CHAPTER 5 - FINANCE INTRODUCTION Notes: loan real estate loan leverage assume and agree to pay

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1 MacIntosh Real Estate School Uniform Course Chapter 5 CHAPTER 5 - FINANCE INTRODUCTION Notes: Regulation Z Financing is the linchpin for most real estate transactions. Over the years institutional lenders have increased the amount of loan in relation to value of security and have made loans for a longer term under a program of monthly amortization of the principal. Real estate loans in the 1920's and early 30's were normally not amortized, the full amount of principal being payable at expiration of loan term, which usually was from three to ten years. Many homeowners in the depression lost their property since they were unable to make full payment of the loan. A loan is the letting out or renting of a certain sum of money by a lender to a borrower to be repaid with or without interest. Keeping this in mind, a real estate loan is one where the repayment is secured by real property. Nearly all real estate transactions are attended by some form of financing. With the availability of larger loans to value of property the real estate buyer is able to make purchases with a smaller equity, thereby allotting more individuals to become owners of real estate. Also, there is less need for second mortgages. Elimination of second mortgages allows a seller to obtain their entire equity at the time of sale and permits a more orderly repayment program for the buyer. The reduced equity requirements have encouraged the purchase of property. Financing is also closely related to the concept of leverage. Leverage is defined as the ability of a borrower to borrow cash from a lender while pledging assets against the amount of cash borrowed. It is also known as the relationship between one s debt and one s equity. The greater percentage of value that is borrowed, the greater leveraged is that property. The more money that is borrowed against the property (higher leverage), the more capital is freed up for the borrower to invest elsewhere. To balance that positive aspect, however, the more leveraged a property the greater the risk to the lender, and the greater the likelihood that if the investment fails (loses value) the borrower will lose not only that investment, but still be required to pay back the loan. One method of financing is for the purchaser to assume and agree to pay a loan which already encumbers the property. In such a case the broker should examine the trust deed or mortgage to see if there are any limiting provisions concerning the lender's right to change the terms of the loan. The broker should also advise the seller that they may remain personally responsible for the loan if the purchaser defaults. Sometimes a lender will release a seller from personal responsibility if the purchaser who assumes the loan is an acceptable credit risk. 1

2 However, new financing is usually necessary in the sale of real estate. Although loans are occasionally made by private lenders (such as the seller), they are usually made by established lending institutions. A written application is usually made and the lender appraises the property, evaluates the credit rating of the applicant, and the merchantability of the title. If the lender offers a loan commitment, Colorado law requires that such commitment be in writing. The lender must also provide a good faith estimate of loan costs and fees to the borrower, the seller, and any third party who will be liable on the loan. Specific terms and requirements of different lending institutions vary widely. Such variables may involve a prohibition against prepayment of the mortgage (or a penalty for prepayment); prohibition or limitation of the right to sell the property without the consent of the lender; requirements with respect to the amount and nature of insurance required; requirements that escrow payments be made for anticipated property taxes and insurance premiums; limitations on the right to borrow additional funds on the property from another source; limitations on the use of the property; etc. CATEGORIES OF REAL ESTATE LOANS Real estate loans today are categorized into three general types. They are Veterans Administration (VA) guaranteed and direct loans; Federal Housing Administration (FHA) insured loans; and conventional loans, which are any loans not guaranteed or insured by a Federal or State agency. In Colorado, loans to low income buyers are also sponsored by the Colorado Housing Finance Authority (CHAFA). (1) Veterans Administration Loan (VA). To qualify for the benefits of the Veterans Administration loan program, a person must have served in a branch of the Armed Forces and have been released from service with other than a dishonorable discharge or undesirable separation. Members of the Armed Services have been awarded veterans loan benefits for active service during certain periods of service. Certain widows are also eligible for VA loans. The Veterans Administration Loan Guaranty Program was instituted for several reasons. Its primary concern was to provide protection to the veteran in the form of: a) valuation of housing (Certificate of Reasonable Value or CRV); b) moderate interest rate; c) minimum or no down payment; d) moderate payment period (usually 30 years) and e) prepayment of loan without penalty. Here are some specific features of VA-guaranteed loans: VA loans are available on one to four family units and are secured by a first mortgage on real property. Repayment of this loan is guaranteed by the government for a percentage of the reducing loan balance. The veteran must apply for a certificate of eligibility that indicates the maximum guarantee to which the veteran is entitled. 2

