Mortgage history & Instruments Flashcards
Before the Great Depression, mortgages were fairly unregulated, and the systems in which they existed were all fairly localized. But even without a regulated system of home loans, most mortgages looked fairly similar to one another during this period of American history. Most of them had the following characteristics:
Local Lenders
The mortgage lender was commonly a local bank. For example, a farmer looking to get a mortgage for some land would probably go to the local agriculture bank.
Interest Only
Interest is additional money paid to a lender for the use of their money. Interest is calculated as a percentage (or rate) of the loan amount. For most modern residential mortgage loans, the borrower pays down the balance of the loan and interest at the same time. Before the modern mortgage though, borrowers’ payments would only go towards interest. Whenever the mortgage was due, the borrower would owe the total loan balance.
Shorter Terms
As you’ll see in a bit, modern mortgages are frequently paid off over a 15- or 30-year period. This is a stark difference to what they used to look like. Mortgages used to have very short terms, often ranging from three to five years. This means that a buyer would have only a few years to pay off the loan balance.
In practice, borrowers would usually get to the end of their loan term and then refinance the loan to restart the loan term, essentially getting another loan to pay off the original.
Less Money Loaned
The loan-to-value ratio of these mortgages was usually less than 50%. What this means is that homebuyers were using their own money for over half of the cost. For example, if a mortgage on a $100,000 property purchase has a 40% loan-to-value ratio, the loan is $40,000 and the buyer pays for the remaining amount ($60,000) themselves.
Because the homebuyer had to have such a large amount of the home price available when buying a property, it was a real hurdle for a lot of people to be able to afford to buy a home.
And this is how mortgages worked until the Great Depression changed everything.
Early Versions of Mortgages
Another agency birthed out of the financial restructuring following the Great Depression was the Federal Housing Administration, or FHA. The FHA was created by the National Housing Act of 1934 to provide mortgage insurance on loans made by FHA-approved lenders throughout the United States.
It was intended to regulate interest rates and the terms of mortgages that it insured. These new lending practices increased the number of people who could afford a down payment on a house and monthly payments on a mortgage, thereby increasing market size for single-family homes.
Protecting Lenders, Helping Borrowers
FHA mortgage insurance provides lenders with protection against losses due to homeowners defaulting on their mortgage loans. The lenders assume less risk because FHA will pay a claim to the lender in the event of a homeowner’s default. And because the lender bears less risk, they can afford to give borrowers more favorable terms.
The creation of the FHA introduced many valuable mortgage services to the market. Case in point – the 15-year and 30-year mortgage terms that dominate the mortgage market today. The FHA also worked to reduce the typical down payment required on real estate purchases.
Loans that met the FHA’s standards of approval were known as FHA-insured loans. There were also numerous neighborhoods built across the country known as FHA-insured neighborhoods. These efforts increased access to mortgage loans for new homebuyers and encouraged lending activity.
The FHA Today
Currently, the FHA insures mortgages on single-family and multifamily homes (including manufactured homes and hospitals). It is the largest insurer of mortgages in the world, insuring over 34 million properties since its inception.
Additionally, the FHA is the only government agency that operates entirely from its self-generated income and costs the taxpayers nothing. The proceeds from the mortgage insurance paid by the homeowners are entirely sufficient to maintain the program.
Federal Housing Administration (FHA)
Lenders typically will require most borrowers to make a monthly payment that includes payment of the principal (loan balance amount) and interest (the cost of borrowing the money), plus an amount equal to 1/12th of their annual tax bill and 1/12th of the annual home insurance bill.
The tax and insurance payments are deposited into an escrow account for the servicing agency of the loan to pay the annual taxes and insurance on behalf of the property owner.
These monthly payments are referred to as PITI, which stands for principal, interest, taxes, and insurance.
Talkin’ ‘Bout Interest
Interest is additional money paid to a lender for the use of their money. Interest is calculated as a percentage (or rate) of the loan amount.
