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Click on link to go to:
Table of Contents; Chapter I: Real Property; Chapter II: Legal Ownership; Chapter III: Agency & Ethics; Chapter IV: Contracts; Chapter V: Real Estate Mathematics; Chapter VI: Financing; Chapter VII: Mortgage Insurance; Chapter VIII: Appraisal; Chapter IX: Transfers of Real Estate; Chapter X: Property Management; Chapter XI: Land Control; Chapter XII: Taxation; Chapter XIII: Fair Housing Laws; Chapter XIV: Macroeconomics; Chapter XV: Legal Professional Requirements; Chapter XVI: Notarial Law; Chapter XVII: Selling Real Estate; Chapter XVIII: Trust Funds Handling; Glossary; Index.

Chapter VI: Financing the Real Estate Transaction


Educational Objectives: Learn about The Primary and Secondary Market, Financial Reports, Promissory Notes, Types of Mortgages, Trust Deeds and Mortgages, Effects of Security, Lender's Judicial and Non-judicial Foreclosure, Non-mortgage Financing, Equal Credit Opportunity Act, Fair Credit Reporting Act, Truth in Lending, R. E. TERMS GLOSSARY, INDEX.




The primary mortgage market


The Primary Mortgage Market is the financial market where loans are made directly from lenders to borrowers. The primary mortgage market originates and services the loans. The primary mortgage market is made up of savings and loan associations, commercial banks, mortgage bankers and mortgage brokers.


Savings and loan associations are depository institutions which make loans primarily on single family dwellings. They are generally portfolio lenders.


Commercial banks are also depository institutions but they make a wider variety of loans than do savings and loan associations. They are also usually considered portfolio lenders.


Mortgage bankers are a kind of financial middleman. They originate loans directly to borrowers, then "package" groups of loans and sell them into the secondary market. Mortgage bankers make both residential and commercial loans. They receive an origination fee and, sometime, a loan servicing fee.


The function of mortgage brokers is to bring together lenders and borrowers. Mortgage brokers are normally paid a "finder's fee" which is often equal to about one percent of the loan amount. This may be paid by the borrower.


Insurance companies, pension funds and some other sources of mortgage loans often use mortgage brokers rather than dealing with the borrowers directly.


Mortgage brokers are normally not involved in servicing the loan after the deal is done.


The secondary mortgage market


The secondary mortgage market is the second largest money market in the United States. It is second only to the U. S. Government securities market which is the largest borrower of dollars in America to finance the federal government deficit.


The secondary mortgage market is not a single market as the term implies. It is rather, a group of markets operating as a part of the overall capital market.


Perhaps the easiest way to discuss the "secondary mortgage market" is to divide it into two major segments. Some mortgage lenders originate loans and then hold the loans in their own portfolio. These shall be referred to as "portfolio lenders." Other mortgage lenders originate loans and then sell the loan packages to other lenders or investors.


What is a mortgage?


Few people are financially able or willing to buy a home, business, or real property without first borrowing money-usually from a financial institution--to pay the difference between what they can afford to "put down" and the purchase price of the property. This then is the basis for mortgage financing, and the skilled licensee is very familiar with the options for financing and the types of mortgages available tithe prospective buyer to facilitate the sale. In the last decade, of rising and falling interest rates have made the mortgage market increasingly complex but also more flexible in ways not thought possible, or even necessary, a few decades ago. This section, therefore, outlines the types of mortgages available and discusses mortgage financing


Definition of Mortgage


A mortgage is any document used for the purpose of pledging real estate as collateral, or security, for a loan. The mortgage gives the lender a claim, or lien, against the property of a borrower. A mortgage lien, therefore, is a voluntary lien given by a borrower to a lender as security for a real estate loan. Once the debt is repaid the lien is canceled. The mortgage, however, is just one part of a mortgage loan package. Without a debt or obligation, there can be no mortgage. Therefore, accompanying the mortgage as evidence of the debt is a promissory note. In addition to containing the specifics of the loan agreement--such as the loan amount, interest rate, and amortization schedule- the note is the borrower's pledge to pay off the entire balance of the loan, from personal funds if necessary, in the event of a foreclosure sale; it is essentially a second line of security for the lender. Should a foreclosure sale occur and the sale proceeds be in sufficient to pay off the balance of the mortgage loan, the borrower would have to use other funds, as pledged in the promissory note, to make up the deficiency.


Requirements of a Valid Mortgage


As a type of contract, a mortgage must include certain elements to be valid:


1) The mortgage must he in writing.


2) The parties to the mortgage must be legally




3) The parties must reach a meeting of the minds.


4) The parties must exchange valuable


consideration and state what is being given up by both parties.


5) The mortgage must be for a legal purpose.


6) The mortgage must include a legal description of the property being pledged as collateral for the loan.


7) The mortgage must be delivered and accepted.


8)                  The mortgage must be properly witnessed according to state law.


In addition, a mortgage should:


9) Include the borrower's(or borrowers')




10) Be recorded.


11) Describe the note that is recorded.


12) State the foreclosure conditions.


13)              State specifically the interest in the property being mortgaged, such as leasehold, fee simple, and so forth.


Mortgage Covenants


A covenant is simply a promise to do or not do something. The borrower and lender make certain promises as part of mortgaging property. The following are typical covenants contained in a mortgage:


1) The borrower promises to make all payments of principal and interest when due.


2)                  The borrower promises to pay all property taxes, special assessments, and to maintain appropriate insurance to protect the property against loss by fire or other hazard.


3)                  The borrower promises to keep the property in good repair to maintain the value of the security.


4)                  The borrower promises to allow the lender to inspect the property at reasonable times, although rarely does the lender do this.


5)                  The borrower promises to obtain the lender's permission before any major improvements are made to the property, or before placing a second mortgage against the property.


6)                  The lender promises to release or cancel the lien upon payment of all sums secured by the mortgage.


7)                  The lender promises to make known the outstanding loan balance to a prospective buyer who wants to assume the existing mortgage or to determine the amount owed if obtaining new financing.


Mortgage Document Clauses


In addition, a mortgage document contains a number of important clauses concerning the agreement between the lender and borrower. Described below are some of the more common clauses found in a mortgage:


1.   Acceleration Clause: This clause gives the lender the right to accelerate the maturity of the debt In other words the lender can call for immediate payment if the entire debt and for any payments due should the borrower default or breach the mortgage contract. Even though an amortized loan allows the debt to be repaid in regular payments over a period of years, the acceleration clause allows the lender to call the loan without having to sue for each remaining payment when the borrower is in current default.


2.   Defeasance Clause: This clause simply provides that when the borrower has met all the terms of the loan agreement (when the loan is finally paid off), the lender will cancel the debt, and the mortgage lien borrower will have unencumbered title to the property.


3.   Due-On-Sale Clause: Also known as an alienation clause, this clause prevents the mortgage from automatically being assumed by a future buyer. The lender, however, has the choice of whether or not to let a new buyer assume the old mortgage loan. If current mortgage interest rates are higher than the interest rate on the outstanding loan, the lender probably will not allow assumption, but if market rates are about the same as the loan rate, the lender may allow assumption.


4.   Escrow Clause: The mortgage document may contain a provision requiring the borrower to pay approximately one-twelfth of the estimated annual property taxes and insurance premium with each monthly loan payment. The lender then takes the necessary payments to the appropriate taxing jurisdiction or insurance company or both. The term escrow derives from the fact that the lender must keep all such funds in a separate account apart from its other funds and use them only for the designated purpose .


5.   Fixtures and Personal Property Clause: When nonresidential property is mortgaged, such as a hotel, apartment complex, or industrial property, the description of the mortgaged property often includes any furniture, machinery equipment, or personal property that remains with the property. This is particularly important when the items are necessary for continuation of the business for which t he building was designed. Removal of these items would reduce the value of the property and hence the value of the security for the loan. Unless specifically prohibited in the mortgage contract, much of the property listed above can be removed by the seller to the detriment of the lender.


6.   Prepayment and Late Payment Clauses: Usually found in the promissory note, a prepayment clause states that if a borrower prepays the outstanding loan balance he/she will be charged a penalty. This penalty is frequently a percentage of the loan balance. Prepayment is discouraged to keep the lender from having to reinvest funds at rates less than could be earned on the mortgage. The late payment clause imposes a penalty on the borrower for delay in making regularly scheduled payments.


7.   Release Clause: This clause is used when mortgaged property is to be subdivided and sold as individual lots. As the lots are sold and a specified amount of money is paid to the lender, the lender releases the purchased lot as security for the remaining loan balance. Without a release clause, the purchaser of a subdivision lot would be in danger of having his/her property foreclosed on should the developer default.


8.   Subordination Clause: In this clause the lender and borrower agree to the priority of the mortgage. For example, a lender might agree to allow a subordination of the first mortgage to a future mortgage (the first mortgage would be junior to the second mortgage), in exchange for a premium from the borrower. A subordination clause would be used by a developer who borrows money to buy land secured by a mortgage knowing that later he/she would need to borrow additional funds for development and construction. The first mortgage securing the loan for purchasing the land would later be subordinate to the mortgage securing the construction loan.




Types of Mortgages


The basic mortgage loan, referred to simply as a mortgage from now on, can be structured in a number of ways to provide security for various real estate endeavors. Below are discussed some of the more common mortgages the real estate professional will encounter.


Blanket Mortgage


This mortgage secures several properties. A developer of a subdivision might have a blanket mortgage on all the lots. As each lot is sold and the developer makes a stipulated payment to the lender, the lender releases the lot from the mortgage lien.