3 MacIntosh Real Estate School Uniform Course Chapter 5 Limit on the maximum amount of VA guarantee: a. Loans up to $45,000 50%; b. $45,001 to $56,250 - $22,500; c. $56,251 to $203,000 the lessor of $36,000 or 40% of loan; d. More than $203,000 the lessor of $50,750 or 25% of loan. This government guarantee induces the lender to loan with a minimum or no down payment. If the veteran should default and the lender takes a loss, the Veterans Administration must pay the guaranty to the lender. In such event, the veteran borrower may be required to repay the amount paid by VA and in no event will be eligible for another VA loan until the amount is repaid. It is permissible for the veteran to pay a price above the CRV as long as they certify that they understand that they are doing so and as long as they pay the excess and their closing costs in cash. Secondary financing is not permitted. The VA lender must limit the loan to an amount not in excess of the CRV and the property must be occupied by the veteran owner/borrower. Interest rates on VA loans are not set by the Veterans Administration but are determined in the market place. Borrowers must pay a: VA funding fee at closing; and Are permitted to pay origination fee and/or discount points charged by the lender. VA loans are assumable by both veterans and non-veterans but buyers must qualify for assumption of any loan originated after March 1, There is no prepayment fee if the loan is paid off early. In the case of an assumption, the veteran borrower remains liable on the loan unless a release is obtained from VA. (2) Federal Housing Administration Insured Loan (FHA): The Federal Housing Administration (FHA) is a branch of the Department of Housing and Urban Development (HUD). FHA mortgages are distinguishable in that the lender is insured against loss in the event of foreclosure of the mortgage. The Federal Housing Administration is not a lender. Approved private lenders are the mortgagees and only those loans which meet certain requirements of the FHA are insured by the agency. Because of the insurance feature, the approved lending institutions are able to lend a higher percentage of the appraised value of the property than they would under ordinary circumstances. Here are some specific features of FHA-insured loans: 3

4 FHA sets maximum loan amounts for different areas of the country. A purchaser may pay a price in excess of the FHA appraised value when set forth in the contract according to FHA guidelines. FHA insured loans are available for owner occupied properties. (However, there are some FHA programs available for investment properties.) Down payment requirements are set by FHA. Currently, the loan amount that can be insured is the lesser of: 1) 97.75% of sales price or assessed value; or 2) 97% of the first $25,000 of appraised value or contract price whichever is less, 95% up to $125,000, and 90% of the remainder up to the prescribed limit in your area including allowable closing costs. Borrowers may be required to pay both a loan origination fee and discount points charged by the lender. FHA loans are assumable if the buyer qualifies to assume the loan. The original borrower remains liable on loans assumed by subsequent buyers. FHA loans may be prepaid without penalty, but the lender must be advised at least 30 days in advance. Borrower or someone else pays mortgage insurance premium (MIP) in cash or it may be financed. There is generally a large premium paid at closing, and smaller payments paid as part of each subsequent monthly payment. The amount of each of these payments is based on a percentage of the loan amount. If the borrower refinances within a certain period of time (generally two to five years, depending on the FHA loan program) FHA will refund a percentage of the initial MIP premium. Similarly, if the loan balance reduced by payments (to approximately 75% - 80%) of loan-to-value ratio, the borrower may petition FHA for a refund of the remaining balance of the initial MIP premium. (3) Conventional Loans: A conventional loan is one made to the borrower without government insurance or guarantee. The amount of funds loaned and secured by deed of trust or mortgage on a particular piece of property is determined by the lender. In the case of a conventional loan, the borrower must meet the policy requirements of the lender. These requirements are not standard in the industry and vary with different individuals and institutional lenders in the real estate lending market. The requirements for borrowers in most cases are related to the ability of the borrower to repay the loan. The general principle which governs loans is the greater the risk to the lender the higher the interest rate, the shorter the loan terms and the lower the ratio of loan 4

5 to market value. These factors are also affected by the supply of mortgage funds and the supply and demand of the real estate market. Many conventional loans are now insured by private mortgage insurance (P.M.I.) companies. Such insurance allows lenders to make higher loan-to-value loans, often up to 90-95% of a property's appraised value. Cost of the insurance is paid by the borrower. SOURCES OF FUNDS There are several major types of institutional lenders who are active in the primary mortgage market. The primary mortgage market consists of lenders who make loans directly to the consumer. Their ability to invest funds in real estate loans is directly related to operating policies that permit long-term lending. Since the introduction of longer-term loans (up to as long as 40 years), these investors must recognize that the funds loaned may possibly be immobilized for long periods. In some cases, these institutions deal through companies known as mortgage bankers or mortgage brokers. (1) Commercial Banks: The commercial bank creates real estate loans for its own account and for the use of its trust department. In some cases, commercial banks may represent other institutional investors, thereby assuming the function of a mortgage banker. Commercial banks also create subsidiary mortgage companies which operate nationwide as a source of mortgage funds. Banks are regulated by the U.S. Comptroller of Currency and the state Banking Commission. National banks are restricted by law as to the amount which they may lend on real estate and as to the time limit of such loans. Accounts in commercial banks are insured up to $250,000 per depositor by the Federal Deposit Insurance Corporation (FDIC). (2) Savings and Loan Associations: Savings and loan associations have been primarily concerned with loans secured by residential property and have typically enjoyed the most flexible criteria for loan approval. They are chartered by either the state government (Division of Financial Services) or the federal government (Office of Thrift Supervision). Savings and loan associations must be members of S.A.I.F. (Savings Association Insurance Fund), which is a branch of F.D.I.C. (Federal Deposit Insurance Corp.) and provides for insurance on accounts up to a maximum of $250,000 for each depositor. (3) Mutual Savings Banks: A substantial amount of deposits in mutual savings banks are used for real estate loans. The mutual savings banks are concentrated on the eastern seaboard, most particularly in the northeastern part of the United States. The savings bank is the oldest institution in the States primarily concerned with savings. Mutual savings banks are represented in most cases by mortgage bankers or mortgage brokers. 5

