a money order.25

Each bid made at a trustee’s sale is an irrevocable offer to purchase the property. However, any subsequent higher bid cancels a prior bid.26

The trustee’s sale is considered final on the trustee’s acceptance of the last and highest bid.27

Once the highest bid has been accepted by the trustee, the trustee may require the successful bidder to immediately deposit the full amount of the final bid with the trustee.28

If the successful bidder tenders payment by a check issued by a credit union or a thrift, the trustee can refrain from issuing the trustee’s deed until the funds become available.29

If a successful bidder tenders payment by check and the funds are not available for withdrawal:

• the trustee’s sale is automatically rescinded; and

• the trustee will send the successful bidder a notice of rescission for failure of consideration.30

To hold a new trustee’s sale auction, the trustee sets a new trustee’s sale date and records, serves and publishes a new NOTS. The new NOTS is to follow all the same statutory requirements as the original NOTS.

The successful bidder who fails to tender payment when demanded is liable to the trustee for all resulting damages, including:

• court costs;

• reasonable attorney fees; and

• the costs for recording and serving the new NOTS.31

The beneficiary is frequently the only bidder at the trustee’s sale. Thus, the beneficiary automatically becomes the successful bidder.

The beneficiary may bid without tendering funds up to an amount equal to the debt secured by the property being sold, plus trustee’s fees and foreclosure expenses. This amount is called a full credit bid.32

If the beneficiary is the successful bidder under a full credit bid, the trustee retains possession of the beneficiary’s note (or other evidence of the secured debt) in exchange for the trustee’s deed to the property.

25 CC §2924h(b)(1)

26 CC §2924h(a)

27 CC §2924h(c)

28 CC §2924h(b)(2)

29 CC §2924h(c)

30 CC §2924h(c)

31 CC §2924h(d)

32 CC §2924h(b)

Failure to deliver payment

of a bid

rescind The cancellation of a contract which restores the parties to the same position they held before they entered into the contract.

Bids by the beneficiary, a

credit

full credit bid The maximum amount the foreclosing mortgage holder may bid at a trustee’s sale without adding cash, equal to the debt secured by the property being sold, plus trustee’s fees and foreclosure expenses.

Chapter 69: Trustee’s foreclosure procedures 457

The beneficiary is not required to bid the full amount of the indebtedness to acquire the property at the trustee’s sale. The beneficiary can bid an amount below the full amount of the debt, called an underbid.

On the completion of a trustee’s sale, the trustee uses a trustee’s deed to transfer title to the property on to the successful bidder at the auction.

When a buyer other than the beneficiary purchases the property for value and without notice of title or trustee’s sale defects, the buyer is considered a bona fide purchaser (BFP). The title received by the third-party BFP is clear of any interest claimed by the owner, lienholders or tenants whose interests are junior to the foreclosed trust deed.33

The price paid for property by the successful bidder at a trustee’s sale occasionally exceeds the amount of debt and costs due under the foreclosed trust deed. The excess amounts are called surplus funds.

The trustee has a duty to distribute the surplus funds to the junior lienholders and the owner(s). The gross proceeds from the trustee’s sale are distributed in the following order:

• to pay the costs and expenses of the trustee’s sale, including trustee’s fees or attorney fees;

• to pay the indebtedness secured by the property in default, including advances made by the beneficiary;

• to satisfy the outstanding balance of junior lienholders of the property, distributed in the order of their priority; and

• to the owner, the owner’s successor-in-interest or the vested owner of record at the time of the trustee’s sale.34

33 Hohn v. Riverside County Flood Control and Water Conservation District (1964) 228 CA2d 605

34 CC §2924k(a)

Conveyance by a trustee’s deed

bona fide purchaser (BFP) A buyer who purchases a property for valuable consideration in good faith without notice or knowledge of pre- existing encumbrances or conditions affecting their right to full ownership.

Surplus funds

surplus funds The price paid for property by the successful bidder at a trustee’s sale in excess of the amount of debt and costs due under the foreclosed trust deed.

A trust deed is a security device which imposes a lien on real estate. A power-of-sale provision in the trust deed allows the deed holder to nonjudicially foreclose by a trustee’s sale. By foreclosing using the power-of-sale provision, the holder of a lien avoids a court action for judicial foreclosure.

A trustee’s sale is conducted by a trustee either named in the trust deed or appointed by the beneficiary at the start of the foreclosure process.

The trustee initiates nonjudicial foreclosure by recording and serving a notice of default (NOD). Before recording an NOD on a one-to-four

Chapter 69 Summary

458 Real Estate Principles, Second Edition

residential property, a mortgage holder conducts a pre-foreclosure workout with the owner to explore options to avoid foreclosure and provide financial counseling to the owner.

Copies of the NOD are sent to the owner and each person who has requested a copy within 10 business days after it was recorded, and to recorded junior interests in the property within one month.

A trustee or beneficiary may begin noticing the date set for the sale of a property by posting and serving a notice of trustee’s sale (NOTS) on the day following three months after the day the NOD is recorded. If the billing address of the defaulting owner is different from the secured property’s address, residential tenants of the property are served with a 90-day notice to vacate.

