Financing Instruments

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1. Describe and define the two classifications of

encumbrances.: An encum- brance that affects the
physical condition of the property, such as
restrictions, encroachments and easements.
An encumbrance that affects the title, such as
judgments, mortgages, mechanics' liens and other
liens.

2. List and describe three provisions that are

common to most notes. (See other correct answers
on screen 5.): Amount borrowed - This is the face
amount of the note that is advanced when the note
is executed.
Interest rate - The rate can be either fixed or
adjustable. If it's adjustable, the note should specify
how the rate will change.
Amount of payments - The amount of the payments
will be determined by the face amount of the loan,
the length of the loan and the interest rate.
3. What is a mortgage?: A mortgage is a financing
instrument that pledges the real property described
in the mortgage document as collateral for the debt
described in the note.
4. How does a note differ from a mortgage?: A note is
a complete contract. After it is legally signed by the
borrower, it is a legally-enforceable and fully-
negotiable financial instrument. A mortgage
however, always needs a note to be legally valid. 5.
What is a deed of trust?: A deed of trust is a legal
document which transfers title to a property to a
third-party trustee as security for an obligation owed
by the trustor (the borrower) to the beneficiary (the
lender).
6. List two reasons that lenders prefer to use the
deed of trust when making loans. (See other correct
answers on screen 14.): A trustee may be given the
power to sell property after default without going
through the time-consuming judicial foreclosure
process.
A deed of trust can be used to secure more than one
note.
7. List two differences between a mortgage and a
deed of trust? (See other correct answers on screen
17.): A mortgage is a lien on the property being given
as collateral, with the legal title remaining in the
name of the borrower. In a deed
of trust, the borrower conveys the property to the
trustee, who holds the title to the collateral on
behalf of the lender until the loan terms have been
satisfied.
A mortgage may be discharged by a simple
acknowledgement that the loan terms have been
satisfied. A deed of trust is discharged using a
reconveyance of title form. 8. What is a land
contract?: A land contract is a complete financing
contract in and of itself that is executed between a
seller and a buyer, in which the seller pledges to
convey the title to the property at the time when the
buyer completes whatever obligations the contract
stipulates. Under the terms of the land contract, the
buyer gets possession of the property and equitable
title, while the seller holds legal title

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Ch. 2 - Financing Instruments

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to the property and continues to be primarily liable

for payment of any existing mortgage.
9. What is the California rule regarding late payments
on a loan?: A late pay- ment cannot exceed an
amount equal to 10% of the principal and interest
payment. In addition, a late charge cannot be
assessed on any payment received within 10 days of
the due date.
10. According to California law, how much could a
borrower prepay on a loan without incurring any
penalty?: A borrower could prepay up to 20 percent
of the unpaid balance in any 12-month period without
penalty.
11. What is a lock-in clause?: A very drastic form of a
prepayment clause which actually prohibits the
borrower from paying the mortgage loan in full
before a specific date.
12. What is the main advantage and what is the main
disadvantage to a borrower to purchase a property
"subject to" the mortgage?: Advantage: The
borrower cannot be held personally liable for the
amount of debt that encumbers the property. The
original owners are still personally and legally
responsible for the loan and they may be held liable
for any deficiency judgment that could be the result
of a foreclosure sale.
Disadvantage: The borrower risks losing all the
equity he or she has in the property. 13.
Encumbrance: An encumbrance is defined as "a right
or interest in a property held by one who is not the
legal owner of the property."

There are two general classifications of

encumbrances:

An encumbrance that affects the physical condition

of the property, such as restric- tions,
encroachments and easements.
An encumbrance that affects the title, such as
judgments, mortgages, mechanics' liens and other
liens.

There are three basic legal documents that are used

to finance real estate in California:

Note and mortgage

Note and deed of trust
Land contract
Whenever a potential homebuyer borrows money for
the purpose of buying a home, he or she will be
required to sign a document that describes the
amount of money borrowed, the terms under which it
will be repaid, and any conditions that relate
to either the borrowing of the money, or the
consequences in event of default. This document is a
promissory note (usually referred to as a "note") and
establishes legal

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Ch. 2 - Financing Instruments

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incurred.

The two most common types of promissory notes are

Straight note - This is an interest-only note, whereby

the borrower agrees to pay the interest periodically
and to pay the entire principal when the note comes
due. Installment note - This note requires the
periodic payment of both interest and principal and
is the most common note.

A note is itself a complete contract.

14. Mortgage: A mortgage is a financing instrument
that pledges the real property described in the
mortgage document as collateral for the debt
described in the note. While a note is a fully
enforceable legal document, a mortgage always
needs a note to be legally valid. In the event of
default by the purchaser, the lender has the right to
bring legal action through the courts to force a sale
of the property. This is called a judicial foreclosure
since it must be ordered by the court. Proceeds from
the foreclosure sale are used to repay the remaining
debt on the mortgage loan.

A mortgage involves a transfer of an interest in real

estate from the owner to the lender. The Statute of
Frauds requires that the mortgage be in writing;
however, although a number of formal, standardized
documents exist, there is no specific form that is
required for a mortgage to be valid. As a matter of
fact, a mortgage could be handwritten as long as it
contains the requirements needed for a valid
mortgage document:

Wording that conveys the intent of the parties to

create a security interest in a property for the
benefit of the mortgage.
Any other items that the particular state's law
requires.
Once the mortgagor has paid off the mortgage in full,
the lender will execute and record a mortgage
release document indicating that the loan terms
have been met.
A mortgage assumption is the act of acquiring title
to a property that already has an existing mortgage
and agreeing to be personally liable for the terms
and conditions of the mortgage, including the
payments.
15. Deed of Trust: A deed of trust is a legal document
which transfers title to a property to a third-party
trustee as security for an obligation owed by the
trustor (the borrower) to the beneficiary (the lender).
A deed of trust is also called a trust deed.

