Chapter 3: Real Estate Financing – Note and Mortgages

Promissory Note
A promissory note is a written agreement where a borrower promises to repay a loan under
specific terms. It includes:

1. Loan Amount

 This is the total sum of money borrowed from a lender. It is the

principal amount that you agree to repay over time, along with
interest and any applicable fees.
 Example: If you borrow 10,000, the loan amount is10,000.

2. Interest Rate

 The interest rate is the cost of borrowing the loan amount,

expressed as a percentage of the principal. It determines how much
extra you will pay in addition to the loan amount.
o Fixed Interest Rate: Remains the same throughout the loan
term.
o Variable Interest Rate: Can change over time based on
market conditions.
 Example: A 5% interest rate on a 10,000 loan means you’ll
pay10,000 loan means you’ll pay 500 in interest per year
(excluding compounding).
o Given:
o Loan Amount (Principal, P): $10,000
o Annual Interest Rate (r): 5% (or 0.05 as a decimal)

Step 1: Calculate Annual Interest

The formula for simple annual interest (excluding compounding)

is:

Annual Interest= P × r
Where:

 P=10,000 (loan amount)

 r=0.05 (annual interest rate)
Plugging in the values:
 Annual Interest=10,000×0.05=500Annual Interest=10,000×0.05=500

Result:

 Annual Interest Paid: $500

o Example Over 5 Years:

o If the loan is repaid over 5 years with simple interest, the total
interest paid would be:
o Total Interest=Annual Interest × Number of Years = 500 × 5 = 2,500

o So, for a 10,000 loan at 510,000loan at 2,500 in total

interest.

3. Payment Schedule

 This outlines how and when you will repay the loan. It includes:
o Frequency: How often payments are due (e.g., monthly, bi-
weekly).
o Amount: The fixed or variable payment amount, which may
include both principal and interest.
o Duration: The total time to repay the loan (e.g., 5 years).
 Example: A 10,000 loan with a 5 Years 10,000 loan with a 5y
188.71.

4. Consequences of Default

 Default occurs when you fail to make payments as agreed in the

loan terms. Consequences may include:
o Late Fees: Penalties for missed payments.
o Credit Score Damage: Defaulting can significantly lower
your credit score, making it harder to borrow in the future.
o Legal Action: The lender may take legal steps to recover the
debt.
o Collateral Seizure: For secured loans (e.g., car or home
loans), the lender can repossess the asset used as collateral.
o Debt Collection: The loan may be sent to a collections
agency, which can pursue repayment aggressively.
 Example: If you default on a car loan, the lender may repossess
your vehicle and sell it to recover the owed amount.
Example: A borrower signs a promissory note agreeing to repay a $200,000 loan with a 5%
interest rate over 30 years.

To calculate the details of the loan, we’ll determine the monthly

payment, total interest paid, and total amount repaid over the
30-year term. Here's how it works:

Given:

 Loan Amount (Principal, P): $200,000

 Annual Interest Rate (r): 5% (or 0.05 as a decimal)
 Loan Term: 30 years

Step 1: Convert the Annual Interest Rate to a Monthly

Rate

The interest rate is annual, but payments are made monthly. Divide
the annual rate by 12 to get the monthly rate.

Step 2: Calculate the Number of Monthly Payments

Multiply the loan term (in years) by 12 to get the total number of
monthly payments.

Number of Payments (n)=Loan Term×12=30×12=360

Step 3: Use the Loan Payment Formula

The formula for calculating the monthly payment (M) on a fixed-rate

loan is:

Where:

 P = 200,000 (loan amount)

 R = 0.004167 (monthly interest rate)
 N = 360 (number of payments)
 Plugging in the values:

Step 4: Simplify the Calculation

Step 5: Total Amount Repaid

Multiply the monthly payment by the number of payments to find the total amount repaid
over the life of the loan.

Total Amount Repaid=M × n = 1,073.20 × 360 = 386,352

Step 6: Total Interest Paid

Subtract the principal from the total amount repaid to find the total interest paid.

Total Interest Paid=Total Amount Repaid−Principal=386,352−200,000=186,352

Final Results:

 Monthly Payment: $1,073.20

 Total Amount Repaid: $386,352
 Total Interest Paid: $186,352

3.1 The Mortgage Instrument

Definition of Mortgage & Mortgage Document

A mortgage is a legal agreement where a borrower pledges real estate as security for a loan. The
mortgage document outlines the terms, borrower obligations, and lender rights.

