ABCS of Mortgage Loans Flashcards
As already mentioned, most homebuyers require financing to make that purchase. And most people refer to that financing instrument as a mortgage loan. While not totally incorrect, that is a layperson’s usage of the term that is incomplete at best.
One Mortgage Loan = Two Documents
In actuality, a single mortgage loan or mortgage agreement hangs on two important documents:
The promissory note
The security instrument
We’ve talked about these two documents in past levels, and we’re going to take an even deeper look at them again shortly — they’re just that important!
Combined, the promissory note and the security instrument address:
The borrower’s acknowledgment of debt and promise to pay that debt (both the loan amount and earned interest)
The designation of the property as collateral to secure the debt
The terms of repayment and the consequences of failure to meet those terms
The obligations of the borrower to protect the lender’s interest in the property during the life of the loan
The Note Gets the Nod
Should there ever be any conflicts with respect to the terms contained in these two documents, the promissory note will be the controlling document.
Dissecting a Mortgage Loan
I just told you that a mortgage loan is made up of two documents. The first of those we’ll look at is the promissory note.
What we’re going to cover here might be somewhat of a review. But what follows should both reinforce what you have already learned as well as amplify your understanding with new and complementary information.
The promissory note is a keystone of real estate financing. Without it, a borrower would not be able to obtain a loan to purchase property. And since we have already established that most home buyers require financing to accomplish this endeavor, the importance of the promissory note is self-evident.
Promissory Note Defined
A promissory note is a negotiable finance instrument used in a typical mortgage agreement. It is evidence of a debt and a promise to pay that debt. And, to be clear, it is a contract between the lender and the borrower.
The note, as it is sometimes called, can be secured or not. If secured, the mortgage agreement containing the promissory note will also feature a security instrument, usually a mortgage or a deed of trust that pledges the property being purchased as the collateral for the note.
The promissory note doesn’t simply make a blanket promise to repay the loan but contains the specific terms and conditions of the loan, including the interest rate to be earned by the holder of the note. It is a contract in and of itself.
Negotiable Instrument Defined
A promissory note is a negotiable instrument. What exactly does negotiable mean in this context?
Well, it means that the note is transferable and assignable. Which is to say that the present-day note holder is legally entitled to demand payment per the terms of the note, regardless of whether or not they were the one who had originally entered into the note with the borrower.
The original lender has the right to sell the note at any point to another party, who becomes the holder in due course. Once the note has been transferred, the holder in due course has full legal title to the promissory note and can enforce — but not change — the original terms of repayment.
If you have ever owned a home, it is likely that you have personal experience with this. The transfer of promissory notes is a common experience of mortgagors (borrowers).
The Promissory Note
A security instrument is a contract that identifies and pledges the property or asset that will serve as collateral to secure the promissory note.
To fully understand the purpose of a security instrument as a real estate instrument of finance, it helps to look at loan financing from both the borrower and the lender’s perspectives.
A pair of hands, one holding a miniature house, the other holding a stack of coins.
The Borrower’s Perspective
The borrower wants to accomplish something that is beyond their own immediate financial capacity. It’s not that they can’t eventually cover the cost of the purchase, they just can’t do it in one payment. So, they hope, instead, to finance the purchase over time, understanding that there will be a cost associated with doing that.
The Lender’s Perspective
The lender, who has chosen to get into the business of loan origination, has two goals: make a profit and manage risk.
The lender has to evaluate the risk associated with each request for a loan and set their interest rates accordingly. And one of the larger factors in risk determination is whether or not the loan will be secured by collateral, which for real estate, is the property itself.
The promissory note will reflect the interest rate set and will refer back to the security note if there is one.
In the real world, it would be the rare individual who could qualify for an unsecured mortgage loan, which is what a promissory note without a companion security instrument would be. But if someone were to qualify for an unsecured mortgage loan, they should be ready to pay a higher interest rate.
Recap
A security instrument that pledges the property as collateral allows lenders to lower interest rates, making mortgage loans more affordable.
Security Instruments: Two Views
In an earlier level, we talked about how most states fall into one of two classes: lien theory or title theory. And a few states operate under variations of these theories or a combination of the two.
When it comes down to it, a state’s theory regarding mortgage properties really boils down to whom the state recognizes as the legal owner of the property during the life of the mortgage loan.
Why is this important?
In the event of default on the mortgage loan, ownership rights and protections can significantly influence the foreclosure options of the lender. In general, it is easier for the lender to wrest control of a property if it is already in their name.
With all that in mind, let’s revisit title and lien theories and introduce you to Arizona’s approach.
Title Theory States
Title theory states, like Arizona, are those that convey the title to the lender or, more commonly, to a third-party trustee (operating on behalf of the lender), from inception of the loan up until full payment of the debt.
