Chapters 9 and 10 Notes, Mortgages, and Deeds of Trust

1
Chapters 9and 10Notes, Mortgages, and Deeds of
Trust

• _______________________________________

2
Real Estate Finance

• In this section of the course we look at real
  estate finance.
• Real estate is an expensive economic good. In
  order to be able to buy real estate most people
  must borrow.
• Hence the availability and the cost of credit are
  important factors in real estate transactions.
• Making decisions with respect to borrowing money
  how much to borrow and at what cost is an
  important consideration in making real estate
  purchase and investment decisions.

3
Real Estate Finance

• A person may decide to use debt financing even in
  situations where the person does not have to
  borrow to purchase a desired property. Why might
  a person do this?
• The tax deductibility of interest payments on
  home mortgages can make debt financing a
  relatively cheap source of funds.
• Debt financing can be used to increase investment
  returns through the operation of financial
  leverage.
• With debt financing, the major driver of higher
  returns is that the property owner (the equity
  investor) gets to keep all of any price
  appreciation no matter how much equity was
  invested.

4
Leverage Example

• Mary and Ted Jones purchased a house for
  220,000. They put 20 down, or 44,000. The
  remainder (176,000) was borrowed with a trust
  deed at 6 annual interest, monthly payments, for
  30 years, requiring monthly payments of
  1,055.21.
• At the end of 10 years they sell the house for
  320,000. Over the 10 years they paid off
  28,713 of the loan balance through amortization.
  The cost of sale was 20,000. What is the
  return on their investment?
• 320,000 Selling price
• - 20,000 Cost of sale
• - 147,287 Loan balance (176,000 28,713)
• 152,713 Cash equity realized from sale
  
• - 44,000 Initial equity investment
• 108,713 Profit from house purchase
• The total return on equity 152,713 / 44,000
  347
• The annual return (FV/PV)1/n 1
  (152,713/44,000)1/10 1 13.25 per year.
  And in most cases this return is now tax free.

5
Leverage Example

• The previous example is highly simplified. It
  only looks at the profit from sale.
• On the plus side (a factor that increases the
  benefit of ownership), the example does not take
  into account the tax savings from the tax
  deductibility of mortgage interest and the cost
  of renting comparable housing.
• On the negative side (a cost of ownership), it
  does not take into account monthly mortgage
  payments, and the cost of maintenance, upkeep,
  and improvements.
• After-tax mortgage payments and other costs of
  home ownership should be offset against the cost
  of renting comparable housing.

6
Instruments of Real Estate Finance

• Chapters 9 and 10 focus on the legal aspects of
  the basic instruments of real estate finance the
  promissory note, the mortgage, and the deed of
  trust. In addition, we will briefly examine the
  installment sales contract, which is also called
  the contract for deed and the land contract.
• Two separate instruments are normally involved in
  a real estate loan a promissory note and a
  security instrument.
• The promissory note is evidence of the debt. It
  contains the terms and provisions of the debt.
• The security instrument, either a mortgage or a
  deed of trust, depending on the state, offers the
  property as security for the debt. Either
  instrument gives the lender a lien on the
  property being financed.
• The loan principal is the amount of debt owed it
  is the unpaid loan balance.

7
Promissory Note

• A promissory note is a contract between a
  borrower and a lender that establishes the amount
  and terms of the debt, It is also legal evidence
  that a debt is owed.
• Two basic types of promissory note
• A straight note payments on the note are
  interest-only with repayment of the entire
  principal amount at maturity.
• An installment, or amortized, note payments on
  the note consist of interest and some principal.
  Two basic forms
• A fully-amortized loan payments are sufficient
  to pay off the loan by the end of the loan term
  (by its due date)
• A partially-amortized loan payments are not
  sufficient to pay off the loan by its due date,
  with the result that a balloon payment remains
• If the note is secured by a mortgage or a deed of
  trust, the promissory note must reference it.
  Otherwise, the loan is an unsecured personal
  obligation of the borrower.

8
Promissory Note (Continued)

• On pp. 153-155 of the Jacobus text the basic
  contents of a generic promissory note are
  discussed and illustrated.
• The promissory note contain the terms of the
  loan, such as when the loan matures (the length
  of the loan), amount of the monthly payment, when
  each payment is due, loan interest rate, late
  charges, etc.).
• In addition to the terms of the loan, a
  promissory note also normally contains several
  clauses that establish special conditions
  relating to the repayment of the loan.