In real estate lending, interest rates determine how much the borrower will pay in interest over the course of a year. Put most simply, if I borrow $100 with a 1% interest rate, I will pay $1 in interest over the year.
In loan terms, the rate of interest is usually expressed as an annual percentage rate (APR). Mortgage interest rates can vary, and as you’ll see later in this level, can make a huge difference in what the borrower ends up paying over the life of the loan.
Mortgage Payments
To receive the funds of a loan, a borrower needs to sign a promissory note, oftentimes just called the note. In a promissory note, the borrower acknowledges their debt to the lender and promises to repay the holder of the note.
Think of a promissory note like a grown-up IOU. Another way to remember it is that the borrower is promising to repay the loan.
2 agents in an office: 1 holds a note that reads I.O.U. one million dollars, the other relaxing in a chair.
The Terms of a Note
The promissory note specifies:
The amount of the debt
The rate of interest
The date on which interest charges are to begin
The amount and terms of repayment
The note is the complete contract. It is the agreement of the loan terms between the borrower and the lender.
Transferrable to Future Lenders
Notice above that I said the borrower promises to repay the holder of the note. I didn’t say, “promises to repay the lender.”
That’s right, a party who is not the lender could end up holding the note. This is because promissory notes are a negotiable instrument. This means that it can be sold to another investor or lender (more on that when we talk about the secondary market). And because the note can be transferred, a typical promissory note will not include reference to paying back a specific lender.
Recap: If a lender sells a borrower’s loan to another bank, the borrower will owe repayment to the new bank.
What Is a Note?
Promissory notes are either secured or unsecured:
A secured note references a security instrument (either a mortgage or deed of trust) as security for the loan.
An unsecured note doesn’t reference a security instrument.
Secured Notes
A secured note will make reference to the security instrument that secures it — either a mortgage or a deed of trust. In essence, a secured note is backed up by the borrower’s assets, otherwise known as collateral.
EXAMPLE
A borrower signs a promissory note and a mortgage document that secures the note with their house as collateral. The borrower later defaults on their mortgage payments. The lender could then foreclose on the borrower’s home in order to pay for the loan.
Unsecured Notes
In contrast, unsecured notes do not reference security instruments; they only have the borrower’s promise that the debt will be repaid. For this reason, unsecured notes create the most risk for lenders. And because of the high risk, interest rates on unsecured notes are usually much higher than on secured notes.
A lender will look very carefully at the borrower’s credit history before granting them an unsecured loan.
And whether it is a secured note or an unsecured note, it will require the signature of the borrower as an acknowledgment of their debt to be paid. It is not required that the lender sign the note, as notes are transferable.
Securing a Note
One important point to reinforce is that promissory notes in and of themselves are not secured by assets. A secured note is actually secured through its reference to a security instrument.
What’s a security instrument, you ask? A security instrument is a generic term that refers to any document that gives lenders a claim to a borrower’s property in order to secure a loan. In real estate, the security instrument will usually be a mortgage.
Mortgage
Let me say it again in different words: While most people think of a mortgage as the actual loan, the term “mortgage” specifically is a security instrument used by lenders to secure a promissory note. Here’s how a promissory note and a mortgage work together:
Promissory note (borrower’s promise and loan terms): States the terms of the loan and is also where the borrower promises to repay the loan
Mortgage (the collateral): States that the lender and borrower agree that if the borrower does not keep their promise (in the promissory note), the lender can take ownership of the property
Creating a Lien
Another way to say it is that a mortgage is a pledge of property as collateral for the loan.
The mortgage creates a claim that the mortgage holder (lender) has on the property, otherwise known as a lien.
Two-Party Instrument
Mortgage documents are two-party instruments:
Mortgagor: The person who takes out the loan (the borrower)
Mortgagee: The organization or person who lends the money (the lender)
You really, really need to memorize the differences between mortgagor and mortgagee. To help you, be sure to look at the suffixes (the last part of the words).
The suffixes -or and -er refer to a person or object that does a specified action. An employer employs people. A mortgagor (borrower) receives a loan from a bank in exchange for creating a mortgage (the security instrument) for their bank.