Example: A homebuyer takes a mortgage from a bank, giving the bank a claim on the property
until the loan is repaid.

Relationship of Note to Mortgage

 The promissory note is the borrower’s promise to repay.

 The mortgage secures the loan by making the property collateral.

Example: A borrower signs a promissory note for a $250,000 loan and a mortgage document that
allows foreclosure if they default.

Interests That Can Be Mortgaged

 Fee simple interest – Full ownership of property

 Leasehold interest – Lease rights can be mortgaged
 Life estate interest – A person’s right to property for their lifetime

Example: A business owner with a 50-year land lease obtains a mortgage using their leasehold
interest.

Minimum Mortgage Requirements

A valid mortgage must include:

 Identification of lender and borrower

 Clear property description
 Loan terms and repayment schedule
 Borrower’s promise to repay
 Lender’s rights in case of default

Important Mortgage Covenants

1. Charges and Liens

 The borrower must pay taxes and avoid additional liens.

 Example: If a borrower doesn’t pay property taxes, the government may place a tax lien
that could threaten the lender’s claim.

2. Hazard Insurance
  The borrower must insure the property against damage (fire, floods, etc.).
 Example: A lender requires a borrower to maintain homeowners’ insurance to protect
against potential loss.

3. Preservation and Maintenance of the Property

 The borrower must maintain the property’s condition.

 Example: A borrower cannot abandon the property or let it deteriorate, as this reduces the
lender’s security.

4. Breach of Covenants

 If the borrower violates mortgage terms, the lender can demand full repayment.
 Example: A borrower fails to pay property taxes, violating the covenant and triggering
foreclosure.

5. Transfer of Property or Beneficial Interest in Borrower

 Also known as the due-on-sale clause, this prevents transfer of ownership without lender
approval.
 Example: A borrower cannot sell their home and transfer the mortgage without the
lender’s permission.

6. Borrower’s Right to Reinstate

 If the borrower defaults, they can pay the overdue amount to restore the loan.
 Example: A homeowner misses three mortgage payments but reinstates the loan by
paying back the missed payments and penalties.

7. Right of Entry: Lender in Possession

 If the borrower defaults, the lender can take possession of the property before foreclosure
is complete.
 Example: In commercial real estate, the lender may step in to collect rent from tenants if
the owner defaults.

8. Future Advances: Mortgage for Future Advances and Open-End Mortgage

 A borrower can secure additional loans using the same mortgage.

 Open-End Mortgage: Allows a borrower to borrow more money in the future without
needing a new mortgage.
 Example: A homeowner with an open-end mortgage borrows an extra $20,000 for
renovations.
o An open-end mortgage is a type of loan that allows the borrower to access
additional funds (up to a pre-approved limit) after the initial loan amount has been
 disbursed. This is useful for homeowners who may need extra money for
expenses like renovations, repairs, or other purposes. Let’s break down the
example of a homeowner borrowing an extra $20,000 for renovations using an
open-end mortgage.

Key Features of an Open-End Mortgage:

o Reusable Credit: The borrower can access additional funds as needed, up to the
approved limit.
o Flexibility: The borrower only pays interest on the amount they actually use, not
the total approved limit.
o Collateral: The home serves as collateral for the additional borrowing, just like
the original mortgage.

Example:

o The homeowner already has an open-end mortgage with a total approved limit of
$200,000.
o They initially borrowed $150,000 to purchase the home.
o They now want to borrow an additional $20,000 for renovations.

Step 1: Check Available Credit

The homeowner’s available credit is the difference between the

total approved limit and the amount already borrowed.

Available Credit=Total Approved Limit−Amount Already Borrowed

Available Credit=200,000−150,000=50,000Available Credit=200,000
−150,000=50,000
Since the homeowner wants to borrow $20,000, this is within the
available credit limit.

Step 2: Borrow the Additional Funds

The homeowner borrows the $20,000 for renovations. Now, the

total amount borrowed becomes:

Total Borrowed = Initial Loan +Additional Borrowing

Total Borrowed=150,000+20,000=170,000

Step 3: Interest and Repayment

 The homeowner will now pay interest on the $170,000 total
borrowed. The interest rate and repayment terms will depend on
the mortgage agreement. For example:

 If the interest rate is 4%, the annual interest on the additional

$20,000 would be:
Annual Interest on Additional Borrowing = 20,000 × 0.04 = 800
 The homeowner will make monthly payments based on the
total outstanding balance ($170,000), which includes both the
original loan and the additional borrowing.