This popular financing instrument is used in many

states today, including California. A deed of trust
differs from a mortgage in the way the lender
achieves the right to

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Ch. 2 - Financing Instruments

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the loan.

At settlement, when the property is transferred to

the new owner who has obtained a mortgage loan,
the borrower signs the note and then signs a deed of
trust. The deed of trust conveys title rights in the
property over to an assigned trustee. When the
borrower repays the note secured by the deed of
trust, the trustee will reconvey title back to the
borrower using a deed of reconveyance, also called a
release deed.

If the borrower should go into default on the loan,

the lender contacts the trustee who is then
empowered to exercise the "power of sale" granted
in the deed of trust. The property is sold and the
proceeds given over to the lender without any
necessity of going through the court system.

Lenders prefer this non-judicial type of foreclosure

because it can usually be accom- plished in a much
shorter period of time than the judicial foreclosure.
For this reason, California uses the deed of trust
almost exclusively when securing loans.
16. Land Contract: Another common financing
instrument used over the years

is known as a land contract. A land contract has

several other names, including real estate contract,
installment sales contract, agreement for deed,
agreement to convey and contract for deed.

A land contract is not tied to a note. It is a complete

financing contract in and of itself that is executed
between a seller and a buyer. Under a land contract,
a seller pledges to convey the title to the property at
the time when the buyer completes whatever
obligations the contract stipulates. Under the terms
of the land contract, the buyer gets possession of
the property and equitable title, while the seller
holds legal title to the property and continues to be
primarily liable for payment of any existing
mortgage.

In an appreciating market, the land contract enables

buyers to purchase property on reasonable financial
terms and benefit from the property's appreciation.
Many buyers sell the property at a profit before the
final payment comes due. Conversely, in a tight
market when it is hard for buyers to qualify for
conventional financing,

the land contract can be the best method to sell or

purchase, especially for young couples, whose
incomes will most likely increase before the land
contract matures, enabling them to refinance and
pay off the land contract.
17. Each of the three financing instruments we
talked about could be expand- ed by the addition of
any of a number of special provisions designed to ad-
dress the specific requirements of an individual
loan.: A Late Payment Penalty

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Ch. 2 - Financing Instruments

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clause requires the borrower to pay a penalty or late

charge for any payments that are considered to be
late. According to California law, Business and
Professional Code, Article 7, 10242.5, a late payment
cannot exceed an amount equal to 10% of the
principal and interest payment. In addition, a late
charge cannot be assessed on any payment received
within 10 days of the due date.

A Prepayment Penalty clause allows lenders to

control prepayments by including a provision that
allows the lender to assess a penalty to the borrower
for paying early. In California, Article 7, 10242.6 of
the Business and Professional Code allows a
prepayment penalty of up to six months' interest on
any amount of principal paid in excess of 20 percent
of the loan amount in a 12-month period.

If there is not a prepayment penalty clause, a

Prepayment Privilege clause allows the borrower to
repay the balance of the loan at any time without
being assessed a penalty.

A Lock-In clause is a very drastic form of a

prepayment clause as it actually prohibits the
borrower from paying the mortgage loan in full
before a specific date.

A Due-On-Sale clause is a form of acceleration

clause that requires the borrower to pay off the
entire mortgage debt when the property is sold.
18. Subordination, release, exculpatory: A
Subordination clause is an agreement to reduce the
priority of an existing loan to a new loan that will be
recorded in the future.

A Release clause is often used when two or more

properties are pledged as collateral for a single loan,
as developers often do. As the developer sells off
each lot, a portion of the money from the sale is used
to pay part of the mortgage. In return, the lender
executes and records a release of the lot that was
sold.

An Exculpatory clause is inserted in a financing

document when the lender agrees to waive the right
to a deficiency judgment.

In some circumstances, a buyer may purchase a

property "subject to" the existing mortgage. In this
situation, the buyer takes possession of the
property, while the seller retains legal title until the
buyer pays off the loan. The buyer is not liable to the
lender for the payment of the note; however, if the
seller defaults on the note, the buyer can lose all his
or her equity in the property in a foreclosure sale.

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Ch. 2 - Financing Instruments
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device: Chapter 2 Summary
19. What kind of lien is a real estate loan?: Specific,
voluntary
20. Which of the following is not an encumbrance
that affects the physical condition of the property?:
Mortgage

21. Which of the following statements is not true

about a deed of trust?: The statute of limitations
might bar action on a note with a deed of trust that
has power of sale.
22. The provision of a note that tells under what
conditions a borrower may substitute another person
on the loan is called what?: Loan assumability

23. Which of the following conveys title rights in the

property over to an assigned trustee?: Deed of trust
24. All of the following are true about land contracts
except which?: Buyer is primarily liable for the
payment of the existing mortgage.
25. Which of the following terms describes a
financing instrument that pledges the real property
described in the mortgage document as collateral for
the debt described in the note?: A mortgage
26. The provision of a mortgage that pledges the
mortgagor's rights is called what?: Granting clause
27. According to California law, a late payment
penalty cannot exceed what amount?: 10% of the
principal and interest payment
28. Which of the following concepts has led to the
vast industry of residential real estate finance that
we find in place today?: Using leverage to buy a
home