Understanding the Time Value of Money

In order to understand real estate financing, it is important that you understand the time value of money. Because of inf lation, a dollar today is generally worth less in the future. Thus, while real estate values may increase, an all-cash purchase may not be economically feasible, because the investor’s cash may be utilized in more effective ways. The cost of borrowing money is expressed in interest payments, usually a percent of the loan amount. Interest payments can be calculated in a variety of ways, the most common of which is simple interest. Simple interest is calculated by multiplying the loan amount by the interest rate, then dividing it up into period (12 months, 15 years, etc).

Example: A $100,000 loan at 12% simple interest is $12,000 per year, or $1,000 per month. To calculate monthly simple interest payments, take the loan amount (principal), multiply it by the interest rate, and then divide by 12. In this example, $100,000 °— .12 = $12,000 per year ÷ 12 = $1,000 per month.

Mortgage loans are generally not paid in simple interest but rather by amortization schedules (discussed in Chapter 4), calculated by amortization tables (see Appendix A). Amortization, derived from the Latin word “amorta” (death), is to pay down or “kill” a debt. Amortized payments remain the same throughout the life of the loan but are broken down into interest and principal. The payments made near the beginning of the loan are mostly interest, while the payments near the end are mostly principal. Lenders increase their return and reduce their risk by having most of the profit (interest) built into the front of the loan.

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What Is Foreclosure?

Foreclosure is the legal process of the mortgage holder taking the collateral for a promissory note in default. The process is slightly different from state to state, but there are basically two types of foreclosure: judicial and nonjudicial. In mortgage states, judicial foreclosure is used most often, whereas in deed of trust states, nonjudicial (called power of sale) foreclosure is used. Most states permit both types of proceedings, but it is common practice in most states to exclusively use one method or the other.

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The Deed of Trust

Some states (e.g., California) use a document called a “deed of trust” (AKA “trust deed”) rather than a mortgage. The deed of trust is a document in which the trustor (borrower) gives a deed to the neutral third party (trustee) to hold for the beneficiary (lender). A deed of trust is worded almost exactly the same as a mortgage, except for the names of the parties. Thus, the deed of trust and mortgage are essentially the same, other than the foreclosure process.

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The Mortgage in Detail

The security agreement executed by the borrower pledges the property as collateral for the note. Known by most as a “mortgage,” this document, when recorded (discussed below), creates a lien in favor of the lender. The mortgage agreement is generally a standardized form approved by FNMA. While the form of note is generally the same from state to state, the mortgage form differs slightly because the legal process of foreclosure (the lender’s right to proceed against the collateral) is different in each state. The mortgage document will state that upon default of the note, the lender can exercise its right to foreclose on the property. Foreclosure is the process of lenders exercising their legal right to proceed against the collateral for the loan (discussed later in this chapter). It also places other obligations upon the borrower, such as
• maintaining the property,
• paying property taxes, and
• keeping the property insured.

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Promissory Note in Detail

A note is an IOU or promise to pay; it is a legal obligation. A promissory note (also known as a “note” or “mortgage note”) spells out the amount of the loan, the interest to be paid, how and when payments are made, and what happens if the borrower defaults. The note may also contain disclosures and other provisions required by federal or state law.

Most lenders use a form of note that is approved by the Federal National Mortgage Association (FNMA, or Fannie Mae). A sample form of this note can be found in Appendix C. The note is signed (in legal terms, “executed”) by the borrower. The original note is held by the lender until the debt is paid in full, at which time the original note is returned to the borrower marked “paid in full.”

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What Is a Mortgage?

Most of us think of going to a bank to get a mortgage. Actually, you go to the bank to get a loan. Once you are approved for the loan, you sign a promissory note to the lender, which is a legal promise to pay. You also give the lender (not get) a mortgage as security for repayment of the note. A mortgage (also called a “deed of trust” in some states) is a security agreement under which the borrower pledges his or her property as collateral for payment. The mortgage document is recorded in the county property records, creating a lien on the property in favor of the lender. If the underlying obligation (the promissory note) is paid off, the lender must release the collateral (the mortgage). The release will remove the mortgage lien from the property. If you search the public records of a particular property, you will see many recorded mortgages that have been placed and released over the years.