Copies of the NOTS are sent to each party who received copies of the NOD at least 20 calendar days before the trustee’s sale. The NOTS is also posted in a public place in the city of the sale, posted in a conspicuous place on the property to be sold, and published in a local newspaper for three consecutive weeks prior to the sale.

A trustee’s sale is held in the county where the secured real estate is located. A trustee’s sale is a public auction where the property is sold to the successful bidder. The sale is considered final on the trustee’s acceptance of the last and highest bid.

On completion of a trustee’s sale, the trustee uses a trustee’s deed to convey title to the successful bidder. A successful bidder without notice of title or sale defects is considered a bona fide purchaser (BFP) and takes title clear of any claims to the property on interests junior to the foreclosed trust deed.

bona fide purchaser (BFP) ........................................................ pg. 457 Declaration of Default and Demand for Sale ..................... pg. 453 full credit bid ............................................................................... pg. 456 nonjudicial foreclosure ........................................................... pg. 449 notice of default (NOD) ............................................................ pg. 451 power-of-sale provision ........................................................... pg. 450 pre-foreclosure workout .......................................................... pg. 451 recourse mortgage ..................................................................... pg. 450 rescind ........................................................................................... pg. 456 surplus funds .............................................................................. pg. 457 trustee ........................................................................................... pg. 451 trustee’s sale guarantee ........................................................... pg. 453

Chapter 69 Key Terms

Quiz 13 Covering Chapters 68-72 is located on page 618.

Chapter 70: Judicial foreclosure 459

After reading this chapter, you will be able to:

• distinguish foreclosure proceedings as either judicial or nonjudicial;

• discuss the procedural process of a judicial foreclosure; • advise a client of their right to reinstate a mortgage in default or

redeem a property following a judicial foreclosure sale; and • calculate any deficiency in value an owner may owe a mortgage

holder after a property has been sold at a judicial foreclosure sale.

Learning Objectives

Judicial foreclosure

Chapter

certificate of sale

fair value hearing

foreclosure decree

judicial foreclosure

levying officer

lis pendens

litigation guarantee

money judgment

nonjudicial foreclosure

probate referee

recourse mortgage

Key Terms

For a further study of this discussion, see Chapter 48 of Real Estate Finance.

When a mortgage is in default, the mortgage holder’s collection efforts are limited to judicial or non-judicial activities, both of which are very structured. If the note evidences a recourse debt, the mortgage holder may recover against both the property and the named borrower.

To initiate either type of collection effort, the mortgage holder needs to first exhaust the security by foreclosing on the real estate. The mortgage holder’s security interest in a property is exhausted when the mortgage holder completes a foreclosure sale on the property. Further, the mortgage holder’s security interest is wiped out by a senior trust deed holder’s foreclosure.

Deficient property value; recourse paper

460 Real Estate Principles, Second Edition

Only when the note evidences a recourse debt may the mortgage holder pursue a money judgment against the borrower for any deficiency in the property’s value to fully satisfy the debt.1

Foreclosure is an activity comprised of notices and an auction to sell real estate. Foreclosure of the property eliminates the right of redemption held by the owner and any persons holding junior interests in the property. [See Chapter 69]

A trust deed holder may foreclose on a property in one of two ways:

• judicial foreclosure, under mortgage law, also called a sheriff’s sale;2 or

• nonjudicial foreclosure, under the power-of-sale provision in the trust deed, also called a trustee’s sale.3 [See Chapter 69]

Judicial foreclosure is the court-ordered sale by public auction of the secured property. The process can last from eight months to multiple years before it is completed.

Alternatively, when a trust deed holder nonjudicially forecloses by a trustee’s sale, the property is sold as authorized by the trust deed provisions at a public auction, called a trustee’s sale. [See Chapter 69]

Trustee’s sales are considerably less expensive and quicker than judicial foreclosures. A judicial sale requires the filing of a lawsuit, which includes:

• litigation expenses;

• appraisals; and

• attorney fees.

However, when the value of a secured property drops below the balance owed on a recourse debt, the mortgage holder may elect to foreclose by judicial action. A judicial foreclosure is the only foreclosure method which allows a mortgage holder to obtain a money judgment against the borrower for any deficiency in the value of the secured property to fully satisfy a recourse debt.4

The first step in a judicial foreclosure is filing a complaint in the Superior Court of the county where the property is located. The foreclosure complaint names as defendants the original borrowers named in the trust deed as the trustor or in the trust deed note. The complaint also names anyone else holding a recorded interest in the secured property junior to the foreclosing mortgage holder’s trust deed lien.

The mortgage holder foreclosing judicially needs to obtain a litigation guarantee of title insurance. The litigation guarantee lists all parties with a recorded interest in the property and their addresses of record. The guarantee 1 Calif. Code of Civil Procedure §726

2 CCP §725a

3 Calif. Civil Code §2924

4 CCP §580d

nonjudicial foreclosure When property is sold at a public auction by a trustee as authorized under the power-of- sale provision in a trust deed.

Judicial foreclosure

versus nonjudicial foreclosure

judicial foreclosure The court-ordered sale by public auction of the mortgaged property. Also known as a sheriff’s sale.

Suing to foreclose

litigation guarantee A title insurance policy which lists all parties with a recorded interest in a property and their addresses of record, ensuring that all persons with a recorded interest in a property are named and served in litigation.

money judgment An award for money issued by a court resulting from a lawsuit for payment of a claim.