9
Promissory Note (Continued)

• The most prominent of these clauses are
• Acceleration clause makes the entire loan due
  and payable upon the happening of some event,
  such if the borrower misses individual payments
• Alienation (due-on-sale) clause a specific type
  of acceleration clause that gives the lender to
  make the entire loan payable in full if the
  property is sold or title is otherwise
  transferred to a new owner. This clause is
  intended to prevent loan assumptions without the
  approval of the lender.
• Prepayment privilege clause (commonly expressed
  as an or more clause in the note) allows
  prepayment of a loan without penalty. Frequently
  stated as the required monthly payment followed
  by or more, such as 720 per month or more
• Prepayment penalty clause establishes a penalty
  for early prepayment

10
The Security Instrument

• The security agreement, either a mortgage or deed
  of trust (trust deed), is a separate agreement
  from the promissory note. Its purpose is to
  offer the property to the lender as collateral in
  case the borrower defaults on the promises made
  in the note.
• The security instrument is commonly referred to
  as the mortgage even when it is a deed of
  trust.
• With either form of security instrument (mortgage
  or deed of trust), the property owner
  hypothecates the described real estate that is
  being offered for security.
• To hypothecate means to give something as
  security without giving up possession of it.
• Through hypothecation, the owner of the property
  (the borrower) agrees to forfeit the property to
  the holder of the security instrument (the
  lender) if the underlying debt is not paid.
  Otherwise, the owner/borrower retains possession
  and all the rights of ownership.

11
Mortgage

• A mortgage is a two-party agreement between a
  borrower and a lender whereby the borrower gives
  the lender a lien on the property as security for
  a loan on the property.
• Mortgages are not commonly used in California,
  but are widely used in many other states.
• In California, the deed of trust is the dominant
  form of security agreement.
• Mortgagor the person (the borrower) who
  hypothecates the property and gives the mortgage
• Mortgagee the person who receives the mortgage
  (the lender)
• Defeasance clause states that the mortgage
  (lien) becomes null and void upon final payment

12
Mortgage Satisfaction

• When a mortgage loan is paid off, the lender (the
  mortgagee) returns the promissory note to the
  borrower along with a formal document called a
  satisfaction of mortgage or a release of
  mortgage.
• This document states the loan has been paid in
  full and releases the property from the lien.
• The release, or satisfaction, should be
  promptly recorded to remove the mortgage as an
  encumbrance on the title.
• Partial Release It releases a portion of the
  mortgaged property. It is used with blanket
  mortgages, which are mortgages that cover more
  than one property.

13
Mortgage Covenants

• See the simplified mortgage instrument on p. 156,
  and the discussion of its contents on pp 155-158
  of Jacobus text.
• In a mortgage (and in a deed of trust), the
  borrower agrees to abide by a number of covenants
  (promises). A breach of any of these covenants
  can trigger default.
• The covenants are not essential to the validity
  of the mortgage. They are placed in the mortgage
  to protect the lenders security interest in the
  property.
• See pp. 157-158 in the Jacobus text for a list of
  common mortgage covenants.
• An assignment of rents clause, which is discussed
  in the Jacobus text in connection with a deed of
  trust (p. 175), can also be found in a mortgage.
  It is typically found in commercial or investment
  property loan transactions.

14
Priorities of Security Instruments

• A single property can be used as collateral for
  more than one loan. After paying the costs of
  foreclosure, the proceeds from the foreclosure
  sale are distributed according the priority of
  claims. Hence, knowledge of the priorities of
  payment are important.
• First mortgage is always the senior mortgage
• Second mortgage, third mortgage, etc. are junior
  mortgages relative to the first mortgage.
  However, a 2nd mortgage is senior to a 3rd
  mortgage, a 3rd is senior to a 4th, etc.
• The time of recording generally determines
  whether loans are senior or junior to one
  another.
• Subordination A lender whose mortgage is
  originally in a senior position agrees to accept
  a lower priority position than a subsequent
  mortgage on the property it subordinates a
  senior mortgage to one that would otherwise be
  junior.

15
Transfer of an Existing Loan

• In some cases a purchaser of a property is able
  to take over an existing loan on the property.
  This can occur without permission of the lender
  if the loan does not contain a due on sale
  clause. Even with the clause, it can occur if
  the lenders permits it and lender chooses not to
  enforce the clause.
• There are two ways that a purchaser of a property
  can take over an existing loan on the property.
  The purchaser may either assume the existing loan
  or purchase the property subject to the existing
  loan. The distinction between them is important
  only when a deficiency judgment is permitted.
• Transfer of a mortgage subject to the buyer
  agrees to take over the payments on the loan, but
  does not become primarily liable for the loan.
  Liability remains with the seller (the originator
  of the loan).
• Transfer of a mortgage by a loan assumption
  the buyer agrees to take over the payments on the
  loan and to become primarily liable for the loan.
  