The suffix -ee refers to a person or object that receives the action. An employee is employed; they don’t employ. Likewise, a mortgagee (lender) receives the mortgage from the borrower. Another fun way to think about it is that the mortgagee has the money!
The Duties of a Mortgagor
The mortgage is a security instrument that works to secure repayment of the loan. Because the loan is secured by a property, there are various ways that a borrower could default, which could lead to foreclosure (the seizing of the collateral from the borrower). To avoid default, the mortgagor must:
Keep the property in good repair
Keep the property insured
Pay all taxes and assessments
Pay the debt insured by the mortgage
Hypothecation
A good vocabulary word for all of this is hypothecation. It refers to granting real property (hypothec) as collateral for a mortgage loan. Basically describing a secured note.
Drop that word at your next meeting and you’ll probably be considered brainiest agent at the brokerage!
Security Instruments
States are divided into two classes, depending on their legal treatment of security instruments. States are either lien theory states or title theory states.
Lien Theory
Let’s start with lien theory. In a lien theory state, if a home is purchased with a mortgage, the borrower holds the title to the property. So, even though the lender paid for most of the cost of the property, the borrower holds the title.
The lender doesn’t hold the title, but they do have a mortgage lien on the property. This way, the lender still has the power to foreclose on the borrower if they default on the loan. The lien is removed from the property once the borrower pays off the loan in full.
In a lien theory state, the preferred security instrument is a mortgage.
Title Theory
Arizona, however, is considered a title theory state. In a title theory state, when a home is purchased with a mortgage instrument, the title of the home is held by a trustee until the mortgage debt is fully paid off. This theory will get a little clearer once I explain the concept of a deed of trust.
If the trustor defaults, the beneficiary can foreclose on the property without the involvement of judicial proceedings. It is easier and faster for lenders to file for foreclosure on properties in title theory states.
It’s easier because the beneficiary already owns the title of the property (through the trustee’s holding of the deed of trust).
The Differences
While they differ in theory, lien theory and title theory states don’t differ greatly in practice in the real world. In general, lenders can always use security instruments (mortgages and deeds of trust) to secure the title to a property if the borrower defaults on payments.
Lien Theory vs. Title Theory
You’ve learned about the mortgage as a security instrument. Mortgages aren’t the only form of security instrument. In a lot of areas of the country, people use deeds of trust to secure promissory notes.
What Is a Trust?
Before we talk about a deed of trust, let’s talk about what a trust is.
A trust is a fiduciary arrangement where a person (trustee) holds property as its nominal owner on behalf of a beneficiary. The most common example of a trust is when someone (a trustor) creates a trust to manage their wealth so it can be distributed to their heirs (beneficiaries).
The Deed of Trust
A deed of trust is similar; it’s a trust used in real estate to allow lenders to ensure they secure a borrower’s property.
A deed of trust is a right to real property being held by one party for the benefit of another. Whereas a mortgage creates a lien on a property for the lender, a deed of trust literally gives the right to the property to another party.
With a deed of trust, the right to real estate is held by another party until the terms of the loan are satisfied. There are two things that can happen:
If the borrower pays off the loan, the third party will reconvey the property to the borrower.
If the borrower defaults on the loan, the third party will reconvey the property to the lender.
A deed of trust is different than a mortgage in a few other ways, but most notably in its treatment of foreclosures and in the number of parties involved.
Foreclosure is easier with a deed of trust, because the third party holding the deed can easily reconvey the property back to the lender. Using a mortgage as a security instrument, the lender needs to get the deed back from the borrower, who could potentially try and delay the process.
The Parties to a Deed of Trust
The parties involved in a deed of trust are different than those involved in a simple mortgage, too. They include:
Trustor: the person who takes a loan out from a bank (the borrower)
Trustee: a third party holding the right to the property
Beneficiary: the organization or person who lends money (the lender)
The Deed of Trust
Within a deed of trust setup, the trustee is a third-party fiduciary and the one who holds the bare title to the real estate. The trust deed sets out the terms of the deal, including installment payments, interest rates, late penalties, and default provisions.