Chapter 70: Judicial foreclosure 461

further ensures that persons with a recorded junior interest in the property are named and served. Thus, their interest is also eliminated from title by the judicial foreclosure sale.

At the time the lawsuit is filed, the foreclosing mortgage holder records a Notice of Pending Action against the secured property, also called a lis pendens.

The lis pendens places a cloud on the title of the secured property, giving notice of the judicial foreclosure action and subjecting later acquired interests to the results of the litigation.

Until the court enters a judgment ordering the sale of the secured property, called a foreclosure decree, the borrower has the right to bring the delinquencies current. A foreclosure decree ends the reinstatement period. [See Chapter 69]

A foreclosure decree orders the sale of the real estate to satisfy:

• the outstanding debt; and

• cover foreclosure sale expenses incurred by the mortgage holder.5

The foreclosure decree also states whether the borrower will be held personally liable for any deficiency in the property’s fair market value (FMV) to satisfy the debt owed.6 FMV is never determined by the amount of the high bid at the judicial foreclosure sale.

A judicial foreclosure sale is conducted by a court-appointed receiver or sheriff, called a levying officer.

After the judicial foreclosure sale is ordered by the court, the foreclosing mortgage holder is issued a writ of sale by the court clerk. The writ of sale authorizes the receiver or sheriff to record a notice of levy. Both describe the property to be sold and state the levy is against the security interest the mortgage holder holds in title to the property under its trust deed lien.7

The receiver or sheriff who conducts the sale records the writ of sale and the notice of levy in the county where the property is located. The receiver or sheriff also mails the writ of sale and the notice of levy to the owner and any occupant of the property.8

Similar to the notice of trustee’s sale used in a nonjudicial foreclosure, the receiver’s or sheriff’s notice of sale states the necessary details of the auction, such as the:

• date;

• time; and

5 CCP § 726(a), (b)

6 CCP §726(b)

7 CCP §712.010;

8 CCP §700.010

lis pendens A notice recorded for the purpose of warning all persons that the title or right to possession of the described real property is in litigation.

The foreclosure decree

foreclosure decree A court judgment ordering the sale of mortgaged property.

Notice of Levy

levying officer A court-appointed receiver or sheriff who conducts a judicial foreclosure sale.

The notice of judicial sale

462 Real Estate Principles, Second Edition

• location of the sale.9

When a deficiency judgment is sought by the foreclosing mortgage holder, the notice of judicial sale also states:

• the property is being sold subject to the borrower’s right of redemption; and

• the amount of the secured debt, plus accrued interest and foreclosure costs.10

If a money judgment for any deficiency is prohibited, as occurs with a nonrecourse debt, the receiver or sheriff waits at least 120 days after service of the notice of levy before proceeding to notice the judicial sale.11

However, if the mortgage holder seeks a deficiency judgment, no waiting period applies before noticing the sale. The receiver or sheriff may notice the judicial sale immediately after the decree is issued.12

At least 20 days before the sale, the notice of judicial sale is:

• served on the borrower personally or by mail;13

• mailed to any person who has recorded a request for a notice of judicial sale;14

• posted in a public place in the city or judicial district where the property is located, and on the property itself; and

• published weekly in a local newspaper of general circulation.15

The public sale held by a court-appointed receiver or sheriff is conducted as an auction. The property is sold to the highest bidder.16

Payment at the public sale is made in cash or by certified check at the time of the sale. The foreclosing mortgage holder is entitled to a credit bid up to the full amount of the debt owed. However, amounts over $5,000 permit a credit transaction.17

If the successful bidder fails to pay the amount bid, the receiver may sell the property to the highest bidder at a subsequent sale. The defaulting bidder is liable for interest, costs and legal fees for their failure to pay their bid.18

The foreclosing mortgage holder is often the highest — or only — bidder at a judicial sale. When intending to seek a deficiency judgment, the mortgage holder needs to bid no less than an amount it believes the court will set as the FMV of the property. Any successful bids for less than the property’s FMV on the date of the sale will generate an uncollectible loss on the mortgage for the mortgage holder.19

9 CCP §701.540(a)

10 CCP §729.010(b)(1)

11 CCP §701.545

12 CCP §729.010(b)(2), (3)

13 CCP §701.540(c)

14 CCP §701.550(a)

15 CCP §701.540(g)

16 CCP §701.570

17 CCP §701.590(a), (c)

18 CCP §701.600

19 Luther, supra

Highest bidder

acquires the property

Chapter 70: Judicial foreclosure 463

Figure 1

Collecting a recourse debt

A certificate of sale is issued to the successful bidder on the completion of a judicial sale.

Although the bidder purchased the property at the public auction, they will not become the owner of the property or be able to take possession of it until the applicable redemption period expires.20 [See Chapter 69]

The certificate of sale reflects the owner’s continuing right to redeem the property and avoid losing it to the highest bidder.21 20 CCP §729.090

21 CCP §729.020

Judicial sale completed

certificate of sale A certificate issued to the successful bidder on the completion of a judicial sale of a property.