Construction Mortgage


This mortgage finances the construction of improvements on real estate, such as homes, business properties, apartments, and so on. The lender pays out the proceeds in installments as various phases of the construction are completed. Usually the installments are paid to the general contractor who in turn pays the subcontractors and material suppliers. This type of loan is also known as interim financing because of its short-term nature


Conventional Mortgage


This mortgage is not backed by any government agency, such as the VA or FHA. These are mortgages strictly between private parties who rely on their own credit reports, appraisals, and other information regarding the prospective borrower.


Junior Mortgage


Any mortgage that is subordinate, or stands behind, another mortgage in terms of priority of claim to the property in the event of a foreclosure sale is a junior mortgage. A second mortgage is junior to a first or senior mortgage. More risky than the senior mortgage, junior mortgages usually carry a higher interest rate or shorter loan term.


Package Mortgage


Quite commonly this mortgage secures items, in addition to real estate, such as personal property. For instance, a lender may offer a package mortgage that secures a house's major appliances that are purchased out of the proceeds of the loan. This allows buyers to purchase home appliances and other major items of equipment they otherwise might not afford by financing the cost over the term of the loan.


Participation Mortgage


This mortgage is usually used for a large development project where one lender may be unwilling or unable to finance the entire project. Thus, the participation mortgage would be used to share the risk among lenders. Two or more lenders would finance the project, with each having a proportionate share of the project as collateral, as designated in the participation mortgage documents.


Purchase Money Mortgage or Take-back Mortgage


This mortgage is taken back by the seller in lieu of cash from the buyer. This may be a first mortgage, if the property is not encumbered by an existing mortgage, or it may be a second or third mortgage if a first or second mortgage already exists.


Open-End Trust Deed Mortgage


A loan arrangement in which additional money is lent from time to time under the same trust deed. If the lender is obliged (rather than having just an option) to such additional loans, then the additional amounts are considered part of the original loan.


Swing Mortgage


A temporary loan made on a "contemplated" property as down payment.


Refinance Mortgage


An extension of additional credit on a property already financed, where interest or terms of payment are changed.


Unsecured Loan


A loan based on a promissory note without any collateral security.




Fixed Rate Mortgage


Fixed rate mortgages have an interest rate and monthly payments that remain constant over the life of the loan. This sets a maximum on the total amount of principal and interest you pay during the loan. Traditionally, these mortgages have been long-term. As the loan is repaid, ownership shifts gradually from lender to buyer.


For example, suppose you borrow $50,000 at 13% for 30 years. Your monthly payments on this loan would be $553.10. Over 30 years, your total obligation for principal and interest would never exceed this fixed, predetermined amount.


Fixed rate mortgages are usually available at higher rates than many other types of loans. But, if you can afford the monthly payments, inflation and tax deductions may make a fixed rate mortgage a good financing method, particularly if you are in a high tax bracket and need the interest deductions.


Fifteen-Year Mortgage


The fifteen year mortgage is a variation of the fixed rate mortgage that is becoming increasingly popular. This mortgage has an interest rate and monthly payments that are constant throughout the loan. But, unlike other plans, this loan is fully paid off in only fifteen years. And, it is usually available at a slightly lower interest rate than a longer-term loan. But it also requires higher payments.


Suppose you buy a house for $100,000, and after making a $15,000 down payment, you still need to borrow $85,000. You find a 30-year mortgage for 12%. This means your monthly payments would be $874.32. But, another lender offers you a 15-year plan for a lower rate, 11.5%. However, under this plan, your payments would be $992.96, $119 higher than the longer-term financing.


In the fifteen-year mortgage, you pay off the loan balance faster than a long-term loan. Because of this, a smaller proportion of each of your monthly payments goes to interest. So, if you can afford the higher payments, this plan will save you interest and help you build equity and own your home faster. Because you are paying less interest, though, you may also have fewer tax deductions .


Variable Rate Mortgage (VRM) or Adjustable Rate Mortgage (ARM)


Adjustable rate mortgages have an interest rate that increases or decreases over the life of the loan based upon market conditions. Some lenders refer to adjustable rates as flexible or variable. Because adjustable rate loans can have different provisions, you should evaluate each one carefully.


In most adjustable rate loans, your starting rate, or "initial interest rate," will be lower than the rate offered on a standard fixed rate mortgage. This is because your long-term risk is higher your rate can increase with the market so the lender offers an inducement to take this plan.


Changes in the interest rate are usually governed by a financial index. If the index rises, so may your interest rate. In some plans, if the index falls, so may your rate. Examples of these indexes are the Federal Home Loan Bank Board's national average mortgage rate and the U.S. Treasury bill rate. Generally, the more sensitive the index is to market changes, the more frequently your rate can increase or decrease.


Suppose your interest rate is tied to the Bank Board index. Your mortgage limits rate changes to one per year, although it doesn't limit the amount of the change. For example, assume your starting interest rate is 11% on September 1, 1986. Based on these terms, if the Bank Board index rises 2 percentage points by September 1, 1987, your new rate for the next year will be 13%.


Rate Caps


To build predictability into your adjustable rate loan, some lenders include provisions for "rate caps" that limit the amount your interest rate may change. These provisions limit the amount of your risk.


A periodic rate cap limits the amount the rate can increase at any one time. For example, your mortgage could provide that even if the index increases 2% in one year, your rate can only go up 1%. An aggregate rate cap limits the amount the rate can increase over the entire life of the loan. This means that, for example, even if the index increases 2% every year, your rate cannot increase more than 5% over the entire loan.


Many flexible rate mortgages offer the possibility of rates that may go down as well as up. In some loans, if the rate can only increase 5%, it may only decrease 5%. If no limit is placed on how high the rate can go, there may be a provision that also allows your rate to go down along with the index. Because they limit the lender's return, capped rates may not be available through every lender.


Payment Caps


If the interest rate on your adjustable rate loan increases and your loan has a payment cap, your monthly payments may not rise, or they may increase by less than changes in the index would require.


For example, assume your mortgage provides for unlimited changes in your interest rate but your loan has a $50 per year cap on payment increases. You started with a 11% rate on your $75,000 mortgage and a monthly payment of $714.24. Now assume that your index increases 2 percentage points in the first year of your loan. Because of this, your rate increases to 13%, and your payments in the second year two should rise to $828.33. Because of the payment cap, however, you'll only pay $764.24 per month in the second year.


But remember: if your payment capped loan results in monthly payments that are lower than your interest rate would require, you still owe the difference. Negative amortization may take place to ensure that the lender eventually receives the full amount. In most payment-capped mortgages, the amount of principal paid off changes when interest rates fluctuate. Suppose you are paying $650 a month with $500 going toward interest, with your rate at 12%. Then your rate increases to 13%. This means your monthly payment should increase to $697.39, but because of a cap, it increases to only $675. Because this change in interest rates increases your debt, the lender may now apply a larger portion of your payment to interest. If rates get very high, even the full amount of your monthly payment ($675) won't be enough to cover the interest owed; the additional amount of interest you owe will be added to the principal. This means you now owe and eventually will pay interest on interest.




One variation of the adjustable rate mortgage is to fix the interest rate for a period of time 3 to 5 years, for example, with the understanding that the interest rate will then be renegotiated. Loans with periodically renegotiated rates are also called rollover mortgages. Such loans make monthly payments more predictable because the interest rate is fixed for a longer time.


Another variation is the pledged account buy-down mortgage with an adjustable rate. This plan was introduced by the Federal National Mortgage Association (Fannie Mae), which buys mortgages from lenders and provides a major source of money for future mortgage offerings.


In this plan, a large initial payment is made to the lender at the time the loan is made. The payment can be made by the buyer, the builder, or anyone else willing to subsidize the loan. The payment is placed in an account with the lender where it earns interest. This plan helps lower your interest rate for the first year.


This plan could lower your rate, for example, by 4% in the first year. If you borrowed $50,000 at 13%, for example, this would reduce your rate to 9% and your monthly payments to $402.31, a savings of approximately $151 monthly. Then, for the next 5 years, your interest rate would only increase, for example, by 1 point each year. After that, your mortgage becomes an adjustable rate mortgage with interest rate and payment changes based upon an index.


This plan may not include any payment or rate caps other than those in the first years. But, there also may not be negative amortization, so possible increases in your total debt may be limited. Because of the buy-down feature, some buyers may be able to qualify for this loan who otherwise would not be eligible for financing.


Balloon Mortgage


Balloon mortgages have a series of equal monthly payments and a large final payment. Although there usually is a fixed interest rate, the equal payments may be for interest only. The unpaid balance, frequently the principal or the original amount you borrowed, comes due in a short period, usually 3 to 5 years.


For example, suppose you borrow $30,000 for 5 years. The interest rate is 1%, and the monthly payments are only $325. But in this example, the payments cover interest only, and the entire principal is due at maturity in 5 years. That means you'll have to make 59 equal monthly payments of $325 each and a final balloon payment of $30,325. If you can't make that final payment, you'll have to refinance (if refinancing is available) or sell the property.


Some lenders guarantee refinancing when the balloon payment is due, although they do not guarantee a certain interest rate. The rate could be higher than your current rate. Other lenders do not offer automatic refinancing. Without such a guarantee, you could be forced to start the whole business of shopping for housing money once again, as well as paying closing costs and front-end charges a second time.


A balloon note may also be offered by a private seller who is continuing to carry the mortgage he or she took out when purchasing the home. It can be used as a second mortgage where you also assume the seller's first mortgage.