6 Like savings and loan associations, the investments made by mutual savings banks in mortgage loans are mostly in the field of one-to four-family dwellings. The preponderance of real estate loans outside of the domicile State of these institutions is made up of FHA and VA loans. (4) Life Insurance Companies: Life insurance companies are concerned with the investment of funds held in trust for the benefit of policyholders and beneficiaries of policy contracts. The investments made by life insurance companies are diversified. The investment portfolio includes government bonds, obligations of states and municipalities, real estate and corporate securities of many types. In general, life insurance companies are in a position to make loans on almost any type of improved real estate, but specialize in larger commercial loans. The amount insurance companies can loan in relation to the value of the property pledged as security is determined by the statutes of the State in which the company is domiciled. Insurance companies in most cases are represented by mortgage bankers or mortgage brokers, but some operate directly thorough mortgage loan field offices located in larger cities. (5) Mortgage Bankers and Mortgage Brokers: The distinction between mortgage bankers and mortgage brokers has blurred in recent years. Mortgage bankers traditionally have originated loans from their own funds, sold the loan, and retained servicing rights to the loan. Today, many mortgage bankers operate as subsidiary agents for large institutional lenders or as independent mortgage brokers who retain servicing rights. Fees are earned through both origination fees paid by the borrower and servicing fees paid by the loan holder. Mortgage brokers act as intermediaries to arrange loans between lenders and borrowers, but often work closely with a regular clientele of institutional lenders. They process loan applications for a lender but usually do not actually approve or service the loan. Fees are earned through origination fees paid by the borrower. Mortgage bankers and mortgage brokers represent a broad spectrum of lenders and can be a source for every type of real estate loan. Both groups have grown greatly in recent years. Effective 2008, mortgage brokers are regulated and must be licensed in Colorado. (These requirements are discussed in Chs. 14, 15 & 16.) (6) Pension Funds: Pension funds act as trustees for retirement funds. They invest most of their resources in the secondary mortgage and securities market, but are a potentially rich source of mortgage funds. Most pension fund loans are placed through mortgage bankers and mortgage brokers. (7) Credit Unions: Credit Unions deal mostly in consumer credit loans with their members, but may make real estate loans. Credit unions are also a source for secondary financing and home equity loans. 6

7 (8) Federal Land Bank: The Federal Land Bank System was established in 1917 by act of Congress as a farmers cooperative credit system. It is regulated by the Farm Credit Administration which also supervises similar sister organizations. The Federal Land Bank system consists of 12 Federal Land Banks that are owned by the various land bank associations throughout the country. A borrower must belong to an association to be eligible for a loan. (9) The Farmers Home Administration: The Farmers Home Administration (FmHA), an agency of the United States Department of Agriculture, makes and insures farm ownership loans accompanied by technical management assistance to farmers and ranchers who are or will become operators of family farms. Ownership loans are available only to those who are unable to obtain the credit they need from other sources. Besides a home ownership program there is a financial assistance program for small towns and rural groups and also rental housing programs. Additionally, loans are available for certain high risk borrowers or disaster relief. (10) Real Estate Investments Trusts (REIT): Federal legislation in the 1960's allowed for the creation of unincorporated trusts to encourage the pooling of small savings for investment in real estate. REIT's generally invest in larger commercial and industrial projects and must be registered as a security. (11) Owners: Sellers of property are often overlooked as prime sources of real estate financing. Owner equity in real estate represents the largest potential pool of funds available to purchasers of real estate in this country. "Owner will carry" or "Seller Carry-Back" transactions can often be structured to the benefit of both buyer and seller, but sellers must always be advised to seek competent legal and professional assistance. THE SECONDARY MORTGAGE MARKET The secondary mortgage market consists of institutions which purchase loans from lenders in the primary mortgage market who originally funded the primary market. Funds for the secondary market are largely obtained through the sale of mortgage-backed securities, which are investments secured by real estate mortgages. The secondary market is largely controlled by the Federal government. The initial action to create the secondary mortgage market was passage of the National Housing Act. The National Housing Act was enacted June 27, The reason for its inception was the slump of housing construction in the depression of the early 1930's. The goal of the Federal government through this legislation was the early remedy of such national problems as lack of housing, excessive foreclosures and a defunct building industry. The National Housing Act was the authority for the creation of the Federal Housing Administration, the Federal 7

