Financing Real Estate

Learning Objectives Upon completion of this section you should:

● Explain the differences between a lien theory state and a title theory state. ● Define and describe the following terms: Security instrument, Financing

instrument, Mortgage, Usury, Deed of trust, Promissory note. ● Explain the significant differences of a mortgage and a deed of trust. ● Define interest and amortization and describe the various methods by which

interest is computed. ● State the reasons for prepayment penalties. ● Describe various loan payment plans. ● Explain the priorities involved in recording mortgages and deeds of trusts. ● Explain tax and insurance reserves and describe how financial institutions insure

their payment. ● Describe the difference between “buying subject to” and “assuming” a mortgage

or deed of trust. ● Describe why a short sale might occur. ● Explain what happens in a foreclosure action or a forfeiture action. ● Describe what is meant by conventional, insured, and guaranteed loans. ● Identify the significant elements and differences between the various government

insured and guaranteed loans, including but not limited to FHA, VA, and USDA programs.

● Define and describe other forms of financing including: Purchase money mortgages, Blanket mortgages, Wraparound mortgages, Open-end mortgages, Construction loans, Sale and leaseback, Installment/owner contracts, Adjustable

rate mortgages, Graduated payment mortgages, Reverse annuity mortgages, Personal lines-of-credit.

● List and give examples of the various sources of real estate financing. ● Describe the influence of government in mortgage lending, including the Federal

Reserve System, the secondary mortgage market, and the Rural Housing Service.

● Describe how the Uniform Commercial Code affects a real estate transfer. ● Describe the financing legislation that affects mortgage lending, including:

Truth-In-Lending Act (Regulation Z), Equal Credit Opportunity Act (ECOA), Real Estate Settlement Procedures Act (RESPA), Federal Flood Insurance Programs.

● Explain why “points” are charged and how to calculate them. ● Explain the advantages, disadvantages and purposes of real estate investment. ● Define the terms: Leverage, Equity, Basis, Capital gain.

Financing Real Estate

Money and the Monetary System Money is what we use to exchange with one another so we don’t have to trade goods and services directly. It allows us to avoid the awkward situation of offering things like corn to the dry cleaner as a means of payment. Odd, but true. Money is our primary means of exchange and we use it to purchase real estate. The issue we run into is purchasing real estate requires large sums of money we rarely have, and therefore need to borrow money. This falls under our current topic, financing real estate.

There are a lot of ways to finance a property purchase, and there are also important governmental regulations which control real estate finance. Before we discuss these, let’s first establish what the market for money is and how it’s created.

Supply of Money Just like many other goods and services, there is supply and demand for money. The demand for money is driven by how many people need and want dollars. Dollars are needed for capital purchases, such as equipment or plant construction, even foreign companies require dollars so they can pay US based companies for goods and services. Home buyers and commercial property buyers also require dollars so they can pay for their purchases.

The supply of money is controlled by United States government through the operations of the Federal Reserve and the Treasury Department. The Treasury Department is in charge of minting (creating) money, and acts as the country’s money manager, paying employees of the government and collecting taxes. The Federal Reserve controls the credit in the economy. Because the Federal Reserve controls the credit in the economy, they have a larger role in determining the amount of money available.

The Federal Reserve System (“The Fed”) is the central banking system of the United States. The Fed was created by an act of Congress and operates independently. The Federal Reserve is tasked with a goal of maximum employment, stable prices, and moderate long-term interest rates. It does this through monetary policy, which it implements to control the cost of credit in the country. While this is done in a number of ways, it is primarily influenced through the federal funds rate, the interest rate banks charge each other for short term loans. When you hear on TV that the Fed has raised or

lowered rates, it is the federal funds rate they are talking about. It is vital as it relates to real estate since the cost of credit ends up affecting mortgage rates and the economy. There are economic reasons for why the federal reserve will raise or lower rates to help meet their obligations of full employment, stable prices and moderate long term interest rates, but these are outside the focus in this course.

Interest rates are affected not only by the action of the Federal Reserve, but also by acts of Congress and the President through tax and spending policies. The federal budget and taxation is known as fiscal policy. Fiscal policy has an effect on the employment, economic growth and the size of our deficit. Interest rates are affected by fiscal policy through its debt management, spending, and economic effects. It is typically assumed by economists that fiscal policy affects the economy, but does so on a much slower timeline than monetary policy. The effects of tax increases or decreases are not immediate and any structural shift Congress enacts is likely to take quite a while to take hold and even longer to evaluate. Fiscal spending can go to a number of areas so the legislative and executive branch have an opportunity to target specific industries and geographic locations to help stimulate the economy.

Cost of Money (Interest Rates) Money has a cost. It costs money to borrow from others because they charge interest as a condition of lending. Interest is paid by the party borrowing money because finance follows a basic principle, money now is worth more than money later. Essentially the party lending the money wants to receive more money in the future since they are foregoing the opportunity to use and enjoy the money. Conversely, the borrower pays extra to enjoy someone else’s money now. Because the economy in the US is so large and robust, interest rates are whatever the market will bear through supply and demand for return.

Simple Interest (No Compounding) The nominal interest rate is an annual rate quoted in percentages. The simple interest method does not consider the effects of compounding. This method calculates interest as the product of the original balance, the nominal interest rate, and the time period (in years).

Example: Consider a $5,000 savings account balance with a 12% nominal interest rate, using the simple interest method. In one year, your account would equal the interest payment of $5,000 x 12% = $600 plus your original balance of $5,000, for a grand total of $5,600.

Let’s suppose you could request to be paid in half of a year. In this case, your balance would be $5,000 x (1 + 12% x 0.5) = $5,300. As you can see, when you use the simple interest method, the yearly interest of $600 is exactly double the semi-annual interest of $300.