Because the title to the property already rests with the trustee, rather than with the borrower, foreclosure procedures are usually less complicated and less costly. A nonjudicial foreclosure path is available to the lender because, in signing the note and trust deed, the borrower has waived their right to a court hearing.
Three parties involved in title theory state loan agreements: The borrower (trustor)
The lender (beneficiary)
The trustee (who holds the title on behalf of the lender)
When a title is held by a third-party trustee, it is said to be a naked title, which is a colorful way of saying that the trustee is given the “bare” essentials of rights needed to carry out the terms of the trust.
A chart demonstrating the deeds of trust by three parties.
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Lien Theory States
Lien theory states are those that employ security instruments allowing the borrower, from inception of the loan, to take title while the lender places a lien on the property to secure the loan.
Because the lender doesn’t hold title during the life of the loan, in the event of default, if the lender wants to take possession of the property, it takes a little more effort, and a judicial foreclosure is required.
Two parties involved in lien theory state loan agreements: The borrower (mortgagor)
The lender (mortgagee)
A chart demonstrating mortgages by two parties.
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The Influence of a State’s Theory on Security Instruments
A state’s theory has a direct bearing on the security instrument used.
In lien theory states, the preferred security instrument is usually a mortgage that allows the borrower to hold title to the property while the lender places a lien on the property that is either removed once the loan is repaid or is used to foreclose in the event of default.
In contrast, title theory states rely primarily on a trust deed (aka deed of trust) security instrument, which conveys the title to a third-party trustee to hold on behalf of the lender (beneficiary). If the loan is repaid, the lender instructs the trustee to convey the title back to the borrower.
Recap
Lien theory states tend to favor mortgages.
Title theory states tend to favor trust deeds (deeds of trust).
Arizona is a title theory state.
State Theories Regarding Mortgaged Properties
Although you may have already begun to pick up on the similarities and differences between the two primary types of security instruments, I wanted to pull them all together in one place for you.
Similarities
A mortgage and trust deed each include:
A pledge of the property to secure the promissory note
Provisions or remedies for borrower default of loan
The opportunity to record lender’s interest in the property
Differences
A mortgage and trust deed differ in regards to:
Who holds title to the property during the loan
Number of parties involved
Ease and expense of foreclosure
Security Instrument Comparison Chart
Here’s a snappy little chart that you can refer back to for a quick comparison of the two primary security instruments used in property loan agreements!
A table comparing mortgage and trust deed.
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Comparing Security Instruments
At closing, the borrower signs a number of documents, including the two we just talked about:
A promissory note stating the terms of the loan
A security instrument that designates the property as collateral on the loan
The lien created by the security instrument is then promptly recorded by the mortgage company with the recorder in the county where the property is located. (Prior to closing, the title company would have already completed a title search to rule out any existing liens or claims on the property.)
Protecting the Lender’s Interest
The recording of the security instrument protects the lender’s interest by establishing the lien as the senior mortgage. This ensures that the security instrument will be satisfied first in any future sale of the property. The homeowner and/or any subsequent liens, aka junior mortgages, would have to wait before they could expect to see any funds.
Debt Priority
While we’ll get into debt priority in more detail a little later in this level, for now, just know that the order of recordation is the primary way that priority of debt repayment is established.
This is particularly critical when the sale of a home occurs as a result of a foreclosure. The sale price, under those circumstances, is often for an amount less than what is owed to the lien-holder first in the debt priority line. Consequently, junior mortgages might be hard-pressed to see any funds from the foreclosure at all.
EXAMPLE
Molly has fallen woefully behind on her payments of a $20,000 home improvement loan. Because that loan was recorded after Molly’s original mortgage loan, the home improvement loan is considered a junior mortgage to Molly’s first mortgage.
If the lender of the home improvement loan were to force a foreclosure sale of Molly’s home, any proceeds coming out of that sale would go first to satisfying the outstanding balance on the first mortgage before the lender of the home improvement loan saw a dime.
The junior mortgage lien-holder understands this and has to weigh the pros and cons of taking any action.
Constructive Notice
Constructive notice is a legal term that says that information placed in the public record is assumed to have been accessed by those who have desire, motivation, or need to know it.
It is often referred to as legal fiction because the courts will treat the individuals involved as though they had knowledge whether they do or not. It doesn’t matter, though. Once that knowledge is a matter of public record, the onus is on the public to access it if it is of importance to them.
So, in real estate, when a mortgage or junior lien is placed in the public record through recordation, constructive notice is said to have been given.
Actual Notice
By way of contrast, actual notice is the literal notice that is given directly to an individual.
For example, when someone is served notice that they are a defendant in a lawsuit, they are considered to have received actual notice. Oftentimes, this type of notice is delivered as a legal document by a third party who is prepared to testify, if needed, that the notice was given to the individual served.
