Learning About Mortgages

OK, you’ve found the right house without having to use a buyer’s broker, you’ve seen past the cosmetic repairs made by the seller to market his house, you’ve had your house inspection and your inlaws approve. Now, how do you finance the purchase?

WHERE DO YOU START?

At your own bank. They know you there, or at least they will be hospitable. Since they have some of your track record, they will probably be more motivated to give you favorable treatment in order to keep your business.

WHAT IS A MORTGAGE?

A mortgage is a lien or an interest in land created by a written instrument given to secure the payment of a debt or loan. It must be in writing and there must be an underlying debt or obligation.

The debt is commonly expressed in a mortgage note or bond.

Surprisingly, only a small percentage of the people who have signed mortgage papers really understand the process. An attorney representing borrowers will explain before the papers are signed that title to the property is being transferred to them, subject to the security lien of me mortgage given to the lender to enforce the debt. Many people erroneously believe that the lender holds the deed until the loan is paid off, in fact, the buyer gets the deed, the lender gets the mortgage.

This mortgage lien is enforceable by the lender upon default of the debtor or mortgagor. The term “default’ means breach of the agreement by failure of the debtor to live up to his promises, usually non-payment of principal, interest, or taxes, or failure to maintain insurance on the property given as collateral.

The most immediate and prominent remedy is foreclosure. This involves the commencement of a lawsuit by the creditor-mortgagee resulting in the real property being sold at a public auction to satisfy the balance of principal due, accrued interest, late fees, search fees, attorneys’ fees, publication fees and sheriffs fees. The purpose of the action is to collect the debt by terminating the ownership interest of the defaulting debtor. Very often the lienholder will itself bid a nominal amount over the amount of its lien and become the successful bidder. If there is still a balance due after the foreclosure sale, the lender can sue the defaulting. mortgagor for the deficit. If there is a surplus after the foreclosure sale, it goes to the mortgagor.

mortgages are conventional or insured and are fixed rate or adjustable rate. A conventional mortgage is financing offered by institutional lenders (banks, savings and loans, mortgage companies) and is not guaranteed or insured. It is usually at a fixed interest rate for a fixed term of 15, 20, 25 or 30 years. The monthly payments remain constant during the term of the loan. The portion of the payment allocated to principal increases while the amount of interest from each payment decreases throughout the period of repayment. In today’s economy, there is usually an origination fee (‘points”) paid by the applicant to obtain a commitment for such a mortgage loan. Each “point” is 1% of the amount borrowed (not the purchase price). As a rule, there is a “due on sale” clause, which does not allow for assumption without the written consent of the lender. That means that if you try to sell the property without paying off the mortgage, the lender can “accelerate” or “call in” the balance (make the entire principal balance of the loan and accrued interest due immediately).

An insured mortgage is one where private mortgage insurance is required by the lender (at a premium). A low down payment typifies this kind of mortgage, providing the borrower is found creditworthy. For example, the conventional insured “MGIC mortgage” (Mortgage Guaranty Insurance Corporation) is one where this private mortgage company collects a premium for providing insurance for the repayment of that portion of the mortgage loan that the lender would not have loaned in the absence of such insurance. The buyer pays the premiums until the principal balance has been reduced to the point where the lender would have made the loan without insurance. In essence, this company is a hired co-signer.

A guaranteed mortgage is one guaranteed by an agency of the federal government, such as a VA (Veterans Administration) or FHA (Federal Housing Authority) mortgage. There is also the FNMA mortgage (“Fannie Mae”) guaranteed by the Federal National Mortgage Association, a federally chartered private mortgage company and a FHLMC mortgage (Federal Home Loan Mortgage Corporation).

These agencies usually insure or guaranty to banks and lending companies up to 90% of the principal amount of the loan. These types of mortgages also have a low or no down payment requirement. Such mortgages require that the borrowers reside in the real estate. You cannot finance investment properties with this type of loan. On FHA and VA mortgages, there are very strict limits on what fees the borrower may pay and mandatory appraisals. There is also a very rigorous inspection of the physical condition of the property. All repairs must be made at the expense of the seller.

Assumption of a mortgage can be very hazardous to the seller

As previously stated, in recent years most mortgages have a “due on sale” provision requiring that the mortgage be paid off if the title to the property is transferred. However, the mortgagee may grant permission to the buyer to assume the mortgage after an application with financial information. Unless the mortgagee releases the seller from the mortgage, the seller remains as a

surtey (or guarantor) of the obligation. The seller can apply for a release if the buyer presents a satisfactory credit report and executes a “collateral bond.” This, of course, is discretionary with the lender. If the seller remains obligated on the assumed mortgage, there is a great danger that the buyer (unless he has a considerable equity invested in the property) will default and leave the seller “holding the bag” by walking away from the property. This means that after a foreclosure, the mortgagee can obtain a personal judgment against the seller. Also, while the assumption remains in effect and until the assumed mortgage is satisfied, the seller must list this mortgage as a contingent liability on any financial statement.