To generalize, simple interest can be computed once you know:

1. The balance of the loan or savings account (P) 2. The annual nominal interest rate (r) 3. The time in years (t)

The general formula is:

Balance after t years = P * (1 + r t) Compounding Interest Compound interest is calculated very much like simple interest, but it takes into account that the balance changes after each time interest is paid out. If you consider the simple interest example at 6 months, the interest paid was $300, creating a total balance of $5,300. At the end of the year the balance is $5,600 under the simple interest method. Compounding takes into account the fact that $5,300 is the balance at 6 months, and therefore, the amount of interest earned is not $300, but more since instead of calculating based on $5,000 the interest is calculated on the new amount, $5,300.

Compound interest uses the same variables as simple interest, but we also need to know the frequency of compounding:

1. The balance of the loan or savings account (P) 2. The annual nominal interest rate (i) 3. The time in years (t) 4. The frequency of compounding in one year (n)

The compound interest formula is:

The formula differs from simple interest in one major way which is interest is compounded on top of what’s already paid. The exponent takes care of compounding

by multiplying n times each year by the number of years, which turns into the total number of periods.

Example: Consider a $5,000 savings account with a 12% simple interest rate; interest is paid semi-annually, but this time use the compound interest method.

What is the account balance in one year? For the first half of the year, no interest has been paid, so the compound method is the same as the simple method. The balance grows in half a year to:

$5,300 = $5,000 x (1 + .12 * .5)

Now comes the interesting part. For the second half of the year, interest is computed on top of the interest that’s already accumulated. Interest is therefore computed using a $5,300 balance (instead of a $5,000 balance in the simple interest case). This is what differentiates compound interest from simple interest. After one year, the ending balance is:

$5,618 = $5,300 x (1 + .12 * .5)

The result is slightly higher than the $5,600 from the simple interest method. To calculate it in one calculation we would use the formula we showed at the beginning.

Need for Credit Credit availability has an affect on real estate prices as it’s cost goes up or down. If a lot of money is available for loans, it leads to more borrowers participating in the market. If credit is hard to obtain, as it was in October 1981 when 30 year mortgage rates hit 18.45%, above some legal lending rates at the time, the number of people who can borrow money is reduced.

Even though getting a loan gives the lender a return on their investment through interest, in real estate, the primary reason it is cheaper than credit card debt is collateral. Collateral is something which is offered as security for the loan, and in the event of default, the borrower forfeits the item to the lender. When there is collateral as

security for the loan, it is also referred to as a secured debt. Secured debt is backed by an asset, such as real estate, and unsecured debt is not, as with most credit card debt. Real estate lenders offer property purchasers lower interest rates because if they don’t pay, the lender has a contractual right to sell the property and recover the money they are owed.

Leverage Even when property secures a debt, the risk taken by the lender for the property purchase is partially dependent on the leverage involved in the transaction. Leverage is how much money is borrowed versus the borrower's contribution, which magnifies gains and losses. Borrowers participate in the purchase by adding money to the transaction in addition to the amount provided by the lender, known as a down payment. This represents the borrower's equity investment in the property. Equity refers to the owner’s portion of the property value. To calculate it, you would take the current market value and subtract the amount of the mortgage on the property.

Equity = Current Market Value - Mortgage Amount Higher down payment by the borrower as a percentage of the purchase price raises the owner’s equity and provides greater security to the lender. Security increases because in the case of default, chances are greater the lender will be able to recover their investment if the borrower invested a higher percentage down payment. If a property goes to foreclosure, the lender will have missed out on some payments they were owed and will need to spend money disposing (selling) the property in order to recover the money. If the down payment is higher, even after accounting for the time they miss payments and costs associated with selling there would be enough equity from the borrower to cover more of the costs to the lender. If however, the borrower put down very little, the chances of full recovery of the money is lowered.

A key concept regarding down payment and security for the lender is the amount due to the lender in first position. First position means in this case, the lender gets paid first, before the borrower receives any funds. This is true with nearly all debt in the world. Debt holders (lenders) get paid before the equity holders (owners). Being a lender sounds like the only way to go, right? Well, the other part of the puzzle is while the lender is in first position to get paid, the amount owed and gained by the lender is fixed. Lenders receive the same amount of money whether the property increases or decreases in value. The owner has what is called equitable title, entitling them to the financial benefits of the increasing property value and the right to sell the property at

their pleasure. Risk is higher for the borrowers because they bear the responsibility of being the first to lose money and the last to get paid.

Let’s quickly examine how varying the amount of leverage affects the gains or losses from the perspective of the borrower.

Example: Two identical properties are purchased for $500,000 by two different borrowers who chose different down payment percentages. Owner A buys with a down payment of 5%, while Owner B buys with a down payment of 25%.

Owner A down payment = $500,000 x .05 = $25,000 Owner B down payment = $500,000 x .25 = $125,000

Now imagine it’s been 5 years and the property has increased in value by 15%.

Property value = $500,000 x 1.15 = $575,000

As a result of the increase in value, the equity gain by each party is the same, but the percentage gained is different.

Monetary Gain Owner equity = Increase in value + Original down payment Owner A equity = $75,000 + $25,000 = $100,000 Owner B equity = $75,000 + $125,000 = $200,000

Percentage Gain on Investment Owner percentage gain = (Current Equity - Original Equity) / Original Equity Owner A % gain = ($100,000 - $25,000) / $25,000 = 3 or 300% gain on equity Owner B % gain = ($200,000 - $125,000) / $125,000 = .6 or 60% gain on equity

Of course, both Owner A, Owner B and their lenders are thrilled with the result of the investment. That said, Owner A is going to be jumping for joy over the percentage gain on their investment. Why does anyone ever want to borrow with a higher down payment? Let’s look at what happens when the market doesn’t look so rosy, and imagine instead of a 15% increase in value, there’s a 15% drop in the value of the properties. Things start to look a bit different.