8 Home Loan Bank, the Federal Public Housing Authority, Federal National Mortgage Association, and the Federal Savings and Loan Insurance Corporation. The Federal National Mortgage Association (FNMA) often called "Fannie Mae", was created as a secondary market to buy and sell mortgages. FNMA's purpose is to stabilize and improve distribution of home mortgage funds. Through the auction process, FNMA agrees to buy acceptable mortgages. FNMA is not a government agency, instead it has been converted to a quasi-governmental public corporation. The Government National Mortgage Association (GNMA), or "Ginnie Mae", can raise funds to support the mortgage market by guarantee of pass-through mortgage securities. They guarantee the mortgage securities of FHA-insured mortgages and VA guaranteed home loans with the full faith and credit of the United States. The investors have yields that compare favorably with high grade corporate issues and receive interest principal payments each month. GNMA supports the mortgage market by buying mortgages from private lenders at prices favorable to the sellers of the mortgages. GNMA also sells the mortgages or commitments at prevailing market prices and absorbs any difference between its committed prices and market prices. This is normally for special program loans. GNMA is an agency of HUD. The Federal Home Loan Mortgage corporation (Freddie Mac or FHLMC) was created by Congress in 1970 to help savings institutions when their deposits became low or they found themselves overcommitted. Freddie Mac is currently under the control of the Federal Home Loan Bank Board (FHLBB). Any financial institution whose deposits are insured by an agency of the Federal government can sell mortgages to Freddie Mac. The mortgages must be of the type that meets the standards imposed on the lending institution. Although Freddie Mac deals primarily with conventional loans, it can purchase VA or FHA mortgages. Real Estate Investment Conduits (REIC's) are mortgage-backed securities which can be issued by both private and governmental entities. Authorized by the Tax Reform Act of 1986, REIC's allow pooling of funds from smaller investors for reinvestment in the secondary mortgage market. DISCOUNT POINTS and ORIGINATION FEES A discount is the percentage of a loan amount required by a lender to obtain the same yield that can be obtained on loans which offer a higher interest rate. Advance payment of a discount (at the time of obtaining the loan, e.g., at closing upon the property) thus allows the lender to offer a lower interest rate, and lower payments, over the life of the loan. 8

9 MacIntosh Real Estate School Uniform Course Chapter 5 The word "points" is often used to express the discount. (For instance, one point would be 1% of the loan amount. So with a $179,500 loan, one point would be $1,795, two points would be $3,590, etc.) FHA allows anyone to pay the borrower's discount points. Loan discount fees should not be confused with loan origination fees and should be specifically provided for in a sales contract. Example: For a $100,000 loan one discount point equals $1,000. Paying points lowers your interest rate, because the lender receives the income immediately (at closing) rather than over the long term as you pay your loan. Each discount point paid on a 30-year loan typically lowers the interest rate by 0.125%. That means a 7.5% rate would be lowered to 7.375% if you purchase one point. For a $100,000 loan/30-year term: 7.5% interest, no points = $ monthly payment (= $251,715 total payments over the life of the loan); 7.375% interest, one point = $ monthly payment ($248,645 total payments). Although over the life of the loan, the savings would be over $3,000, with the $8.53 monthly savings it would take approximately 117 months to recoup the $1,000 cost of the point. Therefore, the borrower should not buy the point if intending to hold the loan for less than 10 years. An origination fee is a fee paid to a lender for processing a loan application. It is usually expressed as a percentage of the total loan amount. It may be stated in the form of points, where one point is 1% of the mortgage amount, (and two points is 2%, etc.), but it should not be confused with Discount Points, above. The origination fee may be paid at closing, and therefore not financed into the loan. However, if the origination fee is rolled into the loan it will have the effect of raising the amount being financed, consequently raising the ultimate cost of the loan to the borrower over the life of the loan and increasing the Annual Percentage Rate, (below). TYPES OF LOANS (1) Fully Amortized Loan: A mortgage which provides for repayment of the loan within a specified time by means of regular equal payments at stated intervals (usually monthly) to reduce the principal amount of the loan and to cover interest as it is due. This is the most common type of residential mortgage. (2) Adjustable Rate Mortgage (ARM): An arm is generally originated at one rate of interest, with the rate fluctuating up or down during the loan term based on some economic indicator. If the interest rate changes, so does the borrower's payments. ARMs contain these common elements: 9