Collecting a recourse debt

Default on a secured mortgage

Judicial action

Notice of sale

Security available

1 to 3 years to complete

Foreclosure suit filed

Reinstatement available prior

to judgment

Deficiency: Notice recorded

immediately

1-year redemption

period

No deficiency: 120-days before notice recorded

3-month redemption

period

Security exhausted

6 months to 2 years to complete

Action filed on the note

Money judgment

464 Real Estate Principles, Second Edition

On a judicial foreclosure, if a trust deed secures a mortgage holder’s purchase- assist mortgage on a buyer-occupied, one-to-four unit residence, or a seller carryback note as a lien solely on the property sold no matter its use, the property owner:

• is not liable for any deficiency in the property value to fully satisfy the debt;22 and

• has three months after the judicial sale to redeem the property by paying off the entire debt and costs.23

However, if the owner is liable on a recourse debt for a deficiency in the property’s value, the owner has up to one year after the judicial sale to redeem the property.24

The property can only be redeemed by the owner or the owner’s successor- in-interest since all junior lienholders are wiped out by the judicial foreclosure sale.

Successors-in-interest to the owner are lienholders or buyers who acquire the owner’s interest in the property by deed prior to the judicial foreclosure sale.25

The redemption price for the owner (or successor) to recover the property sold at a judicial foreclosure sale is the total of:

• the price paid for the property by the highest bid at the judicial foreclosure sale (even if it is less than the property’s FMV on that date);

• taxes, assessments, insurance premiums, upkeep, repair or improvements to the property paid by the successful bidder; and

• interest on the above amounts at the legal rate on money judgments (10%) from the date of the payments through the date the redemption amount is tendered in full.26

On redemption, the owner (or successor) is entitled to:

• an offset for any net rents collected by the mortgage holder under an assignment of rents provision in the trust deed; and

• an offset for the rental value of the premises for any period of time the successful bidder occupied the property following the sale.27

If the property is not redeemed by the owner or successor within the redemption period, the sale is final.28

22 CCP §580b

23 CCP §729.030

24 CCP §729.030

25 CCP §729.020;

26 CCP §729.060

27 CCP §§729.060, 729.090

28 CCP §729.080

Redemption follows

foreclosure

Chapter 70: Judicial foreclosure 465

The remaining balance owed on a note may be greater than the fair price of the mortgage holder’s security interest in the real estate. The spread when the fair price is lower than the balance due is the deficiency in the value of the property to cover the debt.

A money judgment for the deficiency in the property value to fully satisfy the debt is available if not barred by anti-deficiency statutes. The mortgage holder will be awarded a money judgment for any deficiency in value at a hearing following the foreclosure sale. At the fair value hearing, noticed within three months after the foreclosure sale, the amount of the deficiency is set by the court.29

The amount awarded as a deficiency judgment is based on the debt owed on the date of the judicial foreclosure sale, and the greater of:

• the FMV of the property on the date of the foreclosure sale, minus any amounts owed on liens senior to the trust deed being foreclosed, the result setting the fair price of the mortgage holder’s security interest; or

• the amount bid for the property at the judicial foreclosure sale.30

The mortgage holder is awarded a money judgment for the portion of the debt not covered by the fair price of the mortgage holder’s secured position on title, or the price bid at the sale if it is higher.

The mortgage holder and borrower present evidence at the fair value hearing to establish the property’s FMV on the sale of the foreclosure sale. The court may appoint an appraiser, called a probate referee, to advise the court on the property’s FMV.31

29 CCP §§580a, 726(b)

30 CCP §580a

31 CCP §§580a, 726(b)

Obtaining a deficiency judgment

fair value hearing The court proceeding at which a money judgment is awarded for any deficiency in the secured property’s fair market value (FMV) at the time of the judicial foreclosure sale to fully satisfy all debt obligations owed the mortgage holder.

probate referee An appraiser appointed by the court in a judicial foreclosure action to advise the court on a property’s fair market value (FMV) on the date of the judicial foreclosure sale.

Judicial foreclosure is the court-ordered sale by public auction of the secured property. A judicial foreclosure is the only foreclosure method which allows a mortgage holder holding a recourse debt to obtain a money judgment against the borrower for any deficiency in value of the secured property to satisfy the debt.

The first step in a judicial foreclosure is filing a complaint in the Superior Court of the county where the property is located. At the time the lawsuit is filed, the foreclosing mortgage holder records a Notice of Pending Action against the secured property, also called a lis pendens, to cloud title of the secured property.

Until a foreclosure decree ordering the sale is issued by the court, the borrower has the right to reinstate the mortgage by bringing any delinquencies in the note and trust deed current.

Chapter 70 Summary

466 Real Estate Principles, Second Edition

Quiz 13 Covering Chapters 68-72 is located on page 618.

If the borrower does not reinstate the mortgage, the court will then appoint a sheriff to conduct the sale by recording a writ of sale and notice of levy.

At least 20 days before the sale, the notice of judicial sale is:

• served on the borrower personally or by mail;

• mailed to any person who has recorded a request for a notice of judicial sale;

• posted in a public place in the city or judicial district where the property is located, and on the property itself; and

• published weekly in a local newspaper of general circulation.

The sheriff’s sale is conducted as a public auction and the property is sold to the highest bidder. A certificate of sale is issued to the successful bidder on the completion of the judicial sale.

The successful bidder will not become the owner of the property until the redemption period expires. The owner can redeem the debt by paying the redemption price.