Property Value = $500,000 x .85 = $425,000

Monetary Loss Owner equity = Original down payment - Decrease in value Owner A equity = $25,000 - $75,000 = (-$50,000)

Owner B equity = $125,000 - $75,000 = $50,000

Percentage Loss on Investment Owner A % loss = (-$50,000 - $25,000) / $25,000 = -3 or 300% loss on equity Owner B % loss = ($50,000 - $125,000) / $125,000 = -.6 or 60% loss on equity

Ouch. The loss for Owner A is huge in percentage terms and to sell the home they would have to come up with $50,000 or face a short sale, potential bankruptcy and other problems. Meanwhile, Owner B is looking at a tough loss, but is still able to sell without having to come up with money. This illustration is exactly why lenders offer better terms to borrowers who have higher down payments. Lenders of Owner B have a much higher possibility of being paid back in the event of default, even if the property loses value.

As we saw in the example, greater risk is taken by the lender and the borrower when the equity percentage is lower. Lenders measure the percentage put down by the borrower to the total value of the property with what is known as Loan-to-Value ratio (LTV). It is the amount of the loan as a percentage of the total value of the property. It’s a way for the lender to calculate their percentage interest in the property, much like the borrower measures theirs by the down payment. If we refer to our example, the loan-to-value ratio for Owner A would be 95%, and the loan-to-value ratio for Owner B would be 75% when they were given. The lower the better for the lender.

The Primary and Secondary Mortgage Markets

Loans given by lenders to purchase real property are known mortgages, and the debt is secured by the property. This is not a new concept, as you will likely have heard of mortgages prior to this course, or may even have one or two yourself. Before we dive into the details of a mortgage, we need to understand the organization of the system that creates them, the primary and secondary market for mortgages.

Primary Market (Quick Definitions) The primary market for mortgages is where borrowers looking for real estate loans and those who originate (create) loans come together. Primary mortgage market originators include the local banker who offers mortgages, credit unions and mortgage brokers. It is the first line in the mortgage process, where bankers and brokers interact with consumers (borrowers) who are purchasing or refinancing real estate mortgages. Bankers and brokers compete in the primary market for borrowers through rates, fee incentives, loan structure and customer service. After the primary market creates a new loan, more often than not, the loan then moves to the secondary market.

Secondary Market Loans and their servicing rights (accepting payments, handle billing, etc. for a fee) can be bought and sold like other investments. The primary market creates loans that can be sold to investors and institutions who didn’t create the loan, known as the secondary mortgage market. Selling loans to the secondary market helps those who create loans free up money so they can continue to make new loans. The secondary market is a relationship between the loan originator and the investor. A loan originator may hold the loans they originate in their own portfolio, thus removing the need for a secondary market or they sell the loans to an investor.

To avoid unnecessary risk, the secondary markets require the loans they buy meet the standards of uniform underwriting, which are set by the secondary markets. Mortgage underwriting is the process of assessing the risk of making a loan. In addition to private investors, banks, and saving and loan associations, the secondary market also consists of quasi-public organizations. We use the term quasi-public organizations because they are managed privately but were created by government charter and operate with an assumption they are backed by the government, giving them access to lower lending costs than other private companies. They are the Federal National Mortgage Association (FNMA or Fannie Mae), Government National Mortgage Association (GNMA or Ginnie Mae) and Federal Home Loan Mortgage Association (FHLMC or Freddie Mac).

To a very large degree, interest rates are driven by the secondary market that buys loans from the primary market. The secondary market is a very important player in the mortgage industry.

The Market for Residential Finance The size of the market for mortgages in the United States is massive by all measures. As of 2015, the Federal Reserve reported all mortgage debt outstanding to be 13.4 trillion dollars. That’s tough to get your head around. It’s enormous partly because in 2015, 64% of families own their home, which can and does change over time. Take a look at the following chart from the US Census Bureau.

US Census Bureau

Out of 13.4 trillion dollars in mortgage debt outstanding, residences 1-4 units in size accounted for 9.9 trillion dollars worth of debt. This makes the residential lending market the largest portion of the market. With that much money being lent, and the number of people needing mortgages, there are a lot of different participants. In the primary market, there are depository lenders and nondepository lenders.

Depository Lenders in the Primary Market Institutions who take deposits make loans on the money they receive. This activity is known as financial intermediation, the act of matching up borrowers with depositors. The banks will receive deposits which will earn a nominal return and then the bank or credit union will then lend the money to those seeking mortgages, business loans and other forms of credit. Banks and other institutions are able to accomplish this because they are able to pool the savings from multiple parties.

What happens when the depositor wants to get all of their money out? Depository institutions know how much capital is going to be withdrawn on a daily basis by using historical information to project the percentage of assets that may be withdrawn in a given day. While amounts needed can vary, the Fed regulates banks minimum reserve requirement to ensure they have the funds available to meet any requests for money. Also, the Federal Deposit Insurance Corporation (FDIC), a government corporation, insures deposits to provide the security necessary to prevent bank runs. A bank run is a panic where many depositors for fear of there not being enough funds available to receive their own, all attempt to withdraw at the same time.

Depository institutions are all regulated by the government to prevent situations where those who have deposited their money for safekeeping are assured of full access to their funds. Let’s take a look at three types of depository institutions: savings and loans, credit unions, and commercial banks.

Savings and Loans (Thrifts) A savings and loan is a federally regulated institution that operates in many ways like a bank and credit union. The difference is a savings and loan focuses on taking deposits and making residential housing loans. They can also make commercial loans, but are limited in the percentage they can offer. Due to the high exposure to housing, downturns are particularly dangerous for thrifts. In the 1980s savings and loans underwent a severe contraction. This was mostly due to poor lending practices. Regulations were added and there are still many savings and loans operating today.