10 The interest rate is tied to the movement of an index, such as the "cost-of-funds index" for federally chartered lenders. Usually the interest rate is the index rate plus a premium, called the margin, which is the lender's cost of doing business, such as profits and costs. For example, the loan rate may be 2 percent over the U.S. Treasury bill rate. Rate caps limit the amount the interest rate may change. Most ARMs have both periodic rate caps, which limit the amount the rate may increase at any one time, and aggregate rate caps, which limit the amount the rate may increase over the entire life of the loan. The mortgagor is protected from unaffordable individual payments by the payment cap, which sets a maximum amount for payments. With a payment cap, however, a rate increase could result in negative amortization - an increase in the loan balance because payments were not enough to reduce the balance of the loan and the unpaid interest has been re-capitalized into the loan. The adjustment period establishes how often the rate may be changed. The adjustment period is typically annually, or after two to five years. Lenders may offer a conversion option, which enables the mortgagor to convert from an adjustable-rate to a fixed-rate loan at certain intervals during the loan. The option will stipulate the terms and conditions for the conversion. (3) Graduated Payment Mortgage (GPM): Payments are low in the first years of the mortgage term and then are increased to a contracted amount in later years. In residential loans it is sometimes a benefit to younger persons whose income has not yet reached the level necessary but whose future looks promising. Graduated payment mortgages may also result in negative amortization during the early years of the loan. (4) Package Loan: The loan which finances the purchase of a home also finances the purchase of equipment (stove, refrigerator, and the like) essential to the livability of the property. The real estate mortgage describes the equipment and recites the intention of the parties that such articles shall be deemed fixtures. (5) Demand Loan: A mortgage secured note or bond which may be called for payment at any time at the discretion of the lender. This type of financing is usually not good practice for either the lender or borrower. Few loans are made under this program. (6) Balloon Loan: Also known as a limited reduction loan and a partiallyamortized loan. The periodic payments are not sufficient to fully repay the principal loan balance by the end of the term of the loan. For example, equal monthly payments may be based on a 30-year amortization schedule with the 10

11 MacIntosh Real Estate School Uniform Course Chapter 5 entire unpaid balance due in full after only 5 years. The principal balance remaining at the expiration date is known as a balloon payment. (7) Term Loan: This loan calls for periodic payments of interest followed by the payment of the principal in full at the end of the loan term. For example, on a loan of $100,0000 at 12 percent interest per year, with payments due monthly, a borrower would pay $1,000 each month. At the end of the term of the loan, the last payment would be the final interest payment of $1,000 plus the $100,000 principal loan amount. These are generally only used for home improvement and second mortgages. (Also known as a straight loan.) (8) Straight Amortization Loan: This plan provides for the payment of a fixed amount of principal at specified intervals with interest payable on the remaining balance of the loan. This creates a loan payment which reduces with each payment as the amount of interest charge is less, reflecting the reducing loan balance. (9) "Wrap-Around" Loan: (Also know as a Wrap and an all-inclusive mortgage) A wraparound loan enables a borrower with an existing mortgage or deed of trust loan to obtain additional financing from a second lender without paying off the first loan. The second lender gives the borrower a new, increased loan at a higher interest rate and assumes the payment of the existing loan. The total amount of the new loan includes the existing loan as well as the additional funds needed by the borrower. The borrower makes payments to the new lender on the larger loan. The new lender makes the payments on the original loan out of the borrower's payments. A wraparound mortgage can be used as a method of refinancing real property or financing the purchase of real property when an existing mortgage cannot be prepaid. It also is used to finance the sale of real estate when the buyer wishes to invest a minimum amount of initial cash for the sale. A wraparound loan is possible only if the original loan permits such a refinancing. An acceleration clause, alienation, or due-on-sale clause (all synonyms for the same thing: a clause in a loan whereby the lender can call due the entire remaining balance if the borrower sells or alienates the encumbered property) in the original loan documents may prevent a sale under these terms. The buyer executes a wraparound mortgage to the seller, who will collect payments on the new loan and continue to make payments on the old loan. The borrower could then be at the mercy of an unscrupulous seller who collects the borrower's payments on the new loan, but fails to make payments on the old loan, leading to foreclosure. (10) Construction Loan: The construction loan, also known as a building loan, is unusual in that the full amount of the loan is not immediately paid out by the lender to the borrower at the time the note and mortgage are executed. The loan is intended to aid the borrower in financing the construction of a building, and the commitment as to the full amount permits the builder to begin construction 11