State laws will typically designate what situations call for constructive vs. actual notice and what actions fulfill the requirements of each type.
This diagram compares and contrasts the attributes of constructive and actual notice.
Venn diagram showing similarities and differences between Constructive Notice and Actual Notice.
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Recording a Mortgage
Let’s take a look at some of the provisions that your clients are likely to encounter in their mortgage loan agreements.
Granting Clause
The granting clause is the provision that specifies the names of the parties involved, contains the words of conveyance from one party to another, identifies exactly what rights are being conveyed, and provides a legal description of the property.
While the granting clause does not, in itself, convey title, it states that this is what is to happen.
You want to verify that every detail is correct as written in this clause.
Defeasance/Satisfaction Clause
This clause addresses what happens when the terms of the loan agreement are met in full by the borrower.
Defeasance is the term used in title theory states whereas satisfaction is used in conjunction with lien theory states. But both indicate that the borrower has fulfilled their loan obligation and the title can be recorded free and clear in their name.
Acceleration Clause
An acceleration clause makes the entire loan amount due immediately upon default — which might explain why it’s also known as a due-on-default clause. 😉
While typically triggered by default on one or more installment payments, the acceleration clause can actually be used in response to the default of ANY of the terms of the mortgage agreement.
Right to Reinstate Clause
As kind of a response to or as a defense against the acceleration clause — which demands payment in full of the loan balance — the right to reinstate clause provides the borrower a way to get back on track by bringing current any delinquent payments so that they can proceed forward in a pre-acceleration environment, making regular monthly payments under the original terms of the contract.
This clause, when implemented, has the effect of halting the foreclosure process that would be initiated with the acceleration clause.
Due on Sale/Alienation Clause
An alienation clause or due-on-sale clause refers to a provision in the mortgage contract that triggers the right of the lender to demand payment in full of the loan upon the sale or conveyance of the property.
The primary purpose of this clause is to prohibit a new buyer from being able to assume the terms of the original loan without the lender’s approval and involvement.
Under this clause, the lender can approve or prevent someone from assuming the current loan (most loans are not assumable). They can also choose to increase the interest rate upon assumption.
There’s a Form for That
If a lender is open to a loan assumption, an addendum to the purchase contract should be completed.
The new borrower, via complete novation, formally assumes the loan, and the original borrower can be released from responsibility. The original security instrument remains in effect, and the current (principal) balance becomes the loan amount.
Subject To
If a property is purchased in a manner known as “subject to,” the new buyer makes payments to the lender directly even while the original borrower remains responsible for loan repayment.
In the event of foreclosure, the process would remain the same as though the new buyer were not involved. Any deficiency judgment would be pursued against the original borrower.
And to be clear, a property purchased “subject to” an existing loan containing an alienation clause, could trigger acceleration of the balance due on the existing loan.
FHA & VA: Just Say “No” to Alienation
It should be noted that FHA and VA loans do not allow alienation clauses in their loan contracts, but someone wanting to assume one of their loans must be deemed creditworthy.
Power of Sale Clause
This is a clause in which the borrower pre-authorizes the sale of the property via a nonjudicial foreclosure in the event of a default. Funds from the sale would be applied to the unpaid balance on the loan.
Common Clauses
Meet some more common clauses!
Escalation Clause
This clause gives the lender the right to raise interest rates under certain circumstances.
While the escalation clause is probably best associated with adjustable-rate mortgages that tie interest rates to market indexes, even some fixed-rate mortgage loans allow for interest rate hikes in the event of delinquent payments or change in the usage of the property.
Prepayment Clause
Many mortgage loans contain a prepayment clause, which addresses the right of the borrower to pay all or part of the loan early with or without penalty. Those clauses that include a penalty might do so only for a limited period… oftentimes, only for the earliest years of the loan.
Good for Borrower
Prepayment clauses that carry no penalty allow borrowers to pay down their principal early. This reduces the term of the loan and the amount of earned interest the lender will receive. You can see why this is great for borrowers, but not ideal for lenders.
These are, in effect, open mortgages since the borrower can make the end of the term come about whenever they choose to pay off the balance of the loan.
Must Be Present to Win
Because a prepayment penalty cannot be enforced unless it appears in the contract, a prepayment without penalty environment is the default and does not really need a clause to give the borrower that right. Nevertheless, you’ll usually see a clause addressing this issue one way or the other.
The Lock-In Clause
If a lender is intent on prohibiting prepayment altogether, they will include a lock-in clause that stipulates that the borrower pay exactly what is due each month without variance. A lock-in clause, in effect, creates a closed mortgage, meaning the termination date is fixed.
FHA and VA loans do not allow prepayment penalties.
Condemnation Clause
This clause protects the lender by stipulating that if the government were to force a sale of the property via its power of eminent domain, the borrower would be required to apply the funds from that sale towards the satisfaction of the loan.