Credit Unions Credit Unions are owned by the members, the customers of the credit union. Management is elected by the members of the credit union and are designed to offer very competitive rates. The concept is the credit union can offer rates that are better than those of a bank since there isn’t a need to make a profit for investors, since the customers are the owners. Election of management is done on a one account, one vote basis, and is not dependent on the amount of money the member has.

Commercial Banks Commercial banks offer a large range of services, including taking deposits and making loans. The loans given out are often business loans and the deposits also come from businesses. Commercial banks deal primarily with business accounts. Retail banking is the type of bank or part of the bank that deals with banking for individuals.

Nondepository Lenders in the Primary Market Mortgage Bankers These lenders often use their own money for loans and may or may not sell these loans on the secondary mortgage market. The banker is lending money of the bank or institution they represent and will be limited to the products and services offered by their employer.

Mortgage Brokers These individuals may offer loans for any number of lenders as they attempt to match up a borrower’s loan needs with the best lending source. Mortgage brokers differ from mortgage bankers in the products they sell. The broker can offer products (mortgages) from multiple sources and acts as an independent third party who is seeking to match the buyer with the loan that they think is best. The buyer can benefit from the options provided by brokers, but they also may be steered into a mortgage that may not be in their best interests if there is additional incentives for the broker to go with a particular source of funding. There are laws and ethical guidelines to help avoid these situations.

Choosing between a mortgage banker and a broker is usually a process of discovery for the buyer, getting quotes from multiple sources. It’s always a good idea to have lenders compete to make a loan.

The Secondary Market for Residential Mortgages Mortgage-Backed Securities Mortgages created by mortgage bankers, brokers, banks and credit unions comprise the primary market, where the consumer agrees to the terms with a lender. This isn’t the end of the line for the mortgage in most cases. Mortgages are routinely sold off and then packaged in groups to investors. Because investors are interested in income, at a greater size than provided by a single mortgage, the loans are put into groups. The secondary market is all about the income that is created as a result of the mortgage payments. Investors and secondary market makers are interested in receiving the income which is in the form of an annuity. An annuity is a set of payments made at fixed intervals.

Because there are institutions and investors interested in the income from these mortgages, a lender who has made a loan has two options, keep the mortgage and receive the payments, or sell the loan for a fixed sum. Many opt for selling the loan so they can use the money they receive to make more loans.

Purchasers of Residential Mortgages in the Secondary Market Ginnie Mae (GNMA) Ginnie Mae is a government corporation, and operates under the Department of Housing and Urban Development. It’s job is to make housing affordable for low to

moderate income households. They essentially provide a guarantee that the mortgage backed securities which are made up of federally insured and guaranteed loans (FHA and VA) will pay the principal and interest due. Because the payments are backed by the US government, the loans are seen as higher quality, demanding a higher price for lower return. FHA and VA loans are able to lower the rates households have to pay for a mortgage as a result.

Fannie Mae Created in 1938, as part of the New Deal, it is a government sponsored enterprise and it aims to increase the number of loans given out through secondary market operations. Fannie Mae originally was the entire secondary mortgage market. Today, Fannie Mae buys mortgages from primary providers and either keeps them or bundles them into mortgage backed securities. It purchases loans, provided borrowers meet the terms they set. Even if the market is poor Fannie Mae will buy mortgages as long as primary market participants generate loans that conform to their standards. By being the lender with the deepest pockets and an ability to borrow at extremely low rates, they are uniquely positioned to be the standard setter as to how mortgages are written. Meeting the Fannie Mae guidelines is crucial to lenders in the primary market so they have the option to sell to Fannie. Also, in addition to buying mortgages, Fannie Mae will guarantee loans will have their interest and principal paid back for a fee.

Freddie Mac Freddie Mac has essentially the same goal as Fannie Mae, to increase the liquidity and size of the secondary mortgage market. It does this the same way Fannie Mae does which is by buying conforming loans (those which meet their underwriting standards) from primary market participants. Freddie then securitizes some of the loans for sale in the markets. They also offer a guarantee repayment of interest and principal for a fee. The fee is because Freddie Mac is assuming all of the credit risk. Credit risk is the risk associated with any loan, due to the possibility the borrower may default. Because they will guarantee loans, there is no credit risk to the purchaser of the guarantee.

Private Conduits Private conduits also offer mortgage backed securities, by pooling loans together after purchasing from the primary mortgage market. They are not restricted to purchasing loans which conform to Fannie Mae or Freddie Mac’s standards. Private conduits aggressively purchased mortgage backed securities ahead of the market crash of 2007 and greatly increased their portion of the market, which put a great strain on the financial institutions who purchased them before the market turned sour.

Life Insurance Companies Life insurance companies also lend money in the real estate market. They are one of the main funding sources for commercial real estate loans. As an insurance company they take in premiums and then lend out money to commercial real estate investors for a return which may be paid out in the future. By taking money now and putting it into an investment such as a commercial loan, insurance companies have more money in the future, which they can use to pay out to those they insure.

Insurers also participate in the secondary market for residential mortgages. Much like the return they receive on commercial real estate loans, they purchase mortgage backed securities from Fannie, Freddie, and other sources to earn income on the money they receive from policyholders.