12 although he does not immediately receive the full amount of the loan. The amount of the loan is advanced to the borrower in installments as the work progresses, and the maturity date on the loan is usually a definite period after completion by the builder allowing adequate time to sell the property, (usually nine months to two years). Professional builders usually secure commitments from the lenders by purchasing the commitments to lend a certain amount of money at a certain interest rate. Large builders whose financial worth is great are often able to secure commitments for the construction of many dwelling units. The commitment also usually affords the builder adequate time to sell to residential purchasers. Some builders find it necessary to secure a take-out loan from one lender to pay off a short-term construction loan. Some builders of commercial property will secure a tenant on a long-term lease to encourage the granting of a construction loan. (11) Blanket Loan: A blanket loan is one secured by more than one parcel of real estate. This type of Loan is often used by subdividers who obtain an entire tract of land, execute a mortgage as a lien on the tract, and then subdivide the tract into many lots, building on each lot, and selling each lot to individual purchasers. A partial release clause containing a release schedule is ordinarily contained in this type of mortgage so that individual lots covered by the mortgage are released as they are sold, and the sales price is paid to the mortgagee. (12) Open End Loan: The open end loan contains a clause whereby additional advances of money can be made under the original mortgage instrument for repairs, improvement, or some other worthy reason, without a change in the original instrument. (Home equity loans.) (13) Divided Amortization Loan: The schedule of amortization may be divided so that there is a faster maturity on one part of the loan and a longer maturity on another part of it. Or, there may be only interest charged for several years and a complete amortization schedule developed from that point on. (14) Participation/Shared Appreciation Loans: These loans allow the lender to participate in the income and/or resale profits generated by the property. Depending on the terms, the lender may have a contractual interest or actually hold partial title to the property. Such financing gives added security to a lender, who in turn may offer more attractive terms or make loans to borrowers who otherwise would not qualify. Originally used in large commercial transactions, such loans have become more common in residential sales, particularly if part of the purchase price is advanced by members of the buyer's family. (15) Bridge Loan: A bridge loan is a short-term loan on a property (usually residential), when the closing of the sale of one property is dependent on the sale of another property and the closing of the sale of one of the properties is delayed. A bridge loan accommodates the situation until all transactions are completed. 12

13 MacIntosh Real Estate School Uniform Course Chapter 5 (16) Reverse-Annuity Loan (RAM): Is one in which payments are made by the lender to the borrower. The payments, which may be made as regular monthly payments, in one lump sum or as a line of credit to be drawn against, are based on the equity the homeowner has invested in the property. This loan is typically used by senior citizens on a fixed income, so they may benefit from the equity they have built up in their homes without having to sell. The borrower is charged a fixed rate of interest, and the loan is eventually repaid from the sale of the property or from the borrower s estate upon his or her death. (17) Growing-equity mortgages (GEMs) Increase in payments during the term of the loan reduce the principal amount more rapidly and the borrower's equity grows faster than normal. One example of a GEM is where half-payments are made every two weeks (as opposed to the standard single monthly payment). Since a month averages approximately 4 1/3 rd weeks, by the time one year has passed the borrower has made a total of 13 payments. This will result in paying off a 30-year note approximately 8 years early with a savings of tens of thousands of dollars in interest. (Also known as a rapid-payoff mortgage.) ALTERNATIVE AND SUPPLEMENTARY METHODS OF FINANCING The following supplementary methods of financing have advantages which can promote a widespread ownership in real estate. However, this section is merely to acquaint the licensee with the existence of such methods and to make the most primary explanation. The licensee must research and study extensively to be competent in the field of finance. (1) Second Mortgage: This is a mortgage which is subordinate (lower in priority) to a first mortgage. It is sometimes used where the down payment is not sufficient to make up the difference between the first mortgage and the sales price. For example, a property might sell for $100,000, the buyer is able to obtain a first mortgage in the amount of only $75,000 and has cash available for a down payment of $15,000. This difference of $10,000 could be made up by a second mortgage and can be made either by the seller as a purchase money second mortgage or by a third party. Owner carry backs are a major source of second mortgage financing. (2) Installment Land Contracts. Its most common application is in the instance where the buyer wishes to go into possession but has little money to invest. The seller permits this under a contract to provide a deed (convey title) at a later date. The seller is thus actually doing the financing which may in many cases be supplementary to an earlier and lesser encumbrance that the seller is obligated to pay. This instrument is full of pitfalls for both buyer and seller and may be used under certain circumstances to the injury of the buyer and under other circumstances to the injury of the seller. The broker should be thoroughly familiar with the effects of the installment land contract before using it and all parties should be advised to seek legal counsel. 13

14 (3) Collateral Loans. When the buyer is unable to pay the cash difference between the first mortgage note and the purchase price of the property, or to qualify for a large enough loan, collateral security (in addition to the trust deed) may be given the lender so that the lender will increase the amount of the loan. Collateral security can be either real or, more often, personal property. An offsetting deposit in the lending institution can also serve as collateral security. When a purchaser has reduced the loan to an amount approved by the lender, the collateral security often will be released. (4) Sale and Lease-Back. A sale and lease-back contains two steps which are taken simultaneously, although they appear to be separate and distinct. First, an institution, such as a life insurance company, a college or university, a religious body, or a charitable institution with funds to invest, purchases the real estate owned and used by a well-established business corporation - usually a retailer or a manufacturer. Second, the property is leased back to the seller by the purchaser. From these two steps we obtain the name - "sale and lease-back'. There are tax advantages to both parties in this type of a transaction. The sellertenant, of course, gets additional capital for expansion. The rent the seller pays is a deductible expense item. It is also possible to sell only the land and retain the Improvements and thereby get the benefits of tax deductible real estate depreciation. The buyer-landlord also has advantages. The purchaser usually buys the improvements as well as the land and gets tax shelter from depreciation. In addition to having a stable tenant, the lease is usually a net-net lease which means that there are no administrative problems outside of rent collections. (5) Syndications or Joint Ventures. When the purchase of real estate is made primarily for investment purposes financing is often conducted by a group instead of by an individual. One person may not have sufficient capital for the purchase of the desired equity, therefore, two or more persons may join in the purchase and take title in Common (trusteeships are often used). Pooling money in this fashion makes it possible for a person of limited financial means to share in the profits of a real estate investment. The most popular type of syndication is the Limited Partnership. This is a partnership which contains general partner(s) and limited partner(s). The limited partners are those persons who have invested money in the partnership but who have no voice in the management. The limited partners share in the profits of the partnership proportionately to their respective investments. The limited partners are not responsible for the debts of the partnership except as to the extent of their investment. Title to the real property is taken in the name of the partnership and the articles of agreement of the limited partnership are recorded. If the limited partnership agreement is not recorded, the liability of the limited partners would not be limited to their investment and creditors could attack them as well 14