Graduated Payment Mortgage (GPM) or Graduated Payment Adjustable Mortgage (GPAM)


Graduated payment mortgages (GPM) are designed for home buyers who expect to be able to make larger monthly payments in the near future. During the early years of the loan, payments are relatively low. They are structured to rise at a set rate over a set period, say 5 or 10 years. Then they remain constant for the duration of the loan.


Even though the payments change, the interest rate is usually fixed. So during the early years, your payments are lower than the amount dictated by the interest rate. During the later years, the difference is made up by higher payments. At the end of the loan, you will have paid off your entire debt.


One variation of the GPM is the graduated payment, adjustable rate mortgage. This loan also has graduated payments early in the loan. But, like other adjustable rate loans, it ties your interest rate to changes in an agreed-upon index. If interest rates climb quickly, greater negative amortization occurs during the period when payments are low. If rates continue to climb after that initial period, the payments will, too. This variation adds increased risk for the buyer. But if interest rates decline during the life of the loan, your payments may as well.


Growing Equity Mortgage (Rapid Payoff Mortgage)


The growing equity mortgage (GEM) and the rapid payoff mortgage are among the other plans on the market. These mortgages combine a fixed interest rate with a changing monthly payment. The interest rate is usually a few percentage points below market. Although the mortgage term may run for 30 years, the loan will frequently be paid off in less than 15 years because payment increases are applied entirely to the principal.


Monthly payment changes are based on an agreed-upon schedule of increases or an index. For example, the plan might use the U.S. Commerce Department index that measures after-tax, per capita income, and your payments might increase at a specified portion of the change in this index, say 75 %.


Suppose you are paying $500 per month. In this example, if the index increases by 8% you will have to pay 75% of that, or 6%, additional. Your payments will increase to $530, and the additional pay will be used to reduce your principal.


With this approach, your income must be able to keep pace with the increased payments. The plan does not offer long-term tax deductions. However, it can permit you to pay off your loan and acquire equity rapidly.


Shared Appreciation Mortgage (SAM)


In the shared appreciation mortgage (SAM), you make monthly payments at a relatively low interest rate. You also agree to share with the lender a sizable percent (usually 30 % to 50%) of the appreciation in your home's value when you sell or transfer the home, or after a specified number of years.


Because of the shared appreciation feature, monthly payments in this plan are lower than in many other plans. However, you may be liable for the dollar amount of the property's appreciation even if you do not wish to sell the property at the agreed-upon date. Unless you have the cash available, this could force an early sale of the property. Also, if property values do not increase as anticipated, you may still be liable for an additional amount of interest.


There are many variations of this idea, called shared equity plans. Some are offered by lending institutions and others by individuals. For example, suppose you've found a home for $100,000 in a neighborhood where property values are rising. The local savings and loan is charging 12% on home mortgages; assuming you paid $20,000 down and chose a 30-year term, your monthly payments would be $822.89, or about twice what you can afford. But a friend offers to help. Your friend will pay half of each monthly payment, or $420, for 5 years. At the end of that time, you both assume the house will be worth at least $125,000. You can sell it, and your friend can recover his or her share of the monthly payments to date plus half of the appreciation, or $12,500, for a total of $37,700. Or, you can pay your friend that same sum of money and gain increased equity in the house.


Another variation may give your partner tax advantages during the first years of the mortgage, after which the partnership is dissolved. (You can buy out your partner or find a new one.) Your partner helps make the purchase possible by putting up a sizable down payment and or helping make the monthly payments. In return, your partner may be able to deduct a certain amount from his or her taxable income. Before proceeding with this type of plan, check with the Internal Revenue Service to determine the exact requirements .


Shared appreciation and shared equity mortgages were partly inspired by rising interest rates and partly by the notion that housing values would continue to grow over the years to come. If property values fall, these plans may not be available.


Changing rates


Lenders use indexes to decide when to raise or lower the interest rate on an adjustable rate mortgage. For example, when the financial index your lender uses rises, the interest rate on your mortgage may also increase it depends on how the index is applied. Fluctuations in the interest rate can change your monthly payments, mortgage length, or principal balance.


Some of today's most frequently used indexes are:


    the rate on 6-month Treasury bills, or on 3-year Treasury notes (or how much the U.S. Treasury is willing to pay on money it borrows);


    the Federal Home Loan Bank Board's national average mortgage contract rate charged by major lenders on the purchase of previously occupied homes (or how much people are paying on new mortgages nationwide); and,


    the average costs of funds for savings and loans insured by the Federal Savings and Loan Insurance Corporation (or how much lending institutions are paying on the money they borrow).


Some indexes reflect what the market will bear across the country; others reflect local trends. Also, some money indexes are controlled solely by individual lenders. The index you select should be one that can be verified easily; its past performance may give you an indication of how stable it is. Have someone with expertise translate past and potential changes into dollars and cents. Also find out how the index is used. For example, if the index changes monthly, is the lender also changing the rate on your loan monthly? Or, are there limits on the number of times and/or the amount your rate can fluctuate?


Finally, check how much advance warning the lender will give you before your new rate and/or new payments go into effect.


Assumable Mortgage


An assumable mortgage is a mortgage that can be passed on to a new owner at the previous owner's interest rate. For example, suppose you're interested in a $75,000 home. You make a down payment of $5,000, and you still owe $50,000.The owner of the home has paid off $20,000 of a $30,000, 10% mortgage. You assume the present owner's mortgage, which has $10,000 outstanding. You also make additional financing arrangements for the remaining $40,000, for example, by borrowing that amount from a mortgage company at the current market rate of 12%. Your overall interest rate is lower than the market rate because part of the money you owe is being repaid at 10%.


During periods of high rates, most lending institutions are reluctant to permit assumptions, preferring to write a new mortgage at the market rate. Some buyers and sellers are still using assumable mortgages, however. This has recently resulted in many lenders calling in the loans under "due on sale" clauses. Because these clauses have increasingly been upheld in court, many mortgages are no longer legally assumable. Be especially careful, therefore, if you are considering a mortgage represented as "assumable." Read the contract carefully and consider having an attorney or other expert check to determine if the lender has the right to raise your rate in this mortgage.


Seller Take-back


This mortgage, provided by the seller, is frequently a "second trust" and is combined with an assumed mortgage. The second trust (or "second mortgage") provides financing in addition to the first assumed mortgage, using the same property as collateral. (In the event of default, the second mortgage is satisfied after the first). Seller take-backs frequently involve payments for interest only, with the principal due at maturity.


For example, suppose you want to buy a $150,000 home. The seller owes $70,000 on a 8% mortgage. You assume this mortgage and make a $30,000 down payment. You still need $50,000. So the seller gives you a second mortgage, or take-back, for $50,000 for 5 years at 10% (well below the market rate) with payments of $416.67.


However, your payments are for interest only, and in 5 years you will have to pay $50,000. The seller take-back, in other words, may have enabled you to buy the home. But it may also have left you with a sizable balloon payment that must be paid off in the near future.


Some private sellers are also offering first trusts as take-backs. In this approach, the seller finances the major portion of the loan and takes back a mortgage on the property.


Another development now enables private sellers to provide this type of financing more frequently. Previously, sellers offering take backs were required to carry the loan to full term before obtaining their equity. However, now, if an institutional lender arranges the loan, uses standardized forms, and meets certain other requirements, the owner take-back can be sold immediately to Fannie Mae. This approach enables the seller to obtain equity promptly and avoid having to collect monthly payments.




Another variation on the second mortgage is the wraparound. Suppose you'd like to buy a $75,000 condominium and can make a $25,000 down payment, but can't afford the payments at the current rate (12%) on the remaining $50,000. The present owners have a $30,000, 8% mortgage. They offer you a $50,000 wraparound mortgage at 10%. The new loan wraps around the existing $30,000 mortgage, adding $20,000 to it. You make all your payments to the second lender or the seller, who then forwards payments for the first mortgage. You'll pay the equivalent of 8% on the $30,000 to the first lender, plus an additional 2% on this amount to the second lender, plus 10% on the remaining $20,000.Your total loan costs using this approach will be lower than if you obtained a loan for the full amount at the current rate (for example, 12%).


Wraparounds may cause problems if the original lender or the holder of the original mortgage is not aware of the new mortgage. Upon discovering this arrangement, some lenders or holders may have the right to insist that the old mortgage be paid off immediately.


Land Contract


Borrowed from commercial real estate, this plan enables you to pay below-market interest rates. The installment land contract permits the seller to hold onto his or her original below-market rate mortgage while "selling" the home on an installment basis. The installment payments are for a short term and may be for interest only. At the end of the contract the unpaid balance, frequently the full purchase price, must still be paid.


The seller continues to hold title to the property until all payments are made. Thus, you, the buyer, acquire no equity until the contract ends. If you fail to make a payment on time, you could lose a major investment.


These loans are popular because they offer lower payments than market rate loans. Land contracts are also being used to avoid the due on sale clause. The buyer and seller may assert to the lender who provided the original mortgage that the due on sale clause does not apply because the property will not be sold until the end of the contract. Therefore, the low interest rate continues. However, the lender may assert that the contract in fact represents a sale of the property. Consequently, the lender may have the right to accelerate the loan, or call it due, and raise the interest rate to current market levels.




A buy-down is a subsidy of the mortgage interest rate that helps you meet the payments during the first few years of the loan. Suppose a new house sells for $150,000.After a down payment of $75,000, you still need to finance $75,000. A 30-year first mortgage is available for 12%, which would make your monthly payments $771.46, or beyond your budget. However, a buy-down is available: for the first three years, the developer will subsidize your payments, bringing down the interest rate to 9%. This means your payments are only $603.47, which you can afford.