A money judgment for the deficiency in the property value to fully satisfy the debt is available to the mortgage holder if not barred by anti- deficiency statutes. The mortgage holder is awarded a money judgment at a fair value hearing following the foreclosure sale.

certificate of sale ........................................................................ pg. 463 fair value hearing ...................................................................... pg. 465 foreclosure decree ...................................................................... pg. 461 judicial foreclosure ................................................................... pg. 460 levying officer ............................................................................ pg. 461 lis pendens ................................................................................... pg. 461 litigation guarantee .................................................................. pg. 460 money judgment ........................................................................ pg. 460 nonjudicial foreclosure ........................................................... pg. 460 probate referee ............................................................................ pg. 465 recourse mortgage ..................................................................... pg. 460

Chapter 70 Key Terms

Chapter 71: The homeowner is covered: an anti-deficiency primer 467

After reading this chapter, you will be able to:

• apply anti-deficiency rules available to a buyer to avoid mortgage holder claims of personal liability for payment of nonrecourse mortgage obligations;

• advise homeowners on California’s anti-deficiency protections available to them on trust deed notes, refinancing, mortgage modifications and short sales.

The homeowner is covered: an anti- deficiency primer

Chapter

anti-deficiency

purchase-money debt

short pay-off

For a further study of this discussion, see Chapter 45 of Real Estate Finance.

Key Terms

Learning Objectives

Mortgage debt under California’s anti-deficiency statutes is broken into two types of obligations. All mortgage debt is categorized by responsibility for payment as either:

• recourse; or

• nonrecourse. [See Chapter 69 and 70]

Nonrecourse debt is created by statute covering mortgages in two sets of facts:

• purchase-money debt of any priority on title (first, second or even third trust deed), is a mortgage which funded the purchase or construction of a homebuyer’s one-to-four unit owner-occupied residence; or

Protected: nonrecourse mortgage debt

anti-deficiency California legislation limiting a mortgage holder’s ability to recover losses on a default when the mortgaged property’s value is insufficient to satisfy the mortgage debt.

468 Real Estate Principles, Second Edition

• seller financing, also called a credit sale, installment sale or carryback paper, on the sale of any type of real estate when the debt is secured solely by the property sold.1

A mortgage holder holding a nonrecourse mortgage may not pursue the homeowner personally to collect for a deficiency in the secured property’s value to fully pay off the nonrecourse debt following any type of foreclosure, judicial or nonjudicial. [See Chapter 69 and 70]

Recourse debt is any mortgage other than mortgages classified as nonrecourse debt. A mortgage holder may only pursue a homeowner for a loss on a recourse mortgage due to a deficiency in the price of the secured property through judicial foreclosure, and then only if:

• the court-appraised value of the property at the time of the judicial foreclosure sale is less than the debt; and

• the bid is for less than the debt owed.2

Refinanced purchase-money debt only retains its purchase-money nonrecourse status if:

• the mortgage holder of the original purchase-money debt is the refinancing mortgage holder;3

• the refinanced debt is substantially the same debt as the original purchase-money debt;4 and

• the refinanced debt is secured by the same property as the original purchase-money debt.5

In absence of any of the three conditions, the refinanced debt is considered recourse debt subject to a mortgage holder’s money judgment for any deficiency in the value at the time of the judicial foreclosure sale.

The same logic is used when considering whether the modification of a purchase-money mortgage retains its nonrecourse status. If the modified mortgage is secured by the same property as the original purchase-money mortgage, modification of payments, interest rates or due dates do not change the purchase-money status of the modified mortgage.6

The extension of nonrecourse status to the mortgage holder’s continuation of the same debt under different terms for repayment is important. Taxwise, nonrecourse status for a mortgage means any debt forgiven on the modification is exempt from taxation as cancellation of debt income.

Additionally, a mortgage holder may not require a homeowner to waive their anti-deficiency protection as a condition of granting a mortgage

1 Calif. Code of Civil Procedure §580b 2 CCP §580a

3 Union Bank v. Wendland (1976) 54 CA3d 393

4 DeBerard Properties, Ltd. v. Lim (1999) 20 C4th 649

5 Goodyear v. Mack (1984) 159 CA3d 654

6 DeBerard, supra

purchase-money debt A mortgage which funds the purchase or construction of a one-to-four unit owner-occupied residence, also called a nonrecourse debt.

Refinanced purchase-money

debt: recourse or not?

What about mortgage

modifications?

Chapter 71: The homeowner is covered: an anti-deficiency primer 469

modification when the mortgage remains secured by the same property. The result would simply be a magic trick performed by the mortgage holder to flip nonrecourse into recourse status on a default — an unenforceable departure from the legislative intent of anti-deficiency statutes.7

Anti-deficiency protection has also been extended to homeowners who negotiate short payoffs (short sales) with their mortgage holders and close a short sale to dispose of their homes.

Regardless of the recourse or nonrecourse status of the mortgage, a mortgage holder who agrees to accept a shortpay from an owner-occupant on the sale of a one-to-four unit residential property is barred from seeking a money judgment for any loss incurred on the short sale.8

7 Palm v. Schilling (1988) 199 CA3d 63

8 CCP §580e

Special rules for short sales

short payoff A sale in which the lender accepts the net proceeds at closing in full satisfaction of a greater amount of mortgage debt.