The Power of the Trustee
The trustee is pretty much a holding party. Their role is to hold the title while the trustor works to pay off the debt to the lender. The trustee’s only real power comes into play if the trustor defaults on their payments.
If the trustor defaults, the beneficiary (lender) could tell the trustee that they want to foreclose on the property. The trustee would then proceed with the foreclosure and handle the selling of the property at a foreclosure auction.
The proceeds of the sale would go towards paying off the rest of the loan and any cost from the sale. If there is anything left over after making those payments, the money would return to the trustor.
The Deed of Reconveyance
If the trustor pays off their debt in full, the trustee issues a deed of reconveyance. This deed of reconveyance releases the title to the trustor, who then owns the property outright.
The Trustee
Where do mortgages come from? Well, in the next chapters we will learn all about where they come from and where they go. For now, know that most loans come into being through a mortgage loan originator.
The originator is an institution or individual that works with a borrower through the lending process. The originator will take the application from the buyer and help begin the process of qualifying both the buyer and the property that will serve as security for the loan.
Types of Mortgage Originators
Two common types of mortgage originators are mortgage bankers and mortgage brokers.
Mortgage bankers usually work for a financial institution and are able to loan the money directly from their institution.
Mortgage brokers have NO money to lend. They bring lenders and borrowers together. The mortgage broker usually does business with many lenders and will guide the buyer to the program that will be the most beneficial for the buyer.
The Mortgage Broker’s Role
The mortgage broker will usually take the application and process the file. At some point they will turn the file over to the company that will be creating the loan. The loan company will fund the loan.
After that, the loan can be taken to the secondary market. And don’t worry, we’ll talk more about the secondary mortgage market in a few chapters.
Mortgage Loan Origination
There are a number of different ways a loan can be paid off. As I discussed earlier, for a long time, mortgages were “interest-only,” which resulted in large balloon payments at the end of the loan terms. These kinds of mortgages still exist today, but will usually be seen in commercial real estate, not residential.
Residential mortgages will usually be paid off in portions over the term of the loan, or, amortized. The word amortization originates from a Latin term that means “killing off.” 💀
If the note is to be amortized, there will be equal monthly payments that contribute to both principal and interest until the entire loan is paid. The payments will be credited first to the interest when due, with any remainder credited to the principal. Fully amortized loans usually have higher payment amounts than other types (interest-only, partially amortized), but are consistent in the amount that has to be paid.
Amortized loans are always paid in regular intervals, usually monthly. When the last monthly payment happens, the loan is paid in full.
Negative Amortization
With amortized loans, the interest is paid in arrears. This means that the borrower is paying for borrowing the money after they have already been “using” it for a period of time. Another way of saying this is that they’re paying for what they already owe instead of paying for what they will owe. This is different from when you are renting a property and pay rent. Rent is paid in advance, instead of in arrears, because you’re paying to live there for the following month.
If the payment being made is not sufficient to cover the interest due for any payment period (let alone the principal), the unpaid interest is added to the principal balance. This is known as negative amortization or deferred interest.
Amortization
A default is a failure to fulfill an obligation.
Causes of a Default
A borrower could default on their mortgage for:
Being delinquent in payments
Failure to pay property taxes
Failure to maintain the mortgaged property to a standard
Failure to keep the mortgaged property sufficiently insured
These should look familiar. I mentioned them when we talked about the duties of a mortgagor.
Foreclosure
And what happens if a borrower remains in default for an extended period of time? Well, some lenders allow a grace period which gives the borrower a little extra time to make the payment without penalty.
But, if the borrower continues to not remedy the default, eventually they will probably be foreclosed upon. Foreclosure is the legal process whereby a lender takes control of a property held by a borrower in default and sells it to recover the lender’s losses.