Qualifying Borrowers/Lending Practices A buyer is likely to shop around to multiple lenders in search of the best terms. Even before a lender is selected, a buyer may find a property they like and want to make an offer. If this happens, the best avenue is for the buyer to get a qualification letter for the loan. Prequalification is for borrowers who have had a conversation with a mortgage lender, telling them the details of their financial situation. The lender can then provide a letter of prequalification stating the buyer is qualified to get a loan for specific amount of money. The letter of prequalification will state something along the lines that the person is prequalified to get a loan of “xx” amount while stating clearly that the letter is only a prequalification and is subject to verification of all of the information provided by the buyer. Because a prequalification letter contains large disclaimers as to the buyer's financial security, it isn’t the preferred method of proving to sellers they will be able to get a loan.

There second type of approval for mortgage loans is preapproval. Once they have settled on a mortgage lender, they will make application for the loan. During the loan process the lender will request all of the documentation to back up the statements of the buyer regarding their financial situation, which will allow the lender to issue a different type of letter if they find a property to make an offer on, a preapproval letter. A preapproval process is designed to confirm all documentation provided by the borrower and to make the final determination the borrower meets the financial requirements set by the lender.

Fraud During the application process a borrower could lie about their financial situation or misrepresent who they are, which is fraud. A common tactic is for borrowers to misrepresent they are purchasing a home as their primary residence to get a lower interest rate, when in fact they do not plan to occupy the property. Mortgage fraud is a real risk and is a key reason banks verify everything possible prior to making a loan. Fraud isn’t just confined to the borrower, a banker or broker can commit fraud as well, helping to assist a borrower or deceiving a secondary market participant with false information when they sell loans.

At the federal level, mortgage fraud is prosecuted as wire fraud, bank fraud, and money laundering. Penalties include up to 30 years in prison. Washington state also has mortgage fraud laws in place that are also stringent, much of which is attributable to the lending problems that manifested around 2007.

Mortgage Underwriting Underwriting is the process of risk assessment the lender does to determine if making a loan is worth the risk. The process is broken down into 3 parts, known as the 3 C’s of underwriting: credit, capacity and collateral.

Credit Credit focuses on the borrower's history of repaying debts. If the borrower is consistent in timely payment of debt and managing their balances, they will be seen as a good credit risk. Credit risk is represented by a credit score, provided by the 3 credit rating agencies. It is a statistical representation of the creditworthiness of the person. Over time the rating agencies use all of the payment data on how likely a person is to pay back their debts. Credit is focused on the borrower's willingness to pay back their loans, not necessarily only their capacity (ability) to payback their loan.

Capacity Capacity is how able the borrower is to payback their loan. Lender’s figure this out by examining income, employment, and how much debt they currently have.

Income - The amount of income a borrower receives is always critical in determining their capacity to repay a loan. However, the amount of income is not the only factor when calculating capacity.

Employment - Not all income is created equal. Stability of the income the borrower receives is important to the lender. If a borrower is self employed in a commission based job, income is likely more inconsistent and therefore not valued the same as a full time job given the same amount of time employed. It is more likely that a person with a full time salaried position will continue to earn that amount even as compared to a full time worker who has been receiving overtime. As a result, income is averaged over a longer period of time for less stable income such as self employment and those with overtime.

Current Debt - How much debt is too much. Regardless of the amount of income generated, if it is already being paid out to other sources, it’s unavailable to pay back new debt. To determine if the borrower is within acceptable limits of debt, lenders use guidelines for the ratio of debt to income of the borrower. It’s not important that a person makes a lot of money, it’s more about the portion of their income that is dedicated to debt. There are two main ratios underwriters focus on for conforming conventional loans, the housing expense ratio and the total debt ratio. The general rule of thumb for qualification is 28% or under for the housing expense ratio and 36% or under for a total debt ratio.

Housing expense ratio = Monthly housing expense / Total monthly income

Total debt ratio = Monthly debt / Total monthly income

Monthly housing expense is also referred to as PITI, which means, principal, interest, taxes, and insurance. The principal and interest on the loan, the real estate taxes due on the property and insurance are all necessary to maintain ownership in a home with a mortgage. Also included in the housing expense is any condominium or homeowners dues.

Total monthly income is the gross monthly salary or income of the individual before taxes are taken out. Total income should include any overtime, bonuses, alimony and child support received.

Monthly debt is all debt due on a monthly basis. Don’t include any current mortgage debt that will not be due when the new loan is created, assuming the current home is sold and the mortgage paid off. The debt to add in will include any credit cards, auto and student loans, and any other financial obligations.

Collateral Collateral is the property that is being purchased with the mortgage. Mortgages contain clauses that in the event of default the property itself is used to pay back the debt, therefore it is the collateral for the loan. Evaluation of the property is important to the lender so they can determine if the property is worth what the borrower is paying so if necessary, the lender can sell the asset to satisfy the debt. Lenders use an appraisal to determine the property has the value necessary to make the loan. An appraiser, a third party, will make a detailed analysis of the property to decide what the value is. Collateral value is used to calculate another important lending ratio, the loan to value ratio.

Loan to Value = Total loan amount / Value of the Asset

The ratio that is calculated let’s the lender know what percentage of the property value they are being asked to be responsible for. If the loan to value (LTV) is .90, the lender is putting up 90% of the value of the property. As we discussed, when looking at the effects of leverage, LTV has a big impact on risk.

Home Financing for Marginal Borrowers Affordable Housing Loans The government wants to be able to make home ownership available to as many people as possible. To accomplish that goal, there are programs which relax the lending standards in specific ways. An example is giving loans to borrowers who have good credit and acceptable debt ratio, but lack the cash to make a sizeable down payment in order to meet the LTV requirements. Typically, the programs to help make housing affordable are for those with low enough income, who can’t meet all 3 of the underwriting C’s, most often collateral requirements.

Subprime Lending Subprime lending is for those who fail to qualify under the normal conforming loan standards. Subprime lending goes to those without well documented income, poor credit, or are short of cash needing to borrow at near 100% LTV. Documentation for income is often tougher for those self employed in commission based positions because of their variable income. It may mean they have decent income but that income cannot be documented over a long enough time period required to meet conforming standards.