There are several things to think about in buy-downs. First, consider what your payments will be after the first few years. If this is a fixed rate loan, the payments in the above example will jump to the rate at which the loan was originally made 12% and total more than $770. If this is an adjustable rate loan, and the index to which your rate is tied has risen since you took out the loan, your payments could go up even higher.


Second, check to see whether the subsidy is part of your contract with the lender or with the builder. If it's provided separately by the builder, the lender can still hold you liable for the full interest rate (12% in the above example), even if the builder backs out of the deal or goes out of business.


Finally, that $150,000 sales price may have been increased to cover the builder's interest subsidy. A comparable home may be selling around the corner for less. At the same time, competition may have encouraged the builder to offer you a genuine savings. It pays to check around.


There are also plans called consumer buy-downs. In these loans, the buyer makes a sizable down payment, and the interest rate granted is below market. In other words, in exchange for a large payment at the beginning of the loan, you may qualify for a lower rate on the amount borrowed. Frequently, this type of mortgage has a shorter term than those written at current market rates.


Rent With Option to Buy


In a climate of changing interest rates, some buyers and sellers are attracted to a rent-with-option arrangement. In this plan, you rent property and pay a premium for the right to purchase the property within a limited time period at a specific price. In some arrangements, you may apply part of the rental payments to the purchase price.


This approach enables you to lock in the purchase price. You can also use this method to "buy time" in the hope that interest rates will decrease. From the seller's perspective, this plan may provide the buyer time to obtain sufficient cash or acceptable financing to proceed with a purchase that may not be possible otherwise .


Reverse Annuity Mortgage (RAM)


If you already own your home and need to obtain cash, you might consider the reverse annuity mortgage (RAM) or "equity conversion." In this plan, you obtain a loan in the form of monthly payments over an extended period of time, using your property as collateral. When the loan comes due, you repay both the principal and interest.


A RAM is not a mortgage in the strict sense of the word. No monthly payment of interest and/or principal is made by the homeowner. On the contrary the homeowner receives a payment and the loan balance is increased each month. The due date is made usually contingent upon either death or the resale of the property in probate.


Reading the fine print


Before going ahead with a creative home loan, you may want to have a lawyer or other expert help you interpret the fine print. You may also want to consider some of the situations you could face when paying off your loan or selling your property. Also, make sure you understand the terms in your agreement such as acceleration, due on sale clauses (discussed above), and waivers.


Here, taken from a mortgage contract, is a sample acceleration clause: "In the event any installment of this note is not paid when due, time being of the essence, and such installment remains unpaid for thirty (30) days, the Holder of this Note may, at its option, without notice or demand, declare the entire principal sum then unpaid, together with secured interest and late charges thereon, immediately due and payable. The lender may without further notice or demand invoke the power of sale and any other remedies permitted by applicable law."


Note the use of the term "without notice" above. If this contract provision is legal in your state, you have waived your right to notice. In other words, you've given up the right to be notified of some occurrence for example, a missed payment. If you've waived your right to notice of delinquency or default, and you've made a late payment, action may be initiated against you before you've been told; the lender may even start to foreclose.


Know whether your contract waives your right to notice. If so, obtain a clear understanding in advance of what you're giving up. And consider having your attorney check state law to determine if the waiver is legal.


Due on sale clauses have been included in many mortgage contracts for years. They are being enforced by lenders increasingly when buyers try to assume sellers' existing low rate mortgages. In these cases, the courts have frequently upheld the lender's right to raise the interest rate to the prevailing market level. So be especially careful when considering an "assumable mortgage." If your agreement has a due on sale provision, the assumption may not be legal, and you could be liable for thousands of additional dollars.


(The following reprinted by permission from the CalBRE Reference Book, p. 295-297)


Due-on-Sale Enforcement in California


The California Supreme Court ruled in Wellenkamp v. Bank of America (1978) 21 Cal. 3d 943 that a state-chartered institutional lender could not automatically enforce a due-on-sale provision in its loan documents to accelerate payment of a loan when residential property securing the loan is sold by the borrower. Under this ruling an institutional lender had to demonstrate that enforcement was necessary to protect against impairment of its security or the risk of default (credit considerations). Federally-chartered banks and savings and loan associations successfully asserted that the validity and automatic exercisability of due-on-sale provisions is applicable to them. This contention was upheld by the United States Supreme Court in Fidelity Federal Savings and Loan Association v. de la Cuesta (1982) 50 USLW 4916.On October 15, 1982, the Garn-St.Germain Depository Institutions Act of 1982 became effective. With certain exceptions the law makes due-on-sale provisions in real property secured loans automatically enforceable by all types of lenders, including non-institutional private lenders.




The following concerns the automatic enforceability of due-on-sale provisions in loan instruments:


1. Federally-chartered savings and loan associations may automatically enforce due-on-sale clauses in promissory notes and deeds of trust which they originated while federally chartered.


2.       With certain exceptions of limited application all loans originated after October 15, 1982, may be accelerated by the lender upon transfer of the property securing the loan.


3.       Loans originated before the "window period" which are secured by real property that was not transferred during the window period may be accelerated upon transfer of the property.


4.       Loans originated, assumed or taken "subject-to" during the "window period" are governed by California law and remain assumable under the rationale of Wellenkamp and related California decisional law for a period of up to three years after October 15, 1982, unless and until the California Legislature (for state-chartered lending institutions and individuals) or the Comptroller of the Currency (for national banks) acts to adopt or modify the "window period" provisions of the law.


5.       As of October 15, 1985, loan transfers without the consent of the lender (except in a few instances of limited application) will no longer exist in California. 


Other Exceptions


Some of the notable exceptions to automatic enforceability of due- on-sale clauses enumerated under the new law include, among others, the following:


1.     Creation of a junior deed of trust or lien on property which is not related to a transfer of the rights of occupancy when the security property is an owner occupied residence.


2. Transfer of the property to a joint tenant.


3.     Transfer to a relative of a borrower resulting from the death of the borrower.


4.     Transfer into an intervivos trust of which the borrower is a beneficiary if it does not relate to a transfer of rights of occupancy of the




Assumptions May Still Be Negotiable


The Garn St. Germain Act specifically encourages lenders to allow loan assumptions at blended, the contract, or below market-rate of interest and nothing in Garn is to be interpreted to prohibit any such assumptions.


(End of the CalBRE Reference Book excerpt)




The process of repaying a mortgage loan, or reducing a debt, is known as amortization, The repayment schedule of the majority of real estate loans requires equal, monthly payments consisting of principal and interest. Each payment is first allocated to accrued interest, and the remainder is used to reduce the outstanding loan balance, the principal. Each subsequent payment consists of slightly less interest and slightly more principal. At the end of the loan term, the debt is fully repaid, and thus a fully amortizing, or self-liquidating, loan.


Lien Theory versus Title Theory States


In some states a mortgage lender is recognized as having a lien, or claim, against mortgaged property. In other states, however, the mortgage lender is assumed to be the owner of the mortgaged property. This is because the mortgage contract represents an actual conveyance of title to the lender. These are known as title theory states. The primary difference between lien theory and title theory states is the recourse available to a lender in the event of default.


If a borrower defaults in a lien theory state, the lender must foreclose the lien, usually through court action, offer the property for sale at public auction, and apply the proceeds of the foreclosure sale to the outstanding loan balance to satisfy or reduce the debt. If the proceeds of the sale are insufficient to fully satisfy the amount of the debt, the lender may require the borrower to make up the difference as agreed in the promissory note.


Upon default in a title theory state, the lender must bring foreclosure action to recover the outstanding debt. However, already having title to the mortgaged property considerably shortens the time and expense of foreclosure proceedings. In title theory states, the mortgagee has the right to possession of and any rents from the property upon default. In lien theory states, the mortgagor, not the mortgagee, has these rights while the property is in foreclosure.


Deed of Trust States


Some states such as California use a deed of trust, also known as a trust deed, instead of a mortgage. The deed of trust, like the mortgage, pledges property as collateral for a loan. Unlike the mortgage, however, the deed of trust conveys the real estate as security to a third party, instead of to the lender. In trust deed states, the borrower is known as the trustor, the lender is known as the beneficiary, and the third party, of course, is the trustee. It is the trustee who acquires a lien against the property, not the lender. The trust deed details the action the trustee may take in the event of default. In addition, the trust deed contains covenants and provisions similar to those in a mortgage as described above. A deed of trust simplifies foreclosure proceedings and requires less time than would be required for foreclosure on a mortgage loan. A further advantage of trust deeds over mortgages is that the trust deed's power of sale (nonjudicial action) is not subject to the Statute of Limitations (four years) like mortgages are. In this textbook, the terms "mortgage" or "trust deed", "mortgagor" or "trustor, and "mortgagee" have been used interchangeably.




Loan Instruments


When borrowing money to finance the purchase of a home, the borrower signs two documents. First, the borrower signs a promissory note. A promissory note is a promise in writing to repay a debt. In this note, the borrower promises to the lender to repay the loan in definite installments with interest. The borrower also signs a security document. The security document specifies the property purchased as security for the debt incurred. Thus, the borrower promises to return the property to the lender if unable to repay the loan. This document entitles the lender to foreclose on the property should the borrower fail to pay in accordance with the terms of the promissory note.