Foreclosure usually happens only when the alternatives provided by the lender are not enough to allow the borrower to repay the loan amount. A lender might work with the buyer to modify the loan and reduce the payments or interest rate, or they could help develop a payment plan.
But, as a general rule, if the borrower remains delinquent for three to four months and has not worked out a repayment plan, the lender will begin the foreclosure process.
A model house on a table along with some cash and a judge’s gavel.
Types of Foreclosure
There are two main types of foreclosure:
Judicial foreclosure: A foreclosure that is processed through the court
Nonjudicial foreclosure: A foreclosure that does not involve a suit or ruling of the court; the two types are power-of-sale foreclosures and strict foreclosures
Judicial Foreclosure
A judicial foreclosure is a foreclosure that is processed through the court.
At the foreclosure proceedings, all creditors with a claim against the property appear and present evidence of their claim. The court recognizes the claims and their priority and then orders a public sale of the foreclosed property.
Nonjudicial Foreclosure
A nonjudicial foreclosure is one that does not involve a suit or ruling of the court. There are two types of non-judicial foreclosures:
Power-of-sale foreclosures
Strict foreclosures
Some mortgage documents contain a power-of-sale clause, which allows the lender to perform a power-of-sale foreclosure. A power-of-sale foreclosure bypasses the courts and takes possession of and sells a collateral property when the borrower defaults on their loan.
In a strict foreclosure, the lender gives notice of the default, and, if it is not paid in some specified time period, the lender may foreclose on the property, eliminating the borrower’s redemption rights (both equitable and statutory).
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Defaults
A borrower in default can prevent a foreclosure or redeem (regain possession of) their property through a process called redemption. There are two types of redemption:
Equitable Redemption
Equitable redemption occurs before the foreclosure sale (auction) of a property.
It is derived from common law and allows defaulting debtors to pay the defaulted portion of the debt (as well as costs the lender incurred) in order to reinstate the loan and prevent a foreclosure sale. Other parties with an interest in the real estate also can pay the defaulted portion off, in which case the debtor usually becomes responsible to that party for the redemption cost. The redeemer must pay the entire loan at this time if the debt has been accelerated.
Statutory Redemption
Some states allow debtors to redeem a property after a foreclosure sale. This is known as statutory redemption.
Statutory redemption occurs after the foreclosure sale (auction) of the property. A statutory redemption period gives debtors a specified length of time to recover their property. Unlike equitable redemption where the foreclosure sale is prevented altogether, statutory redemption allows debtors to regain possession of the property after the sale.
Redemption on Mortgage Foreclosures
Speaking of selling a property, what does it look like to sell a property that has a mortgage? Well, there are a few different things that could happen:
The property is sold with a free and clear title, meaning that after closing, the seller’s mortgage is gone and the buyer will have full liability to pay for the property however they choose to do so.
The property is sold subject to the mortgage, meaning the buyer receives the deed and owns the property but the seller is still fully liable for paying the mortgage. The buyer makes payments to the seller, who makes payments to the lender.
The property is sold with the buyer assuming and agreeing to pay the mortgage debt, meaning the buyer assumes all liability for paying off the seller’s original loan. The seller is safe if the buyer defaults.
Subject-to Loans
As I said, a property can be sold subject to the mortgage. This type of transaction gives the buyer the title to the property but lets the seller’s financing remain in place.
The big idea here is that the lending institution is not informed of this change in title holder. It’s a big no-no for a lot of mortgages and violates the terms of a lot of loans — but it allows the buyer to obtain financing without all the overhead costs. It also allows the buyer to obtain the property more quickly, without having to go through the long process of loan origination. Selling via a subject-to transaction effectively creates a wraparound mortgage (more on that later), but with fewer legal structures in place to protect the buyer or seller.
Loan Assumption
The act of taking on a previous borrower’s loan is called assumption. In most cases, the lender will need to approve any loan assumption.
When a borrower assumes a seller’s loan, they are taking on the liability of the loan, so the seller is then free from having to worry about that loan.
Why Assume?