Lending Contracts The majority of all real estate purchases involve a borrower getting some amount of funding through a loan. When a borrower gets money from a lender for a real estate loan, there are two different legal documents that are signed, a mortgage and a note. Often mistaken for the document that contains the terms and conditions of the loan; the mortgage is actually what pledges the property to the lender in the event the borrower defaults.

The Promissory Note The promissory note (note) contains the terms and conditions such as the repayment schedule, interest rate, amount of the loan, late charges, and the term of the loan (length of the loan/repayment period). Notes are very detailed to provide clarity to both parties and attempt to cover all possible events. Commercial loans can be very complicated and contain special provisions, while many of the residential loans are standardized to meet the requirements of the secondary market.

The note itself has value after it’s been originated, since there is a promise to pay money from one party to another. Documents that have a monetary value or are evidence of a monetary transaction, such as drafts, bills of exchange, checks, bonds and promissory notes are known as financial instruments. Almost all documents used in credit are financial instruments.

Types of Interest Rate Terms Interest can be charged on a fixed or adjustable basis. A fixed rate mortgage has the same interest rate for the entire life of the loan. In more recent years, there has been the adoption of another option, known as adjustable rate mortgages. Adjustable rate mortgages (ARM) have interest rates that fluctuate at specified times throughout the mortgage life. The common vernacular is an “ARM” loan, an acronym for adjustable rate mortgage.

Calculating Note Terms There are some key note terms needed to calculate mortgage payments. Let’s look at the key variables in mortgages.

Principal is the amount of the loan outstanding, or the total amount remaining on the loan. Also known as the loan balance. When a loan is originated, the amount that is

borrowed is the initial principal amount. Loan amount is the term used when referring to the total amount borrowed (aka initial principal amount). Mortgages are typically paid on a monthly basis, and each payment, in the case of non-interest only loans, have a certain amount paid which is interest and the remaining portion applied to principal. The amount applied to principal reduces the overall amount owed on the loan.

Example: If the principal amount of the loan before the payment was $600,000 and the total monthly payment was for $3,220.93 and $2,500 was to be for interest, we could calculate the new amount applied to principal and therefore the new loan balance outstanding.

$600,000 is our starting loan balance or principal $3,220.93 is the total monthly payment $2,500 is the amount applied to interest

To determine loan balance after the payment we must first determine how much money was paid towards principal.

Principal payment = Monthly payment - Interest payment Principal payment = $3,220.93 - $2,500 Principal payment = $720.93

After we determine the amount applied to principal it’s a quick step to find our new outstanding balance.

New outstanding balance = Current loan balance - Principal payment New outstanding balance = $600,000 - $720.93 New outstanding balance = $599,279.07

Interest Interest is the rate charged on the loan, the cost of borrowing the money. Rates are typically represented in an annual percentage rate form, such as 6% APR. If you are going to be doing calculations using the interest rate, it needs to be converted into the proper format, be it, the annual or monthly rate. In most cases when working with mortgage calculations, the interest rate will be based on the interest rate per period. Per period means the time the payment is for, be it one month or one year. Mortgages

Note: Be careful not to make the mistake of subtracting the entire monthly payment from the loan balance to get the new loan balance. You must first calculate the portion of the payment applied to principal.

are usually paid monthly, yet the interest rate is expressed as a yearly percentage rate. We can easily accomplish this by dividing our interest rate by 12. In the case of 6% APR, the interest rate per period would be .06 / 12 = .005.

Number of Payments The number of payments made during the life of the loan is calculated by knowing the length of loan and frequency of payments. In the case of a 30 year fixed mortgage, payments are made monthly. The term of the loan, also known as the repayment period, could be a 15 year fixed mortgage depending on the financing the borrower chooses. Using this information we can find the number of payments during the life of the loan.

Number of payments = Length of the loan x Frequency of payments For a 30 year mortgage: 30 years x 12 payments a year = 360 total payments

Armed with the knowledge of interest, principal, and the number of payments you have all the tools to calculate the monthly payment due on a mortgage. The monthly payment formula is:

r = Interest rate per month (annual interest rate and divide by 12) P = Principal loan amount N = Number of payment periods (30 year loan would be 30 * 12 = 360)

You will be calculating this using a spreadsheet or financial calculator, so there is no need to commit it to memory.

Practical Application While you may not need to know the formula for calculating monthly payments, you will be expected to determine the amount of principal and interest payments, and new loan balance when given certain variables. Let’s look at a long form problem where we can figure out each of these important numbers.

Example: A borrower has a current outstanding balance of $599,779.07 after making their first payment on their loan. The monthly payment is $3,597.30 and the interest rate on the loan is 6%.

1. How much of the next payment will be interest? 2. How much will be applied to principal? 3. What is the new loan balance after the payment?

This sounds daunting, but the questions are broken down into the order we would like to calculate them, for our convenience. We’ll first determine the amount of interest paid in the period, use that to determine our principal payment amount, and then use our principal payment amount to calculate our new loan balance. To find the amount paid towards interest, we use the following formula.

Interest payment = Current loan balance x Interest rate (per period)

What parts of this formula do we already know? We have the current loan balance, $599,779.07 and we know the interest rate, 6%. Here we must be careful since the interest rate is currently expressed in annual terms and we need to know how much interest is being paid during the period, which is monthly. To translate our interest rate into the form needed for the calculation, we divide by 12, since there are 12 months in a year.

Interest rate (monthly) = Interest rate (annual) / 12 Interest rate (monthly) = .06 / 12 = .005

We have all of the required elements to plug into our formula and calculate the interest payment.

