In every mortgage loan there are several clauses that state the rights of the mortgagor and the mortgagee during the tenn of the mortgage loan agreement. The various clauses (or provisions) that may be found in the debt agreement are as follows:
A. Acceleration clause
Lenders usually insist that the instrument contain an acceleration clause that makes the entire debt due in the event of default. This clause precludes the necessity for the lender to bring separate lawsuits against the same mortgagor for each late payment. This clause usually states that if any covenants are breached, including the obligation to pay the sums secured by the mortgage when due, then the full amount is due immediately. This declaration of full payment due is at the option of the lender.
B. Renegotiable rate clause
A renegotiable rate mortgage (RRM) is a series of short-term loans secured by a long-term mortgage. The short-term loans are automatically renewable at equal intervals of three to five years each. The mortgage term may not exceed 40 years. The monthly payments are made in equal installments. However, at the end of the life of each short-term loan, the interest rate may be changed. Changes are based on the movement of an index such as the Federal Home Loan Bank Board’s most recent monthly national average contract mortgage rate index. The interest rate is the only term-that may be altered. An interest rate.modification results in a change of the monthly payment. The new payment amount remains stable until the loan term has again expired.
C. Prepayment Clause
To prepay means to pay off the indebtedness before the end of the loan term. Under traditional common law, the mortgagor has no right to prepay a mortgage unless the right is explicitly provided by a prepayment clause. In some states statutory law has reversed this. Now, any note that is silent as to the right of the obligor to prepay the note in advance of the stated maturity date may be prepaid in 111 by the obligor or his successor in interest without penalty. In typical prepayment clauses a statement is made as to (1) whether there is a penalty for prepayment;
(2) whether extra payments directly reduce the principal upon which interest is computed or eliminates the last payment, and (3) whether the number and size of extra payments in any one year are restricted. Some lenders try to discourage a fast turnover of funds, which is costly to them, by imposing prepayment penalties during the early years. These penalties are usually stated as a percentage of the unpaid balance, and the percentage charge is usually reduced in later years of the mortgage term. Most savings and loan institutions have a prepayment clause in the note. Typically it states that the borrower has the right to prepay the outstanding principal amount in whole or in part and that the outstanding amount of the extra payment is applied against the principal amount. In addition, such clauses usually state that any extra payment does not extend or postpone the due date of subsequent monthly installments, or change the amount of the installments.
D. Variable rate clause
The variable rate mortgage (VRM) ties the interest rate to some specified index of market interest rates. As market rates fluctuate, either the periodic (usually monthly) payment or the loan’s maturity would increase or decrease depending on whether the rate went up or down. Until 1980, federally chartered savings and loans were precluded from increasing a loan’s monthly payments. However, financial deregulation during the early 1980s freed S&Ls from such restrictions, and they can now make many types of loans in which periodic payments may vary.
E. Defeasance clause
This clause “defeats” the right of the lender to foreclose on the property as long as the borrower lives up to the terms of the agreement. Thus, as long as the borrower makes periodic payments according to schedule and fulfills all other requirements, the lender may not sei& the property or have it sold.
F. Exculpatory clause
An exculpatory clause relieves the borrower of personal liability to repay the loan. Thus, if the borrower defaults; the lender can look only to the property foreclosure for recovery of the debt. In effect, the lender may not sue the borrower on the note or obtain a deficiency judgment, if sale of the property at foreclosure does not provide sufficient funds to cover the loan’s balance. Obviously, borrowers prefer to negotiate loans with exculpatory clauses, but lenders are usually unwilling to allow them. Probably the most frequent use of this clause is with investment property involving 1imited.partners. In order for limited partners to claim tax depreciation on the mortgaged portion of a property, the general partners must have no personal liability for the mortgaged loan. This means all partners are considered to be “at risk” for the mortgaged portion of the property, and that the limited partners can claim depreciation on the mortgaged portion. To achieve this arrangement, the mortgage will have an exculpatory clause to relieve the general partners of any personal liability.
G. Subordination clause
A lien holder may consent to place his or her interest in a property at a lower priority than another lien holder, through the use of a subordination clause. A subordination clause is often used when the seller of vacant land takes back a purchase money mortgage. In order to make the sale, the seller agrees to lower the priority of the lien to a position inferior to a construction or permanent loan. Sometimes land owners who lease their land will also subordinate their fee position to a construction or permanent loan obtained by the lessee.
H. Release clause
An acquisition and development loan obtained by a developer may be used to develop a number of building lots. Many such loan agreements contain clauses that allow the developer to release developed lots as security for the loan. In addition, a specified amount is paid back to the lender. Usually the amount that must be paid to obtain a release is greater than the proportionate amount of the loan allocated to the lot. For example, if a developer borrows $1 00,000 to develop 10 lots, the release amount might be $12,000 per 1&-$2,000 more than t& amount of loan per lot?.
I. Cognovit clause
This clause is considered to be a confession of judgment. If borrowers allow this clause to be included, they in effect give up their right to a day in court. It authorizes the lender’s attorney to obtain a judgment lien against the debtor’s real property. Without this clause, the lender must sue on the basis of the note and prove it to be in default.
J. Escalator clause
This clause allows the lender to increase the interest rate. Although an escalator clause in its most general sense could allow a lender to increase the rate for any reason, it is usually tied to an event or contingency. For example, if it is discovered that the mortgagor is an investor rather than an owner-occupant. Moreover, it could provide for the interest rate to escalate up to the legal maximum in the event of the borrower’s default. An escalator clause does not create a variable rate mortgage in which the interest rate is tied to a market index. Escalator clauses in which the interest rate change is at the discretion of the lender are very unpopular with borrowers. The potential for abuse and unfavorable public relations far outweighs any benefits.
K. Open end clause
Many institutions @articularly savings and loans) write loan agreements that allow a borrower to increase the amount of a loan after the loan balance has been paid down. The loan can usually be increased to the original amount borrowed. While closing costs and loan fees are avoided by using an open end provision, the lender usually reserves the right to adjust the interest rate if the current market rate is higher than the rate on the loan being opened.
L. Redemption clause
Prior to foreclosure, a borrower has the right to pay the amount owed, plus interest, in order to retain the property or interest in the property. This right is called the equity of redemption and is a matter of law, not negotiation. Nevertheless, the right is stated in most mortgages.
M. Due-on-sale clause
Traditional common law permits a buyer to purchase mortgaged property and preserve the existing mortgage unless the mortgage contains a clause to accelerate the loan upon sale. This dueon- sale clause is especially important to lenders in a world of volatile interest rates. Without it, buyers tend to preserve low interest rate mortgages as long as possible by purchasing second mortgage financing rather than refinancing the existing loan. The clauses discussed in this section are the principal variable provisions found in mortgages or notes. Other provisions that are sometimes used include equity participation and late payment clauses. Depending on the type of lender, each will usually have a standard form that outlines the rights of the lender and the borrower. All borrowers should carefully read these documents before signing. They may contain a clause that is detrimental to their particular needs. Fortunately for home mortgages, the influence of secondary mortgage market agencies has in recent years encouraged the widespread use of a standard home mortgage contract. This document, promulgated by the Federal Home Loan Mortgage Corporation (FHLMC) and the Federal' National Mortgage Association (FNMA), is well crafted to protect the interest of both mortgagor and mortgagee in the fypical home loan situation.
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