15 as the general partners. The limited partnership agreement is a difficult vehicle to draft, it may contain many pitfalls and it should be drafted by an attorney skilled in this field. Limited partnerships are also subject to State and Federal securities laws. (6) Buy Downs. As an incentive to purchase, the builder/ developer of residential property may aid the purchaser in reducing the monthly loan payment. The builder wants to sell the house so as to be relieved of the construction loan. To accomplish this the builder pays a sum of cash to the lender. The lender is concerned with the "yield" on the-loan to the purchaser. If the cash payment by the builder amounts to what the lender would have received at the market rate of interest, the lender will reduce the interest rate accordingly. Sometimes the builder will make a payment to the lender in a sufficient amount to reduce the interest rate for a specific period such as one year or more. Sometimes the builder will make a payment to the lender that will be sufficient to reduce the interest rate for the duration of the loan. Buy downs are not restricted to builders and many sellers (and even brokers) finance buy downs as an inducement to buyers. (7) Lease-Options. A lease-option is not so much a supplementary method of financing as an interim agreement to allow buyer and seller to lock in the terms of a future sale. It can, however, allow time for a buyer to marshal additional resources, such as funds for a down payment, while providing a seller with some assurance of a sale or, at least, compensation if the sale fails. A lease-option agreement should be carefully drafted and not tacked on as an added provision to either a lease or sales contract. The agreement should clearly spell out application and disposition of the option money, rents and security deposits as well as detailing future terms of sale. (8) UCC-1 Financing Statement. The Uniform Commercial Code (UCC) is a commercial law statute that has been adopted, to some extent, in all states including Colorado. The UCC is concerned with personal property transactions, such as warranties on goods sold, and does not deal with real estate. However, when a (construction) loan is procured partly using personal property (such as lumber or construction machinery) as security, then UCC governs the security instruments for those items of personal property. (Remember that the mortgage or deed of trust may only be used as security instruments for real property.) For a lender to create a security interest in personal property, including personal property that will become fixtures, the UCC requires the borrower to sign a security agreement. The agreement must contain a complete description of the items against which the lien applies. The notice of this agreement, called a UCC- 1 Financing Statement, must be filed with the county in which the real property is situated. The UCC-1 identifies any real estate involved when personal property is made part of the real estate. Once the financing statement is recorded, subsequent purchasers and lenders are put on notice of the security interest in 15

16 MacIntosh Real Estate School Uniform Course Chapter 5 personal property and fixtures. Absent a recorded UCC-1 Financing Statement, the lender would be unable to repossess the personal property items should the borrower default on the (construction) loan, since the mortgage or deed of trust only provides security for (and allows foreclosure on) the real property. When the loan is satisfied (paid off), the lender should execute a UCC-3 Termination of Financing Statement, which acts as a release of borrower s similar to a Release of Deed of Trust or Satisfaction of Mortgage. TRUTH-IN-LENDING (REGULATION Z) Title I of the National Consumer Credit Protection Act which is commonly known as the Truth-in-Lending Act, became effective on July 1, 1969 and is regulated by the Federal Trade Commission. The Act authorized the Board of Governors of the Federal Reserve System to prescribe regulations pursuant to the Act and consequently Regulation Z was revised in 1981 effective April 1, Compliance with the revised Regulation Z was made mandatory October 1, The Act and the Regulation are not printed in this Manual because of length and difficulty of interpretation. Therefore this section will only attempt to describe briefly the coverage and effect of this Act and amended Regulation Z as it concerns real estate practice. Essentially, TIL requires disclosure of certain information to a borrower, the most important of which are the Finance Charge and the Annual Percentage Rate (APR). These calculations are intended to reveal the true cost of the loan, including prepaid fees such as discount points, to the borrower over the life of the loan. In a final rule published September 19, 1996 and effective October 21, 1996, fees charged by mortgage brokers and paid directly by the borrower must be included as part of the Finance Charge, unless they are fees that would be excluded when charged by the creditor. Also, the rule establishes new tolerances for errors in the amount of the finance charge. TIL applies only to an extension of consumer credit to a natural person and not to credit extended to corporations, partnerships, associations, government agencies, etc. The Act generally does not apply to business loans or commercial loans such as construction loans to builders, but it will apply when the construction loan is converted to a consumer loan made to the purchaser of the house. Loans to finance rental properties which are not owner occupied or expected to be occupied within one year are considered business loans and are excluded. Loans for rental property containing three or more units are excluded even if one unit is occupied by the owner. All persons (natural persons and organizations) who are "creditors" under Truthin-Lending must comply with the Act. Brokers and licensees who regularly 16