In California, several types of security documents are used. The deed of trust, however, is the security document most frequently used. The mortgage and the installment land contract are used less frequently to secure a loan.


A typical deed of trust transaction involves three parties. On one side of the loan is the borrower, usually called the "trustor." The borrower also is referred to as debtor or mortgagor.


On the other side of the transaction is the lender, usually called the "beneficiary." Financing a home may involve two or more loans from different beneficiaries, and therefore two or more deeds of trust. The beneficiary holding the first, or senior, deed of trust is known also as the senior lienholder or senior beneficiary, while beneficiaries holding a junior (i.e., second) deed of trust are referred to as junior lien holders or junior beneficiaries. In the middle of the transaction is the trustee who serves as a neutral third party. The trustee has the responsibility to foreclose on the property should the borrower default on the loan. Title companies regularly serve as trustees. However, attorneys and other parties can be appointed to serve as trustee. 


The deed of trust specifies the borrower's obligations, which usually include:


          Making payments to the beneficiary in accordance with the terms of the promissory note;


          Keeping the property in good condition and repair;


          Paying, when due, all claims for labor and material caused by work being ordered done on the premises;


          Complying with all ordinances, statutes, and other laws as to physical condition and use of the premises;


          Obtaining policies and paying the premiums for relevant insurance policies;


          Appearing in court and otherwise defending any action or proceeding that may affect the security or the rights of the trustee or beneficiary and paying all reasonable costs, including attorney's fees;


          Paying real property taxes before they become delinquent; and 


          Paying special assessments before they become delinquent.


Failure to comply with any of the obligations listed in the deed of trust can lead to default and result in a foreclosure proceeding. Foreclosure is usually a result of the borrower's failure to make loan payments, but neglecting other responsibilities could result in foreclosure. It is the borrower's responsibility to be familiar with the terms of the agreement with the lender.


Like the deed of trust, the mortgage is a written contract that serves as security for the payment of a debt. The mortgage has two parties to it, the mortgagor who is the debtor and the mortgagee who is the creditor. Another difference between the deed of trust and the mortgage is expiration of the creditor's right to foreclose after default due to the "running of the statute of limitations." In the case of the mortgage, the creditor has four years from the time default occurs in which to file a lawsuit against the debtor. If this is not done within the four year statutory period, the creditor cannot legally proceed to enforce the mortgage lien by foreclosure. The power of sale provision in a deed of trust is not ended by the passage of time.


An alternative to the deed of trust and the mortgage is the installment land contract. Under this arrangement, the buyer may use the property, but no deed is given to the buyer by the seller until the seller is paid in full. Because the seller retains title until the debt is paid, there is no need for a deed of trust or a mortgage.


The installment land contract is used infrequently in California because court decisions have eliminated most advantages this security device offered sellers over the use of a promissory note secured by a deed of trust or a mortgage.


Foreclosure Methods


Beneficiaries, especially institutional lenders, may not always be eager to foreclose. Sometimes lenders will allow a loan to be delinquent for a considerable amount of time before they start the foreclosure. According to a recent study by The California State University Real Estate & Land Use Institute, the average length of time between the first missed payment and the recording of a Notice of Default was approximately 5 months and 21 days. Often a lender will allow a loan to be delinquent for about 90 days before initiating foreclosure. In the case of FHA or VA loans, foreclosure is initiated after payments have been in arrears for at least 90 days.


In California, the beneficiary can choose one of two methods to foreclose: judicial or nonjudicial. In a judicial foreclosure, the beneficiary files a lawsuit against the trustor in Superior Court to foreclose on the property. The case is then set for trial. If the court rules in favor of the beneficiary, the property will be ordered sold at a public sale. In most instances, however, it is a nonjudicial foreclosure. In a nonjudicial foreclosure, the court system is not involved. To foreclose nonjudicially, the deed of trust or mortgage must contain a power of sale clause. The power of sale clause gives the trustee the right to begin foreclosure without going to court. To include a power of sale clause does not require a specific form or language.


If, on the other hand, the security instrument does not contain a power of sale provision, judicial foreclosure is the beneficiary's only way to obtain the property. Most conventional deeds of trust say "with the power of sale."


Judicial and nonjudicial foreclosures differ in many ways. The foreclosure method selected by the beneficiary has significant consequences for the trustor.


Nonjudicial foreclosure is relatively fast, as this method does not involve the court system. In most instances, nonjudicial foreclosure takes, at minimum, about four months after the trustor has failed to meet the obligation or defaulted on the loan. Judicial foreclosure, on the other hand, may take up to several years.


Nonjudicial foreclosure is generally less costly than judicial foreclosure. In a nonjudicial foreclosure, the trustee's and attorney's fees are largely specified by law. In a judicial foreclosure, however, there are generally no legal limits for attorney's fees. As a result, the trustor may be liable for significant legal expenses.


Another major difference between the two foreclosure methods is the beneficiary's right to a deficiency judgment. A deficiency judgment is a court order stating that the trustor still owes money to the beneficiary if the proceeds from the foreclosure sale are not sufficient to pay the balance of the debt.


California law does not allow a deficiency judgment in a nonjudicial foreclosure on residential purchase money loans. A residential purchase money loan is one in which loan proceeds are used to purchase the property. Furthermore, California law does not allow deficiency judgments against the residential trustor where the loan was made by the seller of the property or by a third party lender (often a financial institution) on a four-unit or less residential property that is the principal residence of the trustor. If the beneficiary judicially forecloses on a nonpurchase money residential loan, a deficiency judgment may be obtained against the trustor.


Nonjudicial and judicial foreclosures also differ with regard to the trustor's right of redemption after the foreclosure sale. This is the trustor's right to reclaim the foreclosure property. In a nonjudicial foreclosure, the sale of the property at the trustee's sale is an irrevocable final sale, and the trustor does not have the right to redeem or reclaim the property after the sale. Judicial sales, however, are subject to redemption by the trustor.


This summary of the major differences between nonjudicial and judicial foreclosure shows the advantages of nonjudicial foreclosure for the beneficiary. The nonjudicial foreclosure is timely, economical, not subject to redemption, and may command a higher sales price. Also, it is unlikely that the beneficiary would recover any losses through a deficiency judgment as the trustor could not make the loan payments in the first place. Because of these advantages, beneficiaries typically prefer to foreclose nonjudicially. Beneficiaries might foreclose judicially when they see an opportunity to recover any losses through a deficiency judgment.


The following two sections give detailed information on each of the foreclosure methods.


This section describes the major procedural requirements of nonjudicial foreclosure, discusses the trustor's reinstatement and redemption rights, reviews legal provisions for trustee's fees, and summarizes special legal provisions affecting foreclosures in California. 


California law allows the beneficiary of a deed of trust containing the power of sale provision to foreclose nonjudicially after the trustor has defaulted on one or more contractual obligations. In case of default, the beneficiary may order the trustee to initiate foreclosure.




Notice of Default


Foreclosure begins when the beneficiary notifies the trustee that the trustor has defaulted on any obligations stated in the promissory note and deed of trust. The beneficiary gives the trustee information concerning the condition of the debt such as the amount of the unpaid balance and due dates. Upon receipt of this information, the trustee prepares the Notice of Default.


The Notice of Default must be recorded in the office of the recorder of the county where the property is located. If the deed of trust encumbers property located in more than one county, the Notice of Default should be recorded in the other counties as well 


The trustee must mail a copy of the Notice of Default to the trustor and to each person requesting notice within ten days of recording the notice. The law specifies additional notification requirements under certain circumstances. The Notice of Default must be published weekly for four weeks in a newspaper or personally be served on the trustor, if the trustor has not requested to be notified of its recordation of the notice.


Trustors should always notify the beneficiary and the trustee of any address changes to ensure prompt receipt of any correspondence from the beneficiary or trustee.


Prior to January 1, 1986, the trustor and beneficiaries under subordinate deeds of trust were given three months from the recordation of the Notice of Default to cure the default. An amendment to the law extended the expiration of the reinstatement period to five business days before the scheduled trustee's sale. If the trustee's sale is postponed, the reinstatement period is extended to five business days before the new date of the sale.


At any time during the reinstatement period, the trustor may stop the default by paying the beneficiary all sums of money due on the loan up to that point including additional costs incurred by the beneficiary, and attorney's or trustee's fees as specified by law. It is not necessary to repay the entire loan balance.


After reinstatement of the loan, the foreclosure proceeding is discontinued and the trustor resumes making the regular periodic payments.


Notice of Trustee's Sale


If three months have passed since recording the Notice of Default, and the trustor has not begun to reinstate the loan, the trustee may proceed with the foreclosure by preparing a Notice of Trustee's Sale.


The Notice of Trustee 's Sale must be recorded in the office of the recorder of the county in which the property is located at least 14 days before the date of the sale. As with the Notice of Default, the Notice of Trustee's Sale must be mailed to the trustor's last address actually known to the trustee.


The Notice of Trustee's Sale also must be published in a newspaper of general circulation in the city, judicial district, or county where the property is located. The notice must be published once a week over a 20-day period before the sale.


In addition to mailing and publication, the Notice of Trustee's Sale must be posted for at least 20 days before the sale at the following locations:


          In at least one public place in the city, judicial district, or county in which the property is to be sold; and


          In a conspicuous place on the property to be sold.


Improperly broadcasting the Notice of Trustee's Sale typically will result in the cancellation and renotice of the sale.