16
Chattel Liens

• Chattel mortgage a mortgage secured by personal
  property.
• In California and many other states, liens
  against items of personal property are evidenced
  by a financing statement, as provided for in the
  Uniform Commercial Code (a UCC-1 statement).
  These statements have replaced chattel mortgages
• As a general rule, by properly filing and
  recording a financing statement, a vendor
  (seller) of an item of personal property that
  becomes affixed to the real estate can obtain
  priority over any subsequently recorded interest
  in the real estate.
• In this case, the item would remain personal
  property for the purpose of the preserving the
  vendors security interest in the item even if it
  becomes affixed to the real estate.

17
Loan Default

• Default occurs when the borrower fails to meet
  one or more of the obligations of the note or of
  the mortgage (or deed of trust).
• The usual reason for default is that the borrower
  fails to make the loan payments.
• But technically default occurs when any provision
  of a mortgage or note has been violated, such as
  failure to adequately maintain the property,
  failure to pay property taxes or insurance, etc..
  
• When default occurs, lenders do not usually rush
  to foreclose. Lenders are frequently willing to
  make adjustments to the payments and other terms
  of the loan, especially if they believe the
  conditions leading to borrower default are
  temporary.
• However, if after a period of forbearance the
  borrower fails to satisfactorily remedy the
  situation, the lenders recourse is to exercise
  its rights in the security instrument to have the
  owners interest in the property cut off
  (foreclosed) and the property sold for the
  repayment of debt.

18
Loan Default

• The manner in which the lender proceeds to have
  the property sold differs depending on whether
  the security instrument is a mortgage or a deed
  of trust.
• In many states, including California, the lender
  generally must use judicial foreclosure with a
  mortgage.
• With a deed of trust the power of sale provision
  is generally used.

19
Mortgage Foreclosure

• Through judicial (i.e., court ordered)
  foreclosure the lender goes to court to seek to
  cut off the mortgagor's interest in the property
  and to fix a date for sale of the property to
  satisfy the debt. If the judge agrees with the
  mortgagee that foreclosure is called for, the
  judge orders the property to be sold at a public
  sale (an auction) on a specified date.
• During the time period between when the lender
  files for foreclosure and the foreclosure sale,
  the borrower has the right to redeem the property
  by paying off the debt and foreclosure-related
  costs. The right to redeem during this period is
  called the equity of redemption.
• Following a foreclosure sale, most states provide
  the mortgagor with a statutory right of
  redemption, which allows the mortgagor to redeem
  the property within a certain period of time
  after the foreclosure sale. Note that this is
  different from the mortgagors equity of
  redemption. The latter precedes, and is cut off
  by, the foreclosure sale.

20
Statutory Redemption

• To redeem during the statutory redemption period,
  the mortgagor must pay the costs of the sale and
  foreclosure fees, the purchaser's sale price, and
  any unpaid mortgage debt and interest.
• In states with a statutory redemption period, the
  purchaser of the property at a foreclosure sale
  typically receives a certificate of sale, which
  may or may not allow the purchaser to take
  possession.
• At the end of the statutory redemption period, if
  the property has not been redeemed, title is
  conveyed by a sheriff's deed.
• In California, there is a one year period of
  statutory redemption following judicial
  foreclosure on a mortgage. However, there is no
  statutory redemption following foreclosure on a
  deed of trust.
• In Calif., during the statutory redemption period
  the purchaser of the property at the foreclosure
  sale is not permitted to take possession. The
  mortgagor can retain possession during this
  redemption period, but can be required to pay
  rent. The uncertainty created by statutory
  redemption is a major deterrent to the use of
  judicial foreclosure.

21
Power of Sale Clause

• In many states other than California, mortgages
  may contain a power of sale clause. In
  California, however, the lender must use judicial
  foreclosure with a mortgage.
• A power of sale clause gives the mortgagee
  (lender) the right to conduct the foreclosure and
  sell the property without going through a court,
  i.e., without a judicial proceeding.
• A power of sale clause can reduce the cost, the
  time, and uncertainty of a foreclosure compared
  with foreclosure through a judicial proceeding.
• In California, a power of sale is included in a
  deed of trust. The power of sale is given to a
  third party, called a trustee. We will see more
  about this later.