Assuming a seller’s loan can be very valuable for a buyer if interest rates are rising and there is a low rate on the loan they are assuming.
If the seller bought the home in 2014 with a 3.5% interest rate on a loan and then sells the property in a few years later when interest rates rose, it would probably be to the buyers’ advantage to buy the seller’s equity (remember, equity is the difference between the value of the property and the current loan balance) and assume the seller’s old loan.
Selling a Property with a Mortgage
Even though many people have a working knowledge of mortgages, there are a ton of complexities the average homeowner might not fully understand. As an agent, it will be extremely important for you to be a resource to your clients when they need help navigating the murky waters of real estate financing. Let’s review some of the important terms, concepts, and principles that you just learned!
Key Terms
Here are the key terms you learned in this chapter:
Federal Housing Administration (FHA)
government agency charged with insuring mortgages
Federal Deposit Insurance Corporation (FDIC)
independent agency that provides deposit insurance to depositors in U.S. banks
Federal Reserve System
centralized United States bank created to conduct monetary policy and stabilize the U.S. economy
mortgage
a legal agreement between a creditor and borrower in which the creditor lends money with interest to the borrower for the purchase of property with the condition that the creditor takes ownership of the title if the borrower defaults in repayment of the loan
mortgagee
the organization or person who lends the money in a loan (the lender)
mortgagor
the person who takes out the loan (the borrower)
collateral
property liened by a lender in order to assure payment of the loan and protect the lender’s investment
equity
the portion of a property’s total value owned outright by the holder to title
leverage
the use of a financial instrument or borrowed money to increase a return on investment
amortization
when a borrower’s payment is not large enough to cover the interest due on a loan, the unpaid interest is added to the principal balance
security
the collateral for a loan
arrears
payment that occurs at the end of a period to compensate for charges accrued during that time
annual percentage rate (APR)
how much the borrower will pay in interest over the course of a year
qualification
when a lender decides whether they want to give a loan to a hopeful borrower, and if so, what the terms of the loan would be
foreclosure
the legal process whereby a lender takes control of a property held by a borrower in default and sells it to recover the lender’s losses
assumption
the process of transferring the obligation of the mortgagor to another party who takes over the responsibility to pay the note
Key Concepts & Principles
Here are the concepts and principles you’ll want to master from this chapter.
Financing Basics
A mortgage is a loan used to buy real property. Modern financing as we know it was born out of the New Deal, which was put in place to help Americans out of the Great Depression. In the early to mid-1930s, institutions and legislator created to help restructure financing and the housing market included:
Federal Deposit Insurance Corporation (FDIC)
Home Owners’ Loan Corporation Act
Federal Home Loan Banks (FHLBs)
Federal Housing Administration (FHA)
Types of Foreclosures
Foreclosure is the legal process whereby a lender takes control of a property held by a borrower in default and sells it to recover the lender’s losses. Foreclosure usually happens only when the alternatives provided by the lender are not enough to allow the borrower to repay the loan amount. There are two main types of foreclosure:
Judicial foreclosure: a foreclosure that is processed through the court
Non-judicial foreclosure: a foreclosure that does not involve a suit or ruling of the court; the two types are power-of-sale foreclosures and strict foreclosures
Lien Theory vs. Title Theory
States are divided into two classes, depending on their legal treatment of security instruments. States are either lien theory states or title theory states. In a lien theory state, if a home is purchased with a mortgage, the borrower holds the title to the property. In a title theory state, when a home is purchased with a mortgage instrument, the title of the home is held by a trustee until the mortgage debt is fully paid off. Arizona is considered a title theory state.
Deed of Trust
A deed of trust is a trust used in real estate to allow lenders to ensure they secure a borrower’s property. With a deed of trust, the right to real estate is held by another party until the terms of the loans are satisfied. Deeds of trust include three parties, which are:
Trustor: the person who takes a loan out from a bank (the borrower)
Trustee: a third party holding the right to the property
Beneficiary: the organization or person who lends money (the lender)
Chapter Summary