Sellers must give their attorneys detailed information about their outstanding mortgages well in advance of the closing as many mortgages have special requirements as to “payoff.”

For instance, in the FHA mortgage loan there is a prepayment penalty if a sufficient advance notice of payoff (usually 30 days prior to a payment date) is not given. On the other hand, there could be a rebate of mortgage insurance premium on prepayment or satisfaction if the “panel” of mortgages of which the given mortgage was part had a low rate of default (but this must be applied for.

It is interesting to note that when an FHA insured loan is refinanced, the refund from the old premium may be applied toward the upfront premium required for the new mortgage.

The U.S. Department of Housing and Urban Development sponsors a variety of home mortgage programs, such as

Rehabilitation Home Mortgages, Graduated Payment Mortgage Plan, Adjustable Rate Mortgage Program, Condominium Mortgage Plan, Home ownership Assistance for Low and Moderate Income

Families, Home Equity Conversion Insurance Program (Reverse Mortgage) and others specifically designed to assist senior citizens.

Private Financing

 Frequently, a relative or friend of the buyer will agree to finance the purchase of a home. The seller, in order to make a deal, will often agree to “take back” a first mortgage from the buyer as part of the purchase price. This can be a good invesment on the seller’s part and the buyer can benefit greatly by not having to pay an application fee, appraisal fee, credit approval fee and points. He can also save himself the expense of a survey, provided the seller has one that is relatively current. Most of all, the closing can take place quickly. The terms of such financing must be specifically stated in the contract of sale.

Sometimes, a seller will ‘take back” a second mortgage subject to a first mortgage given to an institutional lender in order to allow the sale to go through or to get a better price. However, care must be exercised since many institutional lenders prohibit “secondary financing.” The reason is that a second mortgage reduces the stake of the owner in the property and increases his motivation to abandon the property if things go bad.

Installment Contracts

 These are often called “land contracts” and are a form of creative financing in which instead of the seller conveying title to buyer, the seller retains title until the buyer pays a stipulated amount of the purchase price. The buyer then either gets his own financing or seller, at this point, takes back a “purchase money mortgage.” This is often done when a buyer has poor credit and cannot initially qualify for a mortgage. In essence, this is a lease-purchase agreement.

Great care must be given in the preparation of such contracts, as the hazards of default by seller, who retains title, are obvious. One way a buyer can partially protect himself is to record the contract or a summary memorandum, which will show up in a title search. The buyer must also make periodic checks of the title to make sure the seller has not placed any additional liens or attempted to sell the property out from under the buyer.

A Wraparound Mortgage is a form of second or subsequent mortgage financing. The wraparound mortgagee (seller) collects the installment on its purchase money mortgage and on the existing first mortgage from the borrower-buyer and makes the mortgage payment on the existing first mortgage, which is retained in order to keep me favorable rate of interest. A default on the first mortgage is a default on the wraparound mortgage.

Of course, the first mortgagee must agree to this arrangement because there is usually a “due on sale” clause. There are many variations on this theme.

Hybrid Mortgages

To meet changing needs, such as tight money situations, high interest rates and instability of money supply, lending institutions, in their ingenuity, have developed novel types of mortgages:

Adjustable or Variable Rate Mortgage: The interest rate fluctuates according to a specific federal index (every one, three, or five years) such as one-year treasury bills at constant maturity, the national mortgage contract rate.

You should make sure there is a yearly and lifetime on increase in the interest rate and (if negotiated) a conversion option (to get a fixed interest rate at prevailing rates after a period of time).

Renegotiable Rate Mortgage: There is a fixed schedule of increases or decreases, e.g. changes allowed every three to five years tied to an index of average mortgage rates at the time of renegotiation.

Graduated Payment Mortgage: The borrower’s income is expected to rise. Monthly payments during the early years are lower than in a conventional mortgage. The payments rise gradually over a period of five to ten years, then level off to an amount higher than with a conventional mortgage.

CAUTION:

One consequence of this mortgage is apt to be negative amortization. Instead of your equity growing as you make payments, your equity may be reduced at any given time to compensate for the lower than normal payments during the early years. One variation of this type of mortgage allows for renegotiation of the rate periodically. This type of financing is not recommended unless you are desperate to buy the house or the price is irresistible.

Balloon Mortgage: Mortgages that allow for payment of only interest for several years before commencement of amortization or payment of principal and interest as if the mortgage were longer than its actual duration. The installment payments will not retire the mortgage when due, and thus leave a balance or “balloon” amount due. Caution: This mortgage can be dangerous: What if, when the time comes for the balloon payment, the mortgage market is tight or you are out of a job? Refinancing could be difficult.