There are two kinds of mortgage debt established by California’s anti- deficiency statutes: nonrecourse or recourse debt.

Nonrecourse debt is:

• purchase-money debt of any priority which funded the purchase or construction of a homebuyer’s one-to-four unit owner-occupied residence; or

• seller carryback paper when the debt is secured solely by the property sold.

A mortgage holder holding a nonrecourse debt may not pursue the homeowner for a deficiency in the secured property’s value following a judicial or nonjudicial foreclosure, unless the owner maliciously injures the property causing its value to drop.

Refinanced purchase-money debt only retains its purchase-money nonrecourse status if:

• the mortgage holder of the original purchase-money debt is the refinancing mortgage holder;

• the refinanced debt is substantially the same debt as the original purchase-money debt; and

• the refinanced debt is secured by the same property as the original purchase-money debt.

If a modified mortgage is secured by the same property as the original purchase-money mortgage, modification of payments, interest rates or due dates do not change the purchase-money status of the modified mortgage.

Chapter 71 Summary

470 Real Estate Principles, Second Edition

Regardless of the recourse or nonrecourse status of the mortgage, a mortgage holder who agrees to accept a short payoff from an owner- occupant of a one-to-four unit residential property is barred from seeking a money judgment against the owner for any loss incurred on the short sale.

anti-deficiency ........................................................................... pg. 467 purchase-money debt ............................................................... pg. 468 short pay-off ................................................................................ pg. 469

Chapter 71 Key Terms

Quiz 13 Covering Chapters 68-72 is located on page 618.

Chapter 72: Home mortgages interest deductions 471

After reading this chapter, you will be able to:

• understand the government policies encouraging tenants to become homeowners through the mortgage interest tax deduction (MID);

• distinguish when interest paid on a home equity mortgage secured by a principal or second residence is tax deductible;

• advise buyers on the ceiling thresholds for mortgage interest deductions; and

• determine a buyer’s income tax reduction due to interest paid on mortgages for the purchase or improvement of a principal residence or second home by use of a tax analysis form.

Learning Objectives

For a further discussion of this topic, see Chapter 1 and 2 of Tax Benefits of Ownership.

Home mortgage interest deductions

Chapter

adjusted gross income (AGI)

fair market value (FMV)

home equity mortgage

itemized deductions

mortgage interest deduction (MID)

points

principal residence

qualified interest

second home

Key Terms

The federal government has a long-standing policy of encouraging residential tenants to become homeowners. The incentive provided by the government to individual tenants comes in the form of a reduction in the income taxes they pay. To qualify, they need to take out a mortgage to finance the purchase of a residence or a vacation home.

Two residences, two deductions

472 Real Estate Principles, Second Edition

For a residential tenant considering their income taxes, the monthly payment on a purchase-assist home mortgage is not just a substitute for their monthly rent payment — it also reduces their combined state and federal income taxes.

A buyer’s agent representing prospective buyers in their purchase of a single family residence (SFR) needs to be able to intelligently discuss this tax reduction incentive. With knowledge about allowable ownership deductions and tax bracket rates, they will be better able to persuade tenants to buy based on the full range of financial benefits of homeownership.

Two categories of mortgages exist to control the deduction of interest paid on any mortgages secured by the principal residence or second home, which include:

• interest on the balances of purchase or improvement mortgages up to a combined principal amount of $1,000,000; and

• interest on all other mortgage amounts up to an additional $100,000 in principal, called home equity mortgages.

As a tax loophole for personal use expenditures, the home mortgage interest deduction (MID) rule for income tax reporting allows mortgaged homeowners to deduct from their adjusted gross income (AGI) the interest paid on first and second homes to reduce their taxable income. The mortgage interest is reported as an itemized deduction, if:

• the mortgages funded the purchase price or paid for the cost of improvements for the owner’s principal residence or second home; and

• the mortgages are secured by either the owner’s principal residence or second home.1

Without the MID rule, interest paid on a mortgage which funded the purchase or improvement of a principal residence or second home is not deductible. These types of expenditures are for personal use, not a business or investment use.

Also, interest paid on home equity mortgages secured by the property owner’s principal residence or second home is deductible under the home MID rules. These additional MID rules apply whether or not the mortgage’s net proceeds were used for personal or business/investment purposes.

The mortgage interest deductions for the first and second home reduce the property owner’s taxable income, and thus reduces the amount of tax they will pay. As an itemized deduction, the accrued interest paid is subtracted from the owner’s AGI under both the standard income tax (SIT) and the alternative minimum tax (AMT) reporting rules. In contrast, the other income tax loophole for real estate property tax deductions on the first and second homes applies only to reduce the owner’s SIT, not their AMT.

1 Internal Revenue Code §163(h)

The MID deduction

rule home equity mortgage A junior mortgage encumbering the value in a home remaining after deducting the principal on the senior mortgage from the market value of the home.

mortgage interest deduction (MID) An itemized deduction for income tax reporting allowing homeowners to deduct interest and related charges they pay on a mortgage encumbering their primary or second homes.

principal residence The residential property where the homeowner resides a majority of the year.

itemized deductions Deductions taken by a taxpayer for allowable personal expenditures which, to the extent allowed, are subtracted from adjusted gross income (AGI) to set the taxable income for determining the income tax due, called Schedule A.