As mentioned before, the trustor can cure the default during the reinstatement period which runs up to five days before the scheduled sale. After the reinstatement period expires, the trustor must pay the entire indebtedness plus foreclosure costs to avoid foreclosure. This is called redemption and only can be done during the five days prior to the sale. The trustor's right of redemption ends once bidding at the foreclosure sale starts.


Trustee's Sale


The trustee or the trustee's agent must conduct the foreclosure sale at a public auction in the county where the property is located. The sale is to the highest bidder who must pay in cash, cashier's check, or cash equivalent as specified in the notice and acceptable to the trustee.


The trustee may postpone the sale at any time before it is completed. The sale may be postponed at the trustee's discretion, upon instruction by the beneficiary, or upon a written request by the trustor who has the right to request a one-day delay to obtain sufficient cash to pay the debt or bid at the sale. The trustor's request for postponement must include a statement identifying the source of the funds. The law allows for three postponements. After three postponements, a new notice of sale must be given, except for postponements, requested by the trustor or ordered by a court.


After the sale to the highest bidder, the trustee executes and delivers a trustee's deed to the purchaser. The trustee 's deed conveys title to the purchaser free and clear. The issuance of the trustee's deed terminates the previous trustor' s legal and equitable rights in the property. It should be noted, however, that title to the property is conveyed subject to all senior liens, including liens for property taxes and assessments.


The purchaser of the foreclosed property is entitled to take immediate possession. A trustor who refuses to vacate the property may be legally forced to do so.


Rent And Rental Income Prior To The Foreclosure Sale


Generally, the trustor occupying the property does not have to pay rent to the beneficiary while in default. If a deed of trust should indicate a rent liability, enforcement of it would be unlikely.


The beneficiary may have a right, however, to any rental income generated by the property during the period of default. In the absence of such a provision in the deed of trust, the beneficiary is generally not entitled to any rental income.


Deficiency Judgment


In the event proceeds from a foreclosure sale are insufficient to pay off the outstanding loan balance, the mortgagee may seek a deficiency judgment against the mortgagor. This is a personal judgment against the borrower and anyone else who may have endorsed or guaranteed the loan on behalf of the borrower. A deficiency judgment allows the lender to collect the debt against the personal assets of the mortgagor. Recall that when the debt was incurred, a promissory note was executed. This note serves as evidence of the debt and is secured by the mortgage. The deficiency judgment is to enforce the pledge made by the mortgagor in the note that the debt will be repaid in full from personal assets if necessary.


Note: A deficiency judgment is not available in all states. Some states expressly prohibit it, while other states have a very liberal policy as to what and how much the mortgagee can attach. 


In general in California, the law prohibits a deficiency judgment in a nonjudicial foreclosure with a power of sale provision. Even if the proceeds from the foreclosure are inadequate to repay the loan, the beneficiary has no other possibility to recover.


Trustee's Fees


The fees a trustee is entitled to charge the beneficiary or deduct from the proceeds of the sale are prescribed by law. The trustee may charge for costs incurred in recording, mailing, publishing, and posting the Notice of Default and Notice of Sale; the costs of postponing the sale by request of the trustor (not to exceed $50 per postponement); and the cost of a trustee's sale guarantee. In addition to charging for these actual costs, the law provides for a fee schedule based on the amount of the unpaid debt.


The legal limitations for trustee 's and attorney 's fees do not apply to attorney's fees the beneficiary is entitled to recover under special provisions of the deed of trust.


Special Legal Provisions Affecting Foreclosure


Special federal and state laws may affect the manner in which the foreclosure is conducted. If the loan is insured or guaranteed by the U.S. Department of Housing and Urban Development (HUD/FHA) or the Veterans Administration (VA), certain procedures must be followed. In the case of a VA-guaranteed loan, the trustor may be liable for any deficiency, unless the veteran obtains a release of liability from the VA. California law does not necessarily protect the trustor from liability for a deficiency on a VA guaranteed loan. Federal laws governing the VA loan program take precedence over any conflicting California law. Trustors should contact the VA for details concerning their rights and to learn about specific requirements.




Judicial foreclosure is tried in the California Superior Court. The beneficiary, upon default of obligation by the trustor, brings a foreclosure lawsuit against the trustor. If successful, the court will issue an order to sell the property at a public sale. The beneficiary must use judicial foreclosure if the security instrument does not contain a power of sale provision. A mortgage or deed of trust containing the power of sale provision may be foreclosed judicially if the beneficiary chooses to do so.


The decision to foreclose judicially or nonjudicially is not necessarily final. The beneficiary may discontinue judicial foreclosure at any time and commence nonjudicial foreclosure. Conversely, the beneficiary may abandon nonjudicial foreclosure and initiate judicial foreclosure. Beneficiaries sometimes initiate both types of foreclosure simultaneously.


Foreclosure Sale


Notice of the sale of the property must be given by a court appointed commissioner or sheriff in a public place for 20 days preceding the date of the sale. This same notice must be published in a newspaper of general circulation weekly for 20 days. The notice also must be sent by certified mail to all defendants at their last known addresses.


At the foreclosure sale, the property must be sold by the auctioneer to the highest bidder who is financially qualified.


Redemption Of Property


In a judicial sale, the trustor has the right to redeem or reclaim the property after the foreclosure sale. For a trustor, the right of redemption makes a judicial sale attractive. It should be remembered, however, that a judicial sale may also lead to a deficiency judgment. This possibility does not exist in a nonjudicial foreclosure.


Deficiency Judgment


In a judicial foreclosure, the beneficiary has, under certain circumstances, a right to a deficiency judgment. The deficiency judgment is limited to an amount equal to either the difference between the indebtedness and the fair market value of the property, or the indebtedness and the sale price at the foreclosure sale, whichever is less.


Rent And Rental Income


The trustor occupying the disputed property does not have to pay the beneficiary rent while in default. The beneficiary may be entitled, however, to any rental income generated by the property.


After the sale, the trustor retains possession of the property, but may have to pay rent during the period of redemption. The purchaser of the property can take possession only after the expiration of the redemption period, which is either three months or one year after the sale.


How to avoid foreclosure


If a trustor is in default, it is essential to take timely and determined steps to deal with the problem. It is necessary to assess the situation, explore options for meeting the obligation, and take decisive action. The trustor's situation may not be as hopeless as it appears; realistic and effective options to avoid foreclosure may be available. Acting quickly may also mean lower fees and costs for which the trustor can be liable.


There are several actions trustors should consider to avoid foreclosure. At the onset of financial difficulties, trustors should immediately contact their beneficiary and negotiate an arrangement to deal with the payment problems. Most beneficiaries are keenly interested in finding ways to help trustors overcome their financial difficulties so that they can meet their loan obligations. The beneficiary may agree to changing the payment schedule, refinancing the loan, delaying filing of Notice of Default and Notice of Sale, or postponing the foreclosure sale.


While negotiating with the beneficiary, a trustor also should explore other methods to avoid foreclosure. Alternative courses of action would include borrowing money to pay the loan obligations or selling the property before the foreclosure sale.


Additionally, a trustor may have sufficient grounds to take legal action to avoid foreclosure. Legal action can be aimed at halting the foreclosure sale or setting the sale aside after it has taken place.


Obviously, the trustor should take all precautions to avoid delinquency and default in the first place. These include avoiding financial overextension and maintaining a sufficient cash reserve to deal with emergencies such as unemployment and illness.


Although most people want to keep their property and avoid foreclosure, especially if there is equity in the property, many do not take timely action to avoid the foreclosure sale. It is common for people to procrastinate during the early phase of the foreclosure process. Some do not open their mail for fear of receiving another threatening letter or legal notice. This can mean that a substantial portion of the typical reinstatement period, when the person could act to avoid foreclosure, is lost through inaction or indifference. By the time the significance of the situation is realized, there is little time remaining to prevent the trustee's foreclosure sale.


Negotiate With The Beneficiary


As many trustors have demonstrated, effective communication with the beneficiary is often the key to avoiding foreclosure. When financial problems first arise, the trustor should contact the beneficiary immediately, discuss the situation, and attempt to negotiate a remedy. A timely and determined response may motivate the beneficiary to explore ways that enable the trustor to meet the loan obligations.


As a rule, the earlier a trustor communicates with the beneficiary, the more likely it is that a solution to the financial difficulties can be found. People should not wait until they are delinquent on one or more payments, or until the Notice of Default has been filed, to contact the beneficiary. They should advise the beneficiary before they become delinquent, when they think that they might have a problem making a loan payment. Dealing with problems in a timely fashion may give the trustor and the beneficiary sufficient time to work out a solution.


A trustor should neither wait for the beneficiary to begin discussions, nor should the trustor wait for the first reminder notice to arrive or for a phone call inquiring about the delay in the payment. A trustor should always make the first contact, although this may be an emotionally difficult step to take. Before contacting the beneficiary, a trustor should review the loan documents, become knowledgeable about a borrower's rights, and assess the ability to pay.


By acting quickly to resolve payment problems, trustors can avoid accumulating excessive debt. Making up one or two payments may be possible, but missing several payments may create a debt that is too large to handle.


In most instances, beneficiaries will make every reasonable effort to work with a deserving trustor. As long as this person acts in good faith, is honest, and makes a conscientious effort to resolve the financial difficulties, a beneficiary will likely work with him or her to avoid foreclosure. A trustor who is chronically late in making loan payments or could make a more determined effort to deal with payment problems will usually receive less assistance from the beneficiary.


Another option is to refinance the property. By obtaining a loan with a lower interest rate, monthly payments may be reduced. It is sometimes possible to negotiate with the beneficiary for a delay in filing the Notice of Default or Notice of Sale or a postponement of the sale. This may give the trustor sufficient time to obtain the funds necessary to reinstate the loan.