22
Deficiency Judgment

• If a property sells in a foreclosure sale for
  less than the amount of the debt, the lender may
  be able to pursue a deficiency judgment against
  other assets of the borrower.
• A deficiency judgment is not permitted with a
  power of sale because only a judge can award a
  lender a deficiency judgment. Recall that a
  power of sale occurs out of court.
• In California, deficiency judgments are only
  permitted with mortgages, not deeds of trust.
  Moreover, even with mortgages, deficiency
  judgments are not permitted with purchase money
  mortgages on one-to-four unit residential
  properties if the owner lives in one of the
  units.
• However, an exception to this no deficiency
  judgment rule with deeds of trust are FHA and VA
  mortgages. These are subject to federal law,
  which overrides state law. The FHA and VA can
  seek deficiency judgments.

23
Deed of Trust Parties

• A deed of trust, commonly called a trust deed. A
  deed of trust is a mixture of mortgage law with
  some elements of trust law.
• A deed of trust involves three parties it is
  created through a three-party transaction
• Borrower Trustor
• Lender Beneficiary
• Neutral Third Party Trustee

24
Deed of Trust Parties (Continued)

• The trust deed, title, and the power of sale are
  conveyed to the trustee, holds these as security
  for the debt. A trust deed technically moves
  title, whereas a mortgage does not.
• The title that the trustee holds is bare naked
  legal title, which is title in name only.
• Technically, the borrower holds a reversionary
  title to the property, which reverts back to it
  upon payment of the debt.
• The beneficiary (lender) holds the promissory
  note.
• The borrower retains full rights of ownership
  along as he/she remains in good standing with
  respect to the loan.
• The provisions of a trust deed are described and
  illustrated on pp. 175-178 of the Jacobus text.

25
Deed of Trust Loan Payoff

• When the debt is paid in full, the beneficiary
  instructs the trustee to convey title back to the
  trustor (borrower).
• The trustee returns title to the trustor by a
  deed of reconveyance.
• Like a mortgage release, this document provides
  evidence that the debt has been paid and that the
  title has been returned to the borrower.
• In effect, this document gives notice to the
  world that the property is free and clear of
  the encumbrance that the debt had placed on the
  property.
• Like a mortgage release, this document should be
  promptly recorded.

26
Foreclosure Under a Deed of Trust

• In California, with a deed of trust, the lender
  (beneficiary) has the choice of foreclosing
  through judicial foreclosure or by exercising the
  power of sale provision in the trust agreement.
• More than nine times out of ten California
  lenders choose to foreclose using the deed of
  trust.
• A lender may choose to use judicial foreclosure
  if it wants to seek a deficiency judgment. The
  trade off is that if it is foreclosed as a
  mortgage the trustor is allowed a one-year period
  of redemption.
• Following a payment delinquency and a permitted
  grace period, once the beneficiary (the lender)
  determines that the trustor (the borrower) is
  unable or unwilling to make the required
  payments, it will order the trustee to file and
  record a notice of default in the county in which
  the property is located.

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Foreclosure Under a Deed of Trust (Cont.)

• Within 10 days after filing a notice of default,
  a copy of the notice must be sent by registered
  mail to the borrower, junior lienholders, and any
  person who filed a request for notice
  (discussed below) with the county recorder.
• The borrowers equity of redemption begins with
  the filing and recording of the notice of
  default.
• The notice of default must run a minimum of 3
  months before any further action can be taken.
• During this period, the borrower can redeem the
  property by paying all delinquent payments,
  penalties, trustees fees, and other foreclosure
  costs incurred to date.
• In Calif., the right to redeem is called the
  right of reinstatement.
• The right of reinstatement runs until 5 days
  prior to the date set for the trustees sale in
  the notice of sale (discussed below).
• At the lenders discretion, the borrower may even
  be allowed to reinstate until right up to the
  date of sale.

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Foreclosure Under a Deed of Trust (Cont.)

• If the trustor fails to reinstate the loan during
  the 3-month period of default notice, the trustee
  will then file and record a notice of sale.
• This notice must be published in a newspaper of
  general circulation in the county in which the
  property is located at least once every 7 days
  for a three week (21-day) period.
• The notice must also be posted in at least one
  public building, such as the courthouse, and in a
  conspicuous place on the defaulted property.
• A public foreclosure sale, called the trustees
  sale, is then held at the time and place stated
  in the notice of sale.
• All bids must be for cash or acceptable cash
  equivalent (such as a cashiers check), except
  for the beneficiary (lender) who may bid the
  amount of indebtedness in lieu of cash.