Chapter 72: Home mortgages interest deductions 473

Interest paid on mortgages and carryback credit arrangements originated to purchase or substantially improve an owner’s first or second home is deductible on combined principal balances of up to $1,000,000 for an individual and for couples filing a joint return if the mortgage is secured by either home.

Thus, if the mortgage funds are used to acquire, construct, or further improve a principal residence or second home, and the mortgage funds collectively exceed $1,000,000, only the interest paid on $1,000,000 of the mortgage balances is deductible under this part of the MID rule.

Purchase/ improvement mortgages

Form 351

Individual Tax Analysis (INTAX)

474 Real Estate Principles, Second Edition

To qualify home improvement mortgages for interest deductions, the new improvements need to be substantial. Improvements are substantial if they:

• add to the property’s market value;

• prolong the property’s useful life; or

• adapt the property to residential use.

Mortgage funds spent on repairing and maintaining property to keep it in good condition and maintain its value do not qualify as funding for substantial improvements.2

Further additional deductions are permitted for interest paid on the excess mortgage amounts, up to an additional $100,000. Interest on this additional principal qualifies for deduction as interest paid on a home equity mortgage.

If an owner refinances a purchase/improvement mortgage, the portion of the refinancing funds used to finance the payoff qualifies as a purchase/ improvement mortgage for future interest deductions. However, interest may only be written off as a purchase/improvement mortgage on the amount of refinancing funds used to pay off the principal balance on the existing purchase/improvement mortgage, unless the excess monies funded the further improvement of the home.

For example, consider an owner who borrows $200,000 to fund the purchase of their principal residence. The mortgage balance is paid down to $180,000 and the owner refinances the residence, paying off the original purchase/ improvement mortgage. However, the new mortgage is for a greater principal amount than the payoff demanded on the original mortgage.

In this scenario, interest on only $180,000 of the refinance mortgage is deductible as interest paid on a purchase or improvement mortgage, unless:

• the excess funds generated by the refinance are used to improve the residence; or

• the excess mortgage amount qualifies as a home equity mortgage under its separate ceiling of $100,000 in principal.

Interest on mortgage amounts secured by the first or second home may not qualify for the purchase/improvement home mortgage interest deduction. This will be due either to a different use of the mortgage proceeds, or the $1,000,000 mortgage limitation.

The interest on mortgage amounts secured by the first or second residence, but do not qualify as a purchase/improvement mortgage, is deductible by a couple as interest paid on additional or other mortgage amounts up to $100,000 in principal.

2 IRC §163; Temporary Revenue Regulations §1.163-8T

second home An individual’s alternative residence where they do not reside a majority of the year.

Refinancing limitations

$100,000 home equity

mortgages

Chapter 72: Home mortgages interest deductions 475

For married persons filing separately, the cap for the principal amount of equity mortgages on which interest may be deducted is limited to $50,000, half of the joint $100,000 ceiling.3

Home equity mortgages are typically junior encumbrances, but also include excess proceeds from a refinance which:

• do not qualify as purchase/improvement funds; or

• exceed the $1,000,000 ceiling.

The proceeds from home equity mortgages may be used for any purpose, including personal uses unrelated to the property.

Interest paid on any portion of a mortgage balance which exceeds the fair market value (FMV) of a residence is not deductible. In practice, the FMV rule applies almost exclusively to home equity mortgages. This includes refinancing proceeds of a greater amount than the balance paid off on the purchase/improvement mortgage that was refinanced.4

The FMV of each residence is presumed to be the original amount of the purchase price, plus any improvement costs. Thus, any future drop in property value below the balance remaining on a purchase-assist mortgage does not affect the interest deduction.5

To qualify for the MID, the mortgages need to be secured by the principal residence or second home.

A principal residence is an individual’s home where the homeowner’s immediate family resides a majority of the year, also called the primary residence or first home. The principal residence is close to the homeowner’s place of employment and banks which handle the homeowner’s accounts, and its address is used for tax returns.6

A second home is any residence selected by the owner from year to year, including:

• real estate;

• mobile homes;

• recreational vehicles; and

• boats.

If the second home is rented out for portions of the year, the interest qualifies for the home mortgage interest deduction if the owner occupies the property for more than 14 days or 10% of the number of days the residence is rented, whichever number is greater.7

3 IRC §163(h)(3)(C)(ii)

4 IRC §163(h)(3)(C)(i)

5 Temp. Rev. Regs. §1.163-10T

6 IRC §163(h)(4)(A)(i)(I)

7 IRC §280A(d)(1)

Property value ceiling

fair market value (FMV) The price a reasonable, unpressured buyer would pay for property on the open market.

Qualifying the principal residence and second home

476 Real Estate Principles, Second Edition

If the owner does not rent out their second home at any time during the year, the property qualifies for the home mortgage interest deduction whether or not the owner occupies it.8

Interest deductions on home mortgages are only allowed for interest which has accrued and been paid, called qualified interest.9

Interest on first and second home mortgages is deducted from an owner’s adjusted gross income (AGI) as an itemized deduction. Further, limitations exist on the total amount of all deductions the homeowner may claim. Conversely, business, rental or investment interest are adjustments that reduce the AGI. Thus, the two types of home mortgage interest deductions directly reduce the amount of the owner’s taxable income (if the interest deductible is not limited by ceilings on the homeowner’s itemized deductions).