Step 4: Impact on Equity

Borrowing additional funds reduces the homeowner’s equity in the

property. Equity is the difference between the home’s market value
and the total amount owed on the mortgage.

Equity = Home Value − Total Borrowed

For example:

 If the home is worth 300,000, the equity after borrowing the

additional 20,000 would be:
Equity = 300,000 − 170,000 = 130,000

Key Considerations:

1. Interest Costs: Borrowing additional funds increases the

total interest paid over the life of the loan.
2. Repayment Terms: The repayment schedule may be
adjusted to account for the additional borrowing.
3. Risk: Since the home is collateral, failing to repay the loan
could result in foreclosure.

9. Subordination Clause

 Gives priority to future loans over the current mortgage.

 Example: A developer takes a second mortgage, but the lender agrees to make it
subordinate to a future construction loan.

3.2 Assumption of Mortgage

 When a buyer assumes a mortgage, they take over the seller’s existing loan and become
responsible for future payments. This can be:

 With lender approval (buyer is liable)

 Without lender approval (seller remains liable)

Release of Grantor from Assumed Debt

If the lender approves the assumption and explicitly releases the original borrower (grantor),
the seller is no longer responsible for the loan.

Example:
John sells his house to Mary, who assumes his $150,000 mortgage. If the lender formally
releases John, he has no further liability. If not, he could still be responsible if Mary defaults.

3.3 Acquiring Title "Subject to" a Mortgage

Buying property "subject to" an existing mortgage means the buyer does not assume
liability for the mortgage. If the borrower defaults, the lender can still foreclose on the
property, but the buyer is not personally liable.

Example:
David buys a house with a $100,000 mortgage still owed by the seller. David makes
payments, but if he stops, the lender can foreclose—without suing David for any unpaid
debt.

Property Covered by a Mortgage

 A mortgage attaches to the property, meaning it remains with the home, even if
ownership changes.

Junior Mortgages

 First Mortgage – The primary loan with the highest priority.

 Junior Mortgage (Second Mortgage, etc.) – Additional loans secured against
the property but ranked lower in priority.

Example:

 A homeowner has a $200,000 first mortgage and takes out a $50,000 second
mortgage for renovations. If they default, the first mortgage is paid off before the
second mortgage gets any money.

Recording of Mortgages
  Mortgages must be recorded with the local government to establish legal priority.
 First to be recorded = first in priority, unless a subordination clause changes
this.

Example:
A bank records a mortgage on June 1, and another lender records a mortgage on July 1.
The June 1 mortgage has priority unless otherwise agreed.

3.4 Other Financing

Seller Financing

 Instead of a bank loan, the seller acts as the lender and finances the buyer directly.
 The buyer makes monthly payments to the seller under agreed terms.

Example:
A buyer with poor credit negotiates a deal where the seller finances $100,000 at a 6% interest
rate over 10 years.

3.5 Land Contracts

A land contract (or contract for deed) is an agreement where the seller retains title until
the buyer fully pays for the property.

How it works:

1. Buyer makes installment payments.

2. Seller retains ownership until the final payment.
3. Buyer receives full ownership after completion.

Example:
A farmer sells land under a land contract. The buyer makes payments for 10 years and
receives full ownership only after the final payment.

Recording of Land Contracts

 Some states require land contracts to be recorded to protect the buyer’s interest.

Example:
A buyer records their land contract at the county office to prevent the seller from selling
the property to someone else.

3.6 Default
 What Constitutes Default?

A default occurs when a borrower fails to meet mortgage obligations. This may include:

1. Missed payments (most common).

2. Failure to pay property taxes or insurance (which could cause foreclosure).
3. Property damage or lack of maintenance (reducing property value).
4. Unauthorized transfer of property (violating the due-on-sale clause).

Example:

 A homeowner fails to pay their mortgage for three months, triggering foreclosure
proceedings.
 A borrower does not maintain homeowners insurance, violating loan terms.

3.7 Alternatives to Foreclosure: Workouts

When a borrower cannot make mortgage payments, alternatives to foreclosure (or
"workouts") may help avoid legal action and property loss.