17 extend credit by way of carrying commissions or lending money in connection with real estate transactions may be creditors under TIL and, therefore, subject to the TIL disclosure and other requirements. Creditors. Regulation Z defines a creditor as anyone who extends consumer credit more than 25 times in a year or more than five times in either the preceding calendar year or the current calendar year in the case of transactions secured by a dwelling and if the extension of consumer credit is subject to a financing charge or is payable by a written agreement in more than four installments (not including a down payment) and to whom the obligation is initially payable, either on the face of the note or contract, or by agreement when there is no note or contract. The disclosure requirements with which all creditors must comply pertain not only to new extensions of credit, but also to assumptions and refinances. Assumptions of existing residential mortgage loans are usually subject to all the requirements of Regulation Z. If the purchaser agrees to pay an existing obligation and it is accepted by the creditors in a written agreement to the effect that the purchaser is the primary obligor, the creditor must make new disclosures based on the remaining obligation. The disclosures must be made before the assumption occurs. Refinancing is also subject to Regulation Z if the existing obligation was subject to Regulation Z and is satisfied and replaced by a new obligation undertaken by the same consumer. Disclosure. The primary purpose of Regulation Z is to disclose to the consumer how much it is costing him to borrow money and to disclose what the terms and conditions are. To accomplish this, the "creditor" must provide the borrower with a statement of such information. The disclosure must be made before the credit transaction is consummated. Consummation means the time when a consumer becomes contractually obligated on a credit transaction, not on a purchase obligation alone. Therefore, in the usual real estate transaction, the disclosure may be made at any time prior to final settlement when the deed is delivered and the credit instruments executed, although earlier disclosure is encouraged. When a seller who is a creditor carries a purchase money mortgage under a liquidated damages contract, for example, disclosure must be made prior to the purchaser's signing the note and trust deed, i.e., prior to becoming obligated on the credit transaction. In the case of an installment land contract, disclosure would be prior to its execution and not prior to the signing of the preliminary contract. In any case, disclosure should be made a reasonable length of time before the signing of the credit instruments. 17

18 Before studying the list of specific disclosures, the licensee should clearly understand two terms defined in Regulation Z, i.e. the Finance Charge and the Annual Percentage Rate. The Finance Charge is the cost of consumer credit as a dollar amount. It includes any charge payable directly or indirectly by the consumer and imposed directly or indirectly by the creditor as an incident to or a condition of the extension of credit. In a residential real estate transaction, the finance charge includes these fees: 1. Interest, service charges, carrying charges. 2. Loan fees, assumption fees, finders fees and similar charges. 3. Mortgage insurance premium if required by the creditor. 4. Points, if paid by purchaser. In a residential real estate transaction, these fees are excluded: 1. Points paid by seller. 2. Fees for title examination, abstract of title, title insurance, survey. 3. Payments into escrow or trustee accounts. 4. Insurance premiums if not required by the creditor and this fact is disclosed and if the consumer signs or initials a statement requesting the insurance. 5. Payments prescribed by law and made to public officials, e.g., filing fees, etc., although these are disclosed on the settlement sheet. The Annual Percentage Rate as it is used in Regulation Z is not the "interest rate" as it is usually understood. Interest is included in computing the Annual Percentage Rate along with the other finance charges. The Annual Percentage Rate is the relationship of the total Finance Charge to the total amount to be financed and must be computed to the nearest 1/8 th of 1 percent. Thus, the Annual Percentage Rate will give to the borrower a description of the total cost imposed by the lender for making the loan. The licensee may have to explain this differentiation to the client. Since the Annual Percentage Rate will vary with the specifics of each loan, such as the term and frequency of payments, calculation of the APR is typically done by the loan officer or mortgage broker by computer. Both the Finance Charge and the Annual Percentage Rate must be disclosed in a more conspicuous manner than other disclosures except for the creditor's identity. The disclosure statement itself must disclose the following information as applicable: 1. Identity of the "creditor". 2. Amount financed. 3. Itemization of amount financed. 4. The Finance Charge and when it begins to accrue. 5. Annual Percentage Rate. 18