29
Foreclosure Under a Deed of Trust (Cont.)

• The property is sold to the highest bidder, which
  frequently is the lender.
• Any funds received in excess of payoff of the
  senior lien and of foreclosure costs goes first
  to pay off junior lienholders in their order of
  priority, and any money left over is returned to
  the trustor.
• The trustee grants a trustees deed to the
  highest bidder, which conveys to the purchaser
  title to the property in the form that it was
  held in by the former owner.
• However, a trustees sale removes all debt
  encumbrances on the property.
• The trustor must vacate the property immediately
  after the trustee sale. The purchaser is
  entitled to immediate possession.
• No right of redemption exists following the
  trustee sale.

30
Rights of Junior Lienholders

• Liens of all junior debt lienholders as well as
  the senior lienholder are extinguished by a
  trustee (foreclosure) sale.
• In light of the danger to its interests posed by
  a pending foreclosure, a junior lienholder is
  given some rights to protect those interests.
• In general, the same rights apply to junior
  mortgage and junior trust deed holders.
• California law requires the senior lienholder on
  the property to send copies of any notice of
  default and notice of sale to all holders of
  liens.
• To be doubly sure of being notified in a timely
  manner, the junior lienholder will want to file
  and record a request for notice of default.

31
Rights of Junior Lienholders (Cont.)

• Once the foreclosure process has begun, any
  junior lienholder can step in and make the
  trustors (mortgagors) payments to all senior
  lienholders, and thereby stop foreclosure.
• The payments made by the junior lienholder are
  then added to the balance owed by the borrower
  (trustor or mortgagor) to this lienholder.
• If the borrower fails to meet its payment
  obligations on a junior loan, the junior
  lienholder can foreclose under the foreclosure
  provisions of the second trust deed (or
  mortgage).
• The successful bidder at the trustees sale
  becomes the owner, subject to the provisions of
  the senior deed of trust.
• The rights of the senior lienholder are not
  extinguished by the junior lenders trustees
  sale.

32
Summary of Major Differences between a Deed of
Trust and a Mortgage in Calif.

• A mortgage requires judicial foreclosure, whereas
  a deed of trust makes use of the power of sale
  provision in the trust agreement.
• The time between default and foreclosure is
  normally shorter with the exercise of the power
  of sale than with judicial foreclosure.
• A deficiency judgment is permitted with
  mortgages, except purchase money mortgages on 1-4
  unit owner-occupied residential properties. No
  deficiency judgment is permitted with a deed of
  trust.
• A required one-year statutory redemption period
  follows judicial foreclosure, whereas there is no
  statutory redemption following a trustee sale.
• During the one year statutory redemption period
  the purchaser of the property at a judicial
  foreclosure holds only provisional title and
  cannot take possession, whereas following the
  trustee sale the purchaser obtains title and can
  take immediate possession.

33
Deed of Trust Advantages

• Upon default, the lender can take possession of
  property and collect rents
• Time between default and foreclosure is short
• Power of sale provision allows for a more speedy
  foreclosure process
• Trustee already has title
• Usually no statutory redemption

34
Land Contract

• A land contract, or an installment sales
  contract, is another type of real estate
  financing instrument. It is both a purchase
  contract and a financing instrument.
• A land contract is widely used for land
  purchases. It is also an alternative for
  financing other real estate purchases in cases
  where the purchaser has difficulty qualifying for
  an institutional mortgage loan.
• The buyer (called the vendee) agrees to purchase
  the property through a series of installment
  payments made to the seller (called the vendor).
  The seller is the lender.

35
Land Contract (Continued)

• The seller gives up use and possession of the
  property to the buyer, but retains legal title as
  a security device until a certain number of
  payments are made, after which title is conveyed
  to the buyer.
• Although legal title remains with the seller, the
  courts today recognize that a contract of sale
  conveys an equitable title to the buyer. Thus,
  in the interim between the signing of the
  contract and the seller delivering the deed the
  buyer holds equitable title to the property.
• An equitable title is the right to legal title if
  all the conditions are satisfied. An equitable
  title means that a person is entitled to receive
  title, even though he or she doesnt have it yet.

36
Comparison of a Mortgage, Deed of Trust, and Land
Contract (Figure 10.5, p. 179)