1. Restructuring the Mortgage Loan

Instead of foreclosing, lenders may restructure the mortgage to make payments more
manageable.

a) Recasting of Mortgages

 The lender recalculates loan terms by adjusting the interest rate, monthly payments, or
loan duration.
 Example: A borrower struggling with a 15-year mortgage might recast it into a 30-year
loan with lower monthly payments.

b) Extension Agreements

 Allows temporary payment reductions or extends the loan term to help the borrower
catch up.
 Example: A borrower behind on payments negotiates a six-month extension to resume
normal payments.

c) Alternative to Extension Agreement

 Instead of an extension, the lender may add missed payments to the loan balance or
require a lump-sum payment later.
 Example: A borrower agrees to a temporary reduction in monthly payments but must
pay the difference in a lump sum at year-end.
 2. Transfer of Mortgage to a New Owner

 A borrower sells the property to someone who assumes the mortgage, avoiding
foreclosure.
 Example: A homeowner in financial distress sells their house to a buyer who takes over
the remaining mortgage payments.

3. Voluntary Conveyance (Deed in Lieu of Foreclosure)

 The borrower hands over the property deed to the lender instead of going through
foreclosure.
 This avoids legal fees and potential credit damage.
 Example: A struggling borrower gives the deed to the bank, canceling the remaining
debt.

4. Friendly Foreclosure

 The borrower cooperates with the lender in foreclosure to speed up the process.
 Example: A homeowner voluntarily moves out and hands over the property to avoid
legal battles.

5. Prepackaged Bankruptcy

 The borrower negotiates with creditors before filing for bankruptcy, minimizing delays.
 Example: A business facing foreclosure agrees with lenders on a repayment plan before
officially filing for bankruptcy.

6. Short Sale

 The borrower sells the home for less than the loan balance, with lender approval.
 The lender accepts the lower amount instead of foreclosing.
 Example: A homeowner owes $250,000 but sells the home for $200,000. The bank
forgives the remaining $50,000.

3.8 Foreclosure
Foreclosure is the legal process by which a lender seizes and sells a property when the
borrower defaults.

1. Judicial Foreclosure

 Requires a court-supervised process to sell the property and repay the loan.
 Common in states using mortgages rather than deeds of trust.
 Example: A lender files a lawsuit to foreclose, and after a court ruling, the home is
auctioned.
2. Redemption

 Borrowers can "redeem" their property by repaying the debt before foreclosure is
finalized.
 Equitable Redemption: Before foreclosure sale.
 Statutory Redemption: After foreclosure sale (varies by state).
 Example: A homeowner in foreclosure gathers enough funds and pays off the mortgage
to reclaim ownership.

3. Sale of Property in Foreclosure

a) Fixing a Price

 The foreclosure property is sold at auction, usually to the highest bidder.

 Example: A home in foreclosure is auctioned for $180,000 to satisfy a $200,000
mortgage.

b) Deed of Trust

 Instead of a mortgage, a deed of trust allows a lender to foreclose without court

involvement (non-judicial foreclosure).
 A trustee (neutral third party) handles the foreclosure.

c) Deed of Trust vs. Mortgage Compared

Feature Mortgage Deed of Trust

Involves court? Yes (judicial foreclosure) No (trustee handles it)

Number of parties Two (lender & borrower) Three (lender, borrower, trustee)

Foreclosure speed Slower Faster

d) Nature of Title at Foreclosure

 A foreclosure sale transfers "clear title", removing junior liens but not unpaid taxes.
 Example: A buyer purchases a foreclosed home free of previous mortgages but still
owes property taxes.

e) Parties to a Foreclosure Suit

 Plaintiff: Lender or mortgage holder.

 Defendant: Borrower (and sometimes junior lienholders).
 Example: A bank sues a borrower and a second mortgage lender to clear all claims on
the property.

4. Effect of Foreclosure on Junior Lienholders

  Junior lienholders (e.g., second mortgage lenders) may lose their claims if the
foreclosure sale doesn’t cover all debts.
 Example: A first mortgage lender forecloses, and the second mortgage lender receives
nothing if the sale proceeds are insufficient.

5. Deficiency Judgment

 If the foreclosure sale doesn’t fully cover the loan, the lender can sue the borrower for
the remaining debt.
 Example: A borrower owes $300,000, but the home sells for $250,000. The lender sues
for the remaining $50,000.

6. Taxes in Default: Tax Sales

 If a homeowner doesn’t pay property taxes, the government can sell the property at a
tax sale.
 Example: A homeowner owes $5,000 in property taxes. The city auctions the home to
recover unpaid taxes.