Interest payment = Current loan balance x Interest rate (per period) Interest payment = $599,779.07 x .005 Interest payment = $2,998.90

Let’s move right into our second step and figure out the amount of principal paid, by using our newly acquired interest amount paid.

Principal paid = Monthly payment - Interest payment Principal paid = $3,597.30 - $2,998.90 Principal paid = $598.40

We have found out how the payment was split between principal and interest, $598.40 towards principal and the remaining $2,998.90 was interest. Finding the new loan balance should be relatively quick.

New loan balance = Current loan balance - Principal payment New loan balance = $599,779.07 - $598.40

New loan balance = $599,180.67 Tough questions, but if taken in parts, very manageable. It will be important to understand and memorize how each element is calculated, and remember to have all of the units in the proper format, such as interest rate, converted to a monthly rate. A term you may come across when dealing with interest rate is basis point. A basis point is one hundredth of a percentage point, or 0.01%.

Example: An interest rate increase may be described as going up 100 basis points, which would translate into 1%.

100 basis points x 0.0001 = 0.01 = 1%

Usury Usury is the act of charging illegally high interest rates on debt. Washington state law dictates the maximum allowable rate on loans is 12% annually or 4% above the Federal Reserve’s 26-week treasury bills. The rate can be whichever is higher. In the early 1980’s treasury bills and rates in general skyrocketed, and the maximum rate on debt in Washington state was 21%. The Washington usury law applies to consumer loans (not business) which are not related to retail installment contracts, consumer leases or credit card debt. Mortgages fall under this law.

Adjustable Rates Adjustable rate mortgages, ARM loans, have different structures than the fixed rate mortgages. They are used by homeowners to get lower interest rates, and are very common in commercial real estate as well as home equity loans. Due to the variable interest rate structure, the note has to contain additional information regarding how the rate is calculated throughout the term of the loan, how frequently it can change, and how much it can change each adjustment period. The contractual clause which states all of these details allowing interest rate adjustments during the loan is known as an escalation clause.

ARM loans start with an initial rate which is the interest rate charged when the loan is started. Often the initial rate is artificially low to entice the borrower to choose that particular lender or loan. When it is artificially low to begin with, it’s referred to as a

Note: The term escalation clause is used in two other contexts, property management (graduated leases) and in purchase and sale agreements (escalation addendum).

teaser rate. A crucial saying in finance applies here, “There is no free lunch.” The phrase is relevant in this case, as it means you will end up paying for what you received eventually. This may happen with higher costs in other parts of the loan.

Included in the ARM loan terms will be a provision describing the adjustment period, which defines when the loan first begins adjusting and the schedule for future adjustments. The terms may state it will adjust every year or even every month. It will set the time frame for the first adjustment if there is a teaser rate that is fixed for a period. When a rate is fixed for a certain period of the ARM loan it’s more commonly known as a Hybrid ARM. The hybrid term is because it is fixed for a specified term then adjustable thereafter.

Terms you will likely hear in reference to a Hybrid ARM are 5/1 ARM or 3/1 ARM. The numbers quoted represent the fixed and variable timelines of the mortgage note. The note would indicate in the case of a 5/1 ARM, the initial fixed term of 5 years, followed by the rate adjusting on a yearly basis thereafter.

If a rate adjusts, what defines the adjustment amount? The adjustment amounts are based on an index and a margin. Banks will use indexes, which are predefined existing financial rates used as a benchmark, while margin is the amount over and above the index, the lender’s profit or markup. Put another way, it’s as if you ask your friend to pay you back monthly an amount equal to $10 more than Big Mac’s are selling for at your local McDonald’s. The index in this situation is the price of Big Mac’s at the local McDonald’s and the margin is $10, the amount over and above the index you are charging. To tie this into our definition of adjustment period, you may say you will check with the price of the McDonald’s Big Mac and adjust the amount due once a year.

The index banks and lenders use vary but there are a few common ones, including the rates of the Cost of Funds Index (COFI), 1 year constant maturity Treasury securities (CMT), and the London Interbank Offering Rate (LIBOR). The indexes can either be calculated using averages or based on spot rates (the going rate at a specific time) like we had in our example of the Big Mac.

Rates can and do change, making the price a borrower pays volatile. However, there are sometimes provisions to protect the borrower from excessively large increases to higher rates through what are known as interest rate caps and payment caps. An interest rate cap limits the size of the interest rate increase which can happen when it adjusts. Interest rate caps come in 3 types: an initial rate cap, periodic rate cap, and a lifetime cap.

An initial rate cap is the amount the rate can increase the first time it adjusts. This is different in the case of Hybrids ARM as rates could have dramatically changed from the time the loan was originated 3 or 5 years ago. A periodic rate cap sets a limit on the increase that can occur from one adjustment period to the next. If a loan has an adjustment period of 1 year, the rate cap may be 1% over and above the rate being charged currently. Since the rates can continue to rise each period there is a maximum amount the rate can increase overall, the lifetime cap. This may be set at 6% above the initial loan rate.

Discount Points There’s a way to get a lower mortgage rate, and that requires the borrower to pay an upfront fee, called discount points. First, it’s helpful to understand what a point is. A point represents one percent of the loan amount. On a $700,000 loan, a point is $7,000. Discount points allow the borrower to pay a fee, and in the case of 1% of the value of the loan, it would be 1 discount point in exchange for the lender lowering the rate on the note. The amount of interest rate discount given for paying 1 discount point will vary, but generally is ⅛ to ¼ of a percent. By paying 2 discount points, the rate can by ¼ to ½ of a percent or more.

The lender does this because they receive money upfront instead of having to wait to collect it in the form of interest. A borrower will want to buy down their rate if they plan on keeping the loan past the breakeven point. There is a point where if the borrower chooses to buydown the rate, it will be worth the reduced rate because the lower payments will save more than it cost in discount points (fees) over time.