The inability to reduce the owner’s AGI by use of the home mortgage interest makes a substantial difference for high income earners. The higher an owner’s AGI, the lesser the amounts allowed for rental loss deductions, by itemized deduction phaseout, and on any tax credits available to the owner.10

Points paid to a lender to originate a mortgage are considered prepaid interest for both tax and financial purposes. One point equals 1% of the mortgage amount. Points essentially buy down the mortgage’s par rate in the market to the note rate, fixed for the life of the mortgage. Alternatively, no points means a higher par rate of interest will be the nominal note rate.

As prepaid interest, general tax rules limit its deduction to an annual fraction of the points paid as the interest accrues annually over the life of the mortgage. Thus, each year the owner may deduct that year’s accrued portion of the points from AGI to reduce the owner’s income tax. When the mortgage is fully prepaid, any remaining unaccrued prepaid interest is then deducted. However, homeowners have another specific loophole to this prepaid interest rule.

As an exception to the life-of-mortgage accrual reporting, and thus a loophole to avoid taxes, the entire amount of the points paid on mortgages that assist in the purchase or improvement of an individual’s principal residence is allowed as a personal deduction in the year the mortgage originated.

The immediate deduction for all points paid in connection with these homeowner mortgages is another government subsidy, part of the overall policy to encourage homeownership in lieu of renting.11

The points deduction exception for a principal residence does not include points paid on mortgages secured by a second homes such as the ownership of a vacation residence.

8 IRC §163(h)(4)(A)(iii)

9 IRC §163(h)(3)(A)

10 IRC §163(a), (h)(2)(A)

11 IRC §461(g)(2)

Taking the deductions

qualified interest Interest on a mortgage which has accrued and been paid and is an allowable interest deduction for ownership of a first and second home.

adjusted gross income (AGI) The total of the taxpayer’s reportable income and losses from all three income categories.

The points of interest

points A fee charged by a lender as prepaid interest which in turn reduces the note rate on the mortgage, with a point equaling 1% of the amount of the mortgage.

Chapter 72: Home mortgages interest deductions 477

Further, the deductibility of the mortgage points in the year paid, instead of over the life of the mortgage, depends on who paid the points — the buyer, the seller or the lender.

To deduct the points in the year they are paid, the purchase-assist or improvement mortgage needs to be secured by a buyer’s or homeowner’s principal residence.

Likewise, points paid by a buyer to finance the purchase or improvement of a second residence need to be deducted as they accrue over the life of the mortgage. For example, points paid on a purchase-assist mortgage for a vacation home, payable monthly with a 30-year amortization, will be deductible 1/360th for each month of the tax year as the prepaid interest accrues.

Mortgage costs incurred and paid by the owner to originate a purchase or improvement on any type of real estate are capitalized by the owner. Thus, mortgage costs are added to, and become part of, the owner’s cost basis in the property and are not deducted as interest

Mortgage charges are non-recurring costs incurred to acquire or improve property, not daily recurring interest which may be deducted as it accrues and is paid.12

Capitalized costs for originating a mortgage on property other than the first and second home are partly recovered by annual depreciation deductions, and fully recovered when the property is sold.

12 Lovejoy v. Commissioner of Internal Revenue Service (1930) 18 BTA 1179

Deductible points

478 Real Estate Principles, Second Edition

The federal government encourages residential tenants to become homeowners by allowing them to reduce their income taxes if they finance the purchase of a residence or vacation home. Under the mortgage interest deduction (MID) tax scheme, the interest accrued and paid on mortgages funding the purchase price or cost of improvements for a principal residence or second home is deductible from the homeowner’s AGI as an itemized deduction which reduces the owner’s taxable income and in turn their income tax.

Interest may be deducted from AGI to lower taxable income on:

• purchase or improvement mortgages up to $1,000,000; and

• home equity mortgages up to $100,000.

Interest paid on home equity mortgages secured by a principal or second residence is also deductible.

When an owner refinances a purchase or improvement mortgage, interest may only be written off on the amount of refinancing funds used to pay off the principal balance of the original mortgage.

Interest paid on any portion of a mortgage balance which exceeds the fair market value of a residence is not deductible. In practice, the FMV rule applies almost exclusively to home equity mortgages.

Points paid to a lender to originate a mortgage are subject to different deductibility criteria than standard interest. As prepaid interest and under the general rule of deductibility, only the fraction of the points paid which accrues annually over the life of the mortgage may be deducted against that year’s income. A specific exception exists for points on mortgages for principal residences which may be fully deducted in the year paid.

adjusted gross income (AGI) .................................................... pg. 476 fair market value (FMV) ............................................................ pg. 475 home equity mortgage .............................................................. pg. 472 itemized deductions .................................................................. pg. 472 mortgage interest deduction (MID) ....................................... pg. 472 point ............................................................................................... pg. 476 principal residence .................................................................... pg. 472 qualified interest ........................................................................ pg. 476 second home ................................................................................ pg. 474

Chapter 72 Summary

Chapter 72 Key Terms

Quiz 13 Covering Chapters 68-72 is located on page 618.