Exculpatory Clause
This clause protects the borrower in the event of default and foreclosure, stipulating that the property serving as collateral for the loan is, in fact, the only security on the note. The effect of this clause is the barring of the lender’s ability to pursue a deficiency judgment against the borrower.
Subordination Clause
In our earlier discussion on debt priority, we talked about subordination. You learned that, after a foreclosure sale, liens are typically paid off in order of their recordation. You also learned that there might be times when a lender would be willing to subordinate their lien’s debt priority to another existing or anticipated lien — particularly when it serves to strengthen the likelihood of repayment of their loan or increases the value of the property securing their loan.
This clause will appear in a mortgage loan agreement when the lender is amenable to subordination.
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More Clauses You Should Know
Chapter 1 covered lots of good info, Anthony. Let’s do a quick review of some of the important terms, concepts, and principles you’ve learned along the way.
Key Terms
acceleration clause
a clause in a security instrument (mortgage/deed of trust) which makes the entire loan amount due immediately upon default
alienation clause (due on sale) a clause in the mortgage contract that triggers the right of the lender to demand payment in full of the loan upon the sale or conveyance of the property; a.k.a. due on sale
defeasance
a clause in a security document that indicates that the loan has been satisfied and that either the title will be conveyed to the borrower or the lien on the borrower’s title will be removed
lien theory state
state that employs security instruments allowing the borrower to retain title while the lender places a lien on the property to secure the loan
negotiable instrument
a note that is transferable and assignable
promissory note
a negotiable financial instrument that is evidence of a debt and a promise to pay that debt; a.k.a. note
title theory state
state that conveys the title to the lender or, more commonly, to a third-party trustee (operating on behalf of the lender) for the life of the loan
Key Concepts & Principles
Here are the concepts and principles you’ll want to master from this chapter:
Hypothecation
Hypothecation involves the pledging of an asset as collateral to secure a loan for the purchase of that same asset, allowing the purchaser of the asset to enjoy all the benefits of ownership as they work to pay off the loan.
One Mortgage Loan = Two Documents
In actuality, a single mortgage loan or mortgage agreement hangs on two important documents:
The promissory note
The security instrument
Promissory Note Defined
A promissory note is a negotiable finance instrument used in a typical mortgage agreement. It is evidence of a debt and a promise to pay that debt. And, to be clear, it is a contract between the lender and the borrower.
The note, as it is sometimes called, can be secured or not.
A promissory note is a negotiable instrument. Which is to say that it is transferable and assignable.
The Purpose of a Security Instrument
A security instrument pledges the property as collateral, allowing lenders to lower interest rates, making mortgage loans more affordable.
State Theories Regarding Mortgaged Properties
A state’s theory regarding mortgage properties boils down to whom the state recognizes as the legal owner (and title holder) of the property during the life of the mortgage loan.
Title Theory States
Title theory states, like Arizona, are those that convey the title to the lender or, more commonly, to a third-party trustee (operating on behalf of the lender), from inception of the loan up until full payment of the debt.
Three parties involved in title theory state loan agreements:
The borrower (trustor)
The lender (beneficiary)
The trustee (who holds the title on behalf of the lender)
A chart demonstrating the deeds of trust by three parties.
Lien Theory States
Lien theory states are those that employ security instruments, allowing the borrower to take title while the lender places a lien on the property to secure the loan.
Two parties involved in lien theory state loan agreements:
The borrower (mortgagor)
The lender (mortgagee)
A chart demonstrating mortgages of two parties.
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The Influence of a State’s Theory on Security Instruments
In lien theory states, the preferred security instrument is usually a mortgage. In contrast, title theory states rely primarily on a trust deed.
A table comparing security instruments.
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When a Mortgage Is Paid in Full
When a mortgage is used to secure a note and the note is paid in full, a mortgage satisfaction is issued and recorded to clear the title of the lien.
When a Deed of Trust Is Paid in Full
When a deed of trust is used and the note is paid in full, the lender authorizes the trustee to execute what is known as a deed of reconveyance or deed of release.
Protecting the Lender’s Interest
The recording of the security instrument protects the lender’s interest by establishing the lien as the senior mortgage.
Debt Priority
Debt priority, determined by the order of recordation, is the primary way that priority of debt repayment is established.
Constructive Notice
Constructive notice is a legal term that says that information placed in the public record is assumed to have been accessed by those who have desire, motivation, or need to know it.
Actual Notice
Actual notice is the literal notice that is given directly to an individual.
Venn diagram showing intersecting circles, one labeled Constructive Notice with its characteristics and one labeled Actual Notice with its characteristics. The area of intersection lists their similarities.
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Mortgage Provisions
Although there are a few different types of security instruments that can be used to secure a promissory note, many of the clauses used in one type of security instrument are similar to what you would find in another.
Chapter Summary