Reverse Mortgage: Instead of the borrower paying the lender, the lender makes periodic installment payments to borrower, the total of which is repayable (with interest) out of the equity when the property is sold or the mortgagor dies. This type of mortgage has an appeal for retired and older mortgagors, who are house-rich but cash-poor. The owner continues to pay taxes and insurance premiums. There are different features, depending on the lenders policies. Some allow the borrower to share in the home’s appreciation of value. In looking for the best deal, it is very important to consider the loan’s interest rate and closing costs.

“Buy-down” Mortgage: If the interest rate is higher than the applicant can reasonably afford, this mortgage allows the applicant or-me-seller to pay several points in advance in order to allow the borrower to start paying at a lower interest rate. The interest rate would then increase by 1% each year over the next two or three years, depending on how many points were paid in the beginning. This is ideal for individuals whose earnings or cash situation will increase with time. However, “negative amortization” may be a consequence and this should be checked in advance.

There are variations of the buy-down feature in which you deposit money in a non-interest-bearing account, which the lender draws on each month to make up the amount of the monthly payment that you are, at first, unable to meet. There is also the so-called 32-1 plan, which reduces the rate for years at the beginning, 1% each year. In the first year, you would pay 2% less than the mortgage rate, in the second year 1% and in the third year the full rate and continue to pay the full rate for the remaining life of the 30-year loan. The overall cost may be higher than the fixed mortgage, but the reduced rate at the commencement of installments may be worth the extra cost, as it allows you to enter a deal that you otherwise would not be qualified for.

Shared-Appreciation Mortgage: This type of mortgage loan can lower monthly payments substantially. In return, the borrower agrees to repay the lender a percentage of the profit when the home is sold. This type of mortgage may be available only in an “up” market. Also, there are risks such as the lender being entitled to repayment after a designated number of years, whether the house is sold or not.

Shared-Equity Mortgage: It works like this: Two parties buy a home but only one lives in it, the remaining party acting only as an investor. The occupant pays a fair market rent to his partner who does not live in the house and keeps the proportion of rent that represents his own ownership. The investor partner pays his share of the carrying charges, the monthly mortgage installments and taxes. He splits the deductions with the occupying partner. Eventually they divide the value of the property, including any appreciation in value; usually within a period of three to ten years, the owner-occupant must buy out the investor. Unfortunately, the investor who wants out of such an arrangement is really stuck, as there is no secondary market for such an investment. This is a very poor investment in practice. It is a “get rich quick” idea that is pitched by real estate gurus on late night TV infomercials. This arrangement is, however, useful for parents who assist a grown child to purchase his first home.

Buyers must be acutely aware that the variations are infinite and should get expert advice when exploring the financing aspects of the transaction.

LOCK-IN AGREEMENTS: Once a financing plan is selected, in order to protect the interest rate and other terms of the mortgage commitment, the applicant should protect himself against any changes by entering into such an agreement with the lender for a consideration. Usually the fee is worth it, since the lender will not ordinarily keep the mortgage commitment open for the length of time of the “lock-in” because lenders hedge on the interest rates due to sudden and volatile changes in the money market. For instance, most mortgage commitments state that the actual interest rate for the loan will be fixed just a few days before the mortgage closing. In a lock-in situation, the lender will agree prior to the issuance of the mortgage commitment that it will guarantee for a specific number of days the availability of a specified rate of interest or formula by which the rate will be determined and a fixed number of points, provided the loan is approved and closed within a stated time period. If the lock-in agreement is executed and the loan not approved, the lender must refund the lock-in fee.

A WORD ABOUT NEW CONSTRUCTION AND CONSTRUCTION MORTGAGES

If you purchase vacant land which you intend to build on, it is assumed that the purchase was subject to soil, percolation and other tests to determine whether a building permit will be issued and whether construction costs will not be prohibitive. This situation must be distinguished from the one previously discussed, where it is a new development and the builder is selling a new home from his subdivision. Here, you own the land and, to finance the construction, unless you are paying all cash, you need to apply to a lender for a construction mortgage loan, which ordinarily will be converted to a permanent mortgage upon completion of the dwelling. Plans and specifications must be agreed upon and an architect chosen, if applicable. Progress payments by the lender will be provided for in the mortgage commitment, and periodic searches of title to ensure the priority of the lenders lien must be made. Some states require that the builder provide a new home warranty but, in any event, one should be obtained.

THE MODULAR HOME

The basic frame of a modular home is usually pre-constructed offsite, marked by the manufacturer and shipped with instructions for installation on the foundation previously constructed on the owner’s site. The advantage is that it may be cheaper than a custom-built home and faster to put up. The materials are usually as good as, and often even better than, those in a standard home. After the basic framed-in shell is in position, subcontractors are used to install the heating, ventilation, air-conditioning, plumbing and electrical systems. The proximity of the factory to the construction site is an important factor, as shipping costs can be substantial.

THE KIT HOME

A kit home is shipped in component parts to the site. It requires much more experience and skill to construct a kit home “from the ground up.” Most popular of all kit homes is the log cabin.