A trustor should examine the deed-in-lieu of foreclosure as an alternative to foreclosure. This is an act to give the property to the beneficiary without going through foreclosure and is sometimes referred to as a "friendly foreclosure." The trustor may benefit from it in several ways. The credit rating may not be adversely affected, the possibility of a deficiency judgment is removed, and the trustor may later seek to set aside the deed-in-lieu. The beneficiary, on the other hand, assumes the property subject to all junior liens. For this reason, beneficiaries are hesitant to pursue this method to reach a settlement.


If a trustor is unable to obtain the funds to reinstate the loan or to negotiate an arrangement with the beneficiary, selling the property may be an option to avoid foreclosure. Trustors should explore the need for and feasibility of selling the property to a qualified buyer.


Explore Legal Alternatives


In addition to the actions mentioned so far, trustors also might explore the possibility of taking legal action to avoid foreclosure. There may be sufficient legal grounds to halt the scheduled foreclosure sale or to have the sale set aside. Trustors should recognize, however, that in most instances legal action is not an effective solution. It may be costly as it usually requires an additional expenditure of money. In many cases, legal action leads only to a temporary stay in the foreclosure process with foreclosure as the ultimate outcome. Trustors are advised to consult an attorney to determine the feasibility of taking legal action.


The three-month period between the Notice of Default and the Notice of Trustee's Sale, and the 20-day period between the Notice of Sale and the actual sale, give a trustor time to explore legal action to have the foreclosure sale enjoined or halted. To enjoin the sale, the trustor may seek a restraining order or injunction from a Superior Court ordering the trustee to halt the foreclosure sale.


A trustor must have sufficient grounds to have the sale enjoined. Grounds for enjoining the sale include the following:


          There was no default under the loan agreement;


          The beneficiary has no valid lien against the property;


          There was fraud in the original loan. transaction; or


      There are irregularities in the sale procedure, including defects in Notice of Default, Notice of Trustee's Sale, or the proposed conduct of the sale.


Courts typically deny an injunction sought by a trustor who is simply trying to gain more time to cure the default. After the foreclosure sale, the trustor can take legal action to have the sale set aside and ownership of the property restored. As with the action to have the sale enjoined, a trustor must have sufficient grounds. Grounds for setting aside the sale include those required to enjoin the sale.


Another legal option to halt foreclosure is to file a petition in bankruptcy if grounds otherwise exist for filing such a petition. Generally speaking, filing a petition in bankruptcy results in an automatic stay which prohibits creditors from taking certain actions to collect debts from the debtor.


(The following reprinted by permission from the CalBRE Reference Book, p.423-427)




The first obvious alternative to mortgage financing is for the individual to buy the entire equity for all cash. Most important of all, the risk is all on the individual alone.


Syndicate Equity Financing.


Syndicates refer to a form of joint method of equity financing involving a number of participants, and offers the investor benefit of the knowledge of values of professional management, including its ability to find, organize and manage a successful syndicated venture. Syndicates commonly describe a setup with passive investors relying on professional expertise of the organizers.


Syndicate Forms


Limited Partnership


Under the California Revised Limited Partnership Act, a limited partner is not liable as a general partner unless the limited partner is named as a general partner in the certificate of limited partnership or the limited partner participates in the control of the business. If the limited partnership agreement otherwise satisfies certain tax requirements, the limited partnership is taxed as a partnership rather than as an association taxable as a corporation.


Real Estate Investment Trusts


A real estate investment trust (REIT) is a trust or corporation that serves as a conduit for real estate investment for its shareholders. A REIT elects special tax treatment on the basis that most of its income is received from real estate and that income is currently distributed to the shareholders. As a result of this election, REITs that distribute all of their income generally pay no entity-level taxes on earnings. In exchange for this special tax treatment, REITs are subject to many very specific qualifications and limitations.


Real estate investment trusts are categorized as equity trusts, mortgage trusts (short-term or long-term) or combination (balanced) trusts.


An equity trust is involved essentially in the ownership of real property (residential, commercial, industrial or vacant land) and its chief source of income is rent.


Mortgage trusts invest their assets in short-term or long-term mortgages or other liens against real property. Thus the investment may be for a permanent portfolio or interim financing involving land development or construction loans. 


Some of the requirements to qualify under federal law are:


1.Must not hold property primarily for sale to customers in the ordinary course of business.


2. Must be beneficially owned by at least 100 investors.


3.     No five persons or fewer may hold more than 50 percent of the beneficial interest.


4.     This "beneficial interest" must be evidenced by transferable shares or certificates of interest.


5.     In California, there is the further limiting proviso that each share or certificate of interest carries with it an equivalent vote.


6.     Investments must account for a minimum of 95 percent of the trust's gross income.


7.     Seventy-five percent of gross income must come from real estate investments.


8.     Less than 30 percent of the trust's gross income may result from short-term gains on sales of stock or securities held for less than six months plus sales (but not involuntary conversions) of real estate held less than four years.


9. Accounting period must be the calendar year.


Commercial Loan.


Another approach is to secure a straight bank loan and use the proceeds to purchase real property without using the real property as collateral. This involves borrowing against the credit of the borrower or the borrower putting up some other kind of security, for example, stock, bonds, personal property, etc.


Bonds or Debentures or Stock.


It is possible for large, well-rated corporations to sell general obligation bonds or debentures to the general public in order to raise money to purchase real property without using a mortgage. The corporation might also issue additional shares of stock.


Long-term Lease.


This provides a good approach provided the property is usable as it is. If the lessee is only leasing the land and has to pay for construction of improvements, it will probably require a larger investment than buying the property improved with a standard conventional mortgage on it.




The use of a trade or exchange of properties is in a sense an alternative to mortgage financing.


Sale Leaseback.


This has become a very popular technique among strongly rated companies with excellent credit. Other names for this form of transaction are purchase-lease, sale-lease, lease-purchase and leaseback. All these terms mean the same thing.


Subordination Agreement.


Any security instrument (mortgage, trust deed or land contract) may contain a "subordination clause," that is, an agreement or clause providing that such lien will be subordinate in priority to any specified existing or anticipated future lien. This clause is extensively used by land developers to permit the placing of construction loans subsequent to the execution of "purchase money trust deeds" with the original landowner.


A real property security instrument that contains a subordination clause shall contain, at the top, in at least 10-point type, underlined, "SUBORDINATED”. Below the word "SUBORDINATED", there must be a statement as follows, in at least 8-point type or typewritten capitals:


"NOTICE: This (security instrument) contains a subordination clause which may result in your security interest in the property becoming subject to and of a lower priority than the lien of some other later security instrument. If the terms of the subordination clause allow the borrower to obtain a loan for purposes other than improving the real property, the following must appear in the same size type as the notice directly above the signature block for the lender: "NOTICE: This (security instrument) contains a subordination clause which allows the person obligated on your real property security instrument to obtain a loan a portion of which may be expended for purposes other than improvement of the land."


(End of the CalBRE Reference Book excerpt)


Consumer protection


The lending process is controlled by three federal laws: the Equal Credit Opportunity Act of 1974, the Fair Credit Reporting Act of 1970 and the Truth-in-Lending Act.




Regulation B of the Equal Credit Opportunity Act provides that lenders may not discriminate against potential borrowers by asking any of the following:


1.   Lenders may not ask about sex, race, national origin, religion or discourage a borrower from applying because he/she receives public assistance.


      (A lender may ask the borrower to voluntarily disclose sex, race or national origin when application is made for a real estate loan. This information helps federal agencies enforce anti-discrimination laws. A lender may inquire about residence or immigration status )


2. A lender may not ask if the borrower is divorced or widowed


3.   If the borrower is applying for a separate, unsecured account, the lender may not ask about the borrower's marital status. (This does not apply in community property states like California.) 


4.   The lender may not ask about the borrower's spouse unless the spouse is also applying for a loan.


5.   The lender may not ask about the borrower's plans for having or raising children.


6.   The lender may not ask the borrower if he/she receives alimony, child support or separate maintenance payments.


      (A lender may ask for this information if the borrower is first told that he/she does not have to reveal it if the borrower does not rely on it to get credit. The lender may ask if the borrower must pay alimony, child support, or separate maintenance payments.)


When deciding to give credit, a lender is prohibited from:


1.   (Considering the borrower's sex, marital status, race, national origin, or religion.


2.   Consider whether the borrower has a telephone listing in his/her name.


      (The lender may consider whether there is a phone in the borrower's home.)


3.   Consider the race of the people who live in the neighborhood where-the borrower wants to buy a home or improve a home with borrowed money.


4. Consider the borrower's age unless:


a. The borrower is under 18 years of age and, therefore, unable to sign contracts


b.          The borrower is 62 or over and the creditor will favor the borrower because of his/her age


c.           The age of the borrower is used to determine the meaning of other factors which are important to credit-worthiness.


             (A lender could use the borrower's age to see if the borrower's income might be reduced because the borrower is about to retire.)


d.         The age of the borrower is used in a scoring system which favors borrowers age 62 and over.


When considering the income of the borrower, the lender may not:


1.   Refuse to consider reliable public assistance income in the same manner as other income.


2.   Discount income because of sex or marital status. (For example, a lender may not count a man's income at 100% and a woman's at 75%.)


3.   Assume that a woman of child-bearing age will stop work to have or raise children.


4.   Discount or refuse to consider income because it is derived from part-time employment or from pension, annuity, or retirement benefit programs.