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Mortgages by purpose

Mortgage forms vary in their payback provisions, terms of agreement, and the types of property used as security. Some are created to achieve specific purposes or to fit the need of the individual borrower. The types of mortgages classified according to purpose are as follows:

1. Purchase money mortgage
The distinguishing characteristic of a purchase money mortgage is that the title and the mortgage are conveyed in the same transaction. The loan involved could be from a third party, and it could be a first mortgage loan. However, typically the purchase money mortgage is a second mortgage given by the seller to the buyer to partially finance the purchase through installment payments. Purchase money mortgages are common in all types of real estate purchases. In the purchases of raw land in large quantities by a developer, the landowner may accept a partial cash payment q d take a mortgage for the remainder of the selling price. As the developer sells lots from the completed subdivision, the mortgage is paid off. In effect, the landowner is a partner with the developer through the use of a purchase money mortgage.

Purchase money mortgages are also common in transactions involving residential properties, such as when the buyer does not have a sufficient down payment. The remainder may be obtained by assuming an existing mortgage or giving the seller a new mortgage. Either way, the seller is willing to take a mortgage as part of the payment. Consider the following example to illustrate the use of a purchase money mortgage in residential properties. Seller A is asking $80,000 for a single-family residence. Buyer B likes the house but only has $10,000 for a down payment. The lending institution will only loan $64,000 on the house. To be able to sell the house, Seller A agrees to take a purchase money mortgage for $6,000 from Buyer B. In addition to taking this purchase money mortgage, Seller A is willing to accept a lower priority of claim if Buyer B should default, In this case, the lending institution has the fust claim because it has a first mortgage. The purchase money mortgage is a second mortgage.


2. Participation Mortgage
A participation mortgage is a loan agreement that provides for a lender to receive part of the income fiom an investment in addition to the interest payments. Participation mortgages became popular during periods of high interest rates and are used by lenders to increase their yields. The participation feature enables them to share in the expected success of income-producing properties. It also, protects the borrower fiom abnormally high payments, if income projections are not realized. The participation can be a specified percentage of gross or net income, a share of proceeds at sale, or both. The use of a closely related term, mortgage participation, occurs when the two or more lending institutions combine their funds to finance a real estate project. For example, a lender does not want the risk of a project of the magnitude for which an investor is seeking a loan. In this case the “primary” lender may call upon another lender to “participate: in this loan, thereby creating a participation. For example, an investor needs $100 million to purchase a large hotel complex. The lending institution to which the developer applies for a loan may not be able to lend that much money. By obtaining one or more “participants,” the original lender is able to obtain the money needed for the investor. In return, all lenders receive evidence of debt from the borrower, as well as an instrument pledging the property as security for each lender’s note.

3. Blanket mortgage
A blanket mortgage covers more than one parcel of land. Developers of subdivisions employ this type of mortgage, which permits small portions of the land (residential lots) to be paid off and released from the mortgage. This clause is known as a release clause, since the remainder of the land continues to be held as security for the loan. The percentage of the original mortgage that is released is usually smaller than the pro rata dollar amount. For example, the developer has a note for $100,000 on a subdivision with 20 lots. The lender will usually require more than lDOth of the mortgage dollar amount to be paid before one lot is released.

4. Reverse annuity mortgage
The reverse annuity mortgage was conceived as a way to enable older homeowners to liquidate and consume the equity “locked up” in their home. As the name suggests, in it’s simplest form the homeowner would receive a regular disbursement from the lender, secured by a mortgage. The regular disbursements and interest accruing against them accumulate eventually to some maximum loan balance. The major problem with this simple RAM is that the homeowner may outlive the time when the maximum loan is reached. While various solutions to this risk are being explored, there is yet to be a significant use of the RAM in the United States. Prudence requires that the loan be made to a homeowner late in life, and for a fairly small percentage of the property’s.

5. Package mortgage
A package mortgage allows home buyers to pledge household items of personal property, in addition to the real estate, as security for a loan. For instance, lending institutions may allow items such as ranges, refrigerators, dishwashers or air conditioners to serve as security, thereby allowing the home buyer to finance major appliances over the term of the loan at relatively low mortgage interest rates. This practice allows lenders to increase the amount of a loan with no added administrative costs and little additional risk. It allows buyers to purchase home appliances and other major items of equipment they may otherwise might not be able to afford.

6. Home equity credit line loan
By far the fastest growing form of mortgage loan in recent years has been the credit line home loan. It is a second mortgage loan that permits any number of draws or balance reductions, subject to a maximum of 75% to 80% of house value, including the first mortgage loan. The monthly payment typically is the greater of a fixed percentage of the current balance, usually 1 %% to 2%, or a modest dollar minimum. The interest rate is variable, usually prime (or another short term interest rate) plus one and a half to two percent. Draws against the mortgage usually are by check, though in some cases credit cards access the credit line.

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