5.   Refuse to consider consistently-received alimony, child support, or separate maintenance payments. (A lender may ask for proof that this income has been received consistently.)


When making application for a loan, the borrower has the following rights:


1.   To have credit in the borrower's birth name, the first name and spouse's last name, or the borrower's first name and a combined last name (Mary Smith-Jones).


2. To have a co-signer other than a spouse if one is necessary.


3.   To keep the borrower's own accounts after a change in name, marital status, reaching a certain age, or retire unless the lender has evidence that the borrower is unable or unwilling to pay.


4.   To know whether the loan application was accepted or rejected within 30 days.


5. To know why the application was rejected.


6.   If offered less favorable terms than the ones the borrower applied for, the borrower has the right to know why other terms were offered. (This does not hold if the borrower accepts the terms.)


NOTE: A good credit history or record of how past bills have been paid is often necessary to obtain credit. Unfortunately, this hurts many married, separated, divorced and widowed women. There are two common reasons women do not have credit histories in their own names: they lost their credit histories when they married and changed their names, and creditors reported accounts shared by married couples in the husband's name only.




The Fair Credit Reporting Act is designed to protect borrowers from inaccurate credit information reported by credit bureaus.


The Act provides that an individual has the right to inspect his/her credit "file" and correct any errors, adding explanatory notes as supplementary information.


The Act also provides that if a lender in a real estate transaction refused credit due to the credit report, the lender must provide the borrower with the identity of the credit bureau which made the report.


(NOTE: Most derogatory information about a borrower is usually dropped from a credit report after seven years. Bankruptcies may remain on the credit report for 14 years.)




Regulation Z of the Truth-in-Lending Act of 1969 covers residential real estate transactions. It was amended in 1982 to become the Truth-in-Lending Simplification and Reform Act.


The Act allows borrowers to obtain correct information about loans and compare costs.


Those exempted from coverage by the Act are loans for business, commercial, agricultural purposes. Personal property transactions over $25,000 are exempted. Loans on dwellings containing more than four living units are exempted. Loans to builders for construction purposes are exempted from coverage.


The Truth-in-Lending Simplification and Reform Act is a disclosure act. It requires lenders to disclose the following information:


1. The date the finance charge will begin.


2. The number of monthly payments.


3. The due dates of payments.


4. Any default or delinquency charges.


5. Any payoff penalties.


6. Any balloon payments


7.   The total amount of credit that will be made available to the borrower.


8. The method of computing credits for early payment.


9. The composition of finance charges.


10. The total finance charge.


11. The total of all payments including principal.


12. A description of any property used as collateral for the loan.


In addition, if the loan is connected with a sale, the cash price, down payment and unpaid balance, must also be stated in writing.


Right to Rescind:


The act provides that the borrower has three days to rescind a loan on home improvements, appliances or furniture where a second mortgage was taken to pay for the purchases. The right to rescind does not apply to a residential mortgage transaction.


Advertising under Regulation Z


An important factor to consider when preparing an ad is whether or not the ad is in fact legal. Legality is based on compliance with Regulation Z, which is a part of the Truth-in Lending Act. Its purpose is to protect consumers by providing full disclosure and giving them the chance to make informed choices.


Almost anyone who advertises financing information is subject to this rule. Just because information about financing has not been included in a classified ad does not mean there is nothing to worry about. The regulation defines advertisements as "any commercial messages that promote consumer credit." The "fact" sheets often displayed in open houses should reveal all the facts.


"Triggering" terms that force the application of the regulation are: monthly payment, terms of the loan or the dollar amount of any finance charges. As with most laws, there are gray areas and exceptions. For instance, if only the down payment is mentioned in an ad, it doesn't trigger the need for other disclosures, unless the seller of the property is doing the financing and meets the definition of "creditor." A creditor is someone who regularly extends credit. Further defined, it means someone who has financed at least five transactions secured by mortgages in the previous year. This would more likely come up when advertising property that has been repossessed by a lender. If financing is offered by the lender who owns the property, and the lender meets the definition of a creditor, then the ad must comply with a full disclosure.


Following is a quick guide to Regulation Z compliance:


For Fixed Rate Loans:


If You Advertise                                                  You Must Also Advertise


1. APR                                                                  No other disclosure


2. Simple interest rate                                             APR


3. Down payment                                                  Disclosure is necessary


                                                                             unless seller meets the


                                                                             definition of a creditor


4. Monthly payment                                               Down payment,


                                                                             loan term and APR


5. Loan term                                                          Payment, down payment


                                                                             and APR


For Buy-Downs: If You Advertise                    You Must Also Advertise


1. Subsidized simple                                            Length of time subsidized


interest rate                                                          rate applies


(Rate advertised is subsidized


by sellers, and buy-down is


reflected in contract between


buyer and lender)


                                                                           Simple interest rate that


                                                                           applies to balance of term


                                                                       and composite APR 


                                                                           (Optional) May show


                                                                           effect of buy-down on


                                                                           payments period without


                                                                           triggering additional




2. Reduced Payment                                            Reduced simple interest,


                                                                           length of time reduced rate


                                                                           and payment apply, simple


                                                                       interest rates that apply to balance of term, and APR


3. APR                                                                No other disclosure




4. Down Payment


                                                                           No other disclosure


                                                                           is necessary, unless


                                                                           seller meets the definition


                 of creditor


The Federal Trade Commission which monitors compliance to Regulation Z concedes most violations are unintentional, but unfortunately for advertisers, ignorance is not considered a defense.


Violations are usually handled administratively. The FTC simply asks violators to bring their advertising into compliance. The agency does seek fines for flagrant violations, however. The largest fine assessed against a single violator has been $300,000.


Borrower Qualification


The ultimate goal in the lender's mind when considering a property and a prospective borrower for a loan is quality. The first question the lender will want answered is, "Is the borrower capable of repaying the debt?" The second question is, "Is the property worth enough to be adequate collateral for the amount loaned?"


The lender will consider the prospective borrower's income and compare that with the amount of existing debt he/she has. The question then becomes there enough room for an additional burden of debt?"


In general, creditworthiness is based on the borrower's capital, capacity and character. The borrower's capital includes such assets as savings, real property, car(s) other property of value.


The borrower's capacity includes his/her job, earnings and continued employment.


The borrower's character includes his/her history of paying debts, promptness in paying debts and straightforward response to creditors if there has been trouble paying debts.


In order to determine capital, capacity and character, a lending institution will usually look at:


1. Whether or not the borrower has a stable monthly income.


2. The pattern of the borrower's employment. Is he/she consistently employed or does he/she "job hop"?


3.   The employment stability of the borrower is also considered. This includes whether the type of employment is currently in demand and its prospects for the future are good or otherwise.


4. Income:


      a. Salaries


      b. Overtime


      c. Bonus


      d. Commissions


      e. Part time job


      f. Dividend and/or interest income


      g. Rental income


      h. Child support or alimony


      i. Public assistance


      j. Retirement income


5. Sources of money for down payment and closing costs.


6.   The borrower's desire for housing and his/her willingness to pay.


7. Liabilities:


      a. Installment debts


      b. Loans other than bank loans (credit unions, for example).


      c. Whether or not there is a co-signer.


      d. Child support and/or alimony payments.


8. Credit history.


In considering the above information, the lending institution will make a comparison of income to debt. The institution will consider the amount of income that goes for the housing payment and the long-term debt-to-income ratio.


Though these ratios vary, the Fannie Mac/Freddy Mac definition of a long-term debt is one that extends beyond 10 months. This includes child support and alimony payments.


Knowing these ratios, the broker or salesperson often can determine whether or not prospective buyers can afford the home they are interested in buying. If the prospective buyer cannot qualify for the required loan from a financial institution, the broker may suggest that the buyer seek financial assistance from family or others in a position to help with the purchase of a home. Alternatively, the broker might convince the seller to assist with financing by taking back a purchase money mortgage.


For conventional loans, lenders primarily use three income ratios:


1)   The first holds that the monthly payments for principal, interest, and an allowance for property taxes, and insurance (PITI) should be no more than 25-30% of the applicant's monthly gross income.


2)   The second ratio implies that total PITI and other housing expenses should not exceed 30-35% of monthly gross income.


3)   Third, the total of PITI, housing expenses and all installment payments should be no more than 45-55% of monthly gross income.


If the loan under consideration is to be insured by the FHA or guaranteed by the VA, different standards are used. With FHA loans, total monthly housing expense should not exceed 38% of monthly net income. Monthly net income is calculated as gross income less taxes. Additionally, total monthly obligations should not exceed 54% of monthly net income. Lenders usually apply only one ratio in analyzing a VA loan. Total monthly housing expense should not exceed 54% of net effective monthly income, calculated as gross monthly income minus taxes, social security, and monthly obligations.




(The following is reprinted by permission from the CalBRE Reference Book, p. 312-313)


Usury. In California the passage of Proposition 2 in 1979 made significant changes to the constitutional provisions on usury. Now all loans secured in whole or in part by liens on real property and made or arranged by a licensed real estate broker are exempt from the usury law. Private individuals making such loans without a broker are controlled by the usury law. However, federal law preempts state constitutional and statutory interest ceilings on most institutional real property loans.


Real estate brokers acting as mortgage loan brokers must be alert to situations in which they may need to satisfy the requirements of the Truth-in-Lending Act and Regulation Z. Brokers who are uncertain about their responsibilities for compliance can seek advice from their attorneys or the Federal Trade Commission.


(End of CalBRE Reference Book excerpt)