Lenders will sometimes offer special programs where they offer negative points, also known as rebates. This is the inverse to discount points, where the lender will pay a certain amount of closing costs and fees on behalf of the borrower, and the borrower agrees to pay a higher rate.

Loans to investors are about one thing, and one thing only, yield. Yield is the overall return to the investor in percentage terms. Investors use yield to compare investments. If two comparable investments have equivalent risk and one has a higher yield, that is the investment which will be selected. It’s a way to compare how much money can be expected to be returned by investing a set amount of money. Risk is of course important, and investors require higher yields (returns) for assuming more risk. This is why poor credit borrowers have to pay higher rates on their mortgage, because investors demand a higher return in exchange for assuming the higher risk of default.

This ties into discount points since any discount points paid are effectively prepaid interest, returning income to investors earlier and increasing the yield to match the yield they would receive at the higher interest rate.

The term points is used more broadly as well to refer to origination fees, such as, “The origination fees for the loan are 1 point.” Origination fees are fees charged by the lender for putting the loan together.

Payments Fixed rate and adjustable rate loans as well all most all real estate loans are paid monthly. It’s an important distinction when attempting to calculate interest payments to make sure the rate is adjusted to the monthly amount. Fixed rate mortgages have constant payment amounts each month and are fully amortizing. Amortization is the payoff of debt on a regular schedule, over the life of the loan, usually with fixed payments. Fixed rate mortgages are fully amortizing because the loan is completely paid off at the end of the term.

Some loans are only partially amortizing, which means only part of the debt is paid off at the end of the loan term with the balance being due at once, known as a balloon payment. Some loans don’t pay any principal, only interest, or interest only loans. Interest only loans also require balloon payments since the principal needs to be paid in one lump sum. There are even loans where negative amortization occurs, essentially through deferring interest payments. Negative amortization happens when the payment made is insufficient to cover the interest due for the period, thereby increasing the total loan amount due.

Term The note will include the term of the mortgage, the length the loan is to be outstanding. Whether the loan is fully amortizing or not, it will have a definitive end point when either the loan is paid off or the balance is due. Most often this is expressed in years for real estate loans, but can vary in length. Some commercial loans are shorter than 30 years in timeline, and are even available to residential borrowers. The payments are higher since there is a higher percentage of principal being paid with each payment, but it reduces the overall amount paid in interest due to the shorter term. The shorter term loan reduces the risk to the investor thereby reflected in a lower interest rate charged to the borrower.

Right of Prepayment The note may or may not contain a provision allowing for a right of prepayment, which grants the borrower the right to pay off part or the entire loan before the term on the note. Some states, not Washington, will implicitly allow borrowers to prepay even if the provision is not included. Borrowers can choose to make small payments towards principal reduction every month, or if they sell the home can repay early without penalty. It can be an important contractual provision for borrowers so they are allowed the flexibility to either move without paying a penalty or to speed up the payoff of their mortgage.

Prepayment Penalties Prepayment penalties are charges that occur when a borrower pays off their mortgage early. This can be through refinancing, and the logic is that the lender doesn’t get the full amount of interest from the loan because it was paid off before it matured (finished). The FHA and VA as well as many other loans do not contain prepayment penalties, but it is something that every borrower should be aware of when they are planning on paying off their mortgage early. The penalty is usually based on a percentage of the remaining mortgage balance or a certain number of months’ worth of interest.

A prepayment penalty will discourage an early payoff before the lender has realized a return sufficient to offset the costs of making the original loan as well any anticipated yield for profit.

Some lenders will offer a lower rate on a loan that carries a prepayment penalty because of this assurance of overall yield. A “soft” prepayment penalty allows for annual principal reduction above and beyond the normal amortization, up to but not exceeding a predetermined percentage of the principal balance. A “hard” prepayment penalty will become due on a note if at any time the loan is paid off prior to the contractual period stated, including refinancing.

Most loans do not carry prepayment penalties. Borrowers should be careful to inquire about prepayment penalties from their lender and read the note carefully before signing. A borrower should be aware of the risks associated with a prepayment penalty. A prepayment penalty can substantially increase the cost of refinancing a mortgage when it would otherwise be more economical.

Loans, which do not have prepayment penalties, are often referred to as open mortgages.

Lock-in Clause A lock-in clause will not allow a borrower to pay off a loan early. It is differentiated from a prepayment penalty in the following way: with a prepayment penalty, the borrower is penalized when paying off a loan early. With a lock-in clause, the borrower is prohibited from paying off the loan early.

Late Fees Included in the note will be a provision stating when and how much late fees, also known as a late payment penalty, will be if a borrower misses a payment. The fees can be more stringent on loans that are made to risky borrowers. It will state if payment is not made by the 15th of the month (as an example) the borrower will owe 5% of the amount of the payment as a late fee. Late fees are not applied to the interest or principal amounts of the loan.

Personal Liability Almost all home loans have the borrower sign a note which makes them personally liable for the debt. When a borrower assumes personal liability, it is known as a recourse loan. A recourse loan allows the lender to go after the borrower for the amount owed even after they have taken the collateral (home, property). They can do this through the courts seeking to garnish wages or personal assets. For large commercial loans, they are typically nonrecourse loans because the signatory is not personally liable for the debt and the lenders only option is to take the asset which was pledged as collateral.

Demand Clause A note containing a demand clause allows the lender to call the loan due at any time during the loan term. This means they can demand the borrower pay back the entire loan prior to the loan term. Lenders receive tremendous leverage with a demand clause because if rates rise they can force the borrower to repay the loan so they can lend out the money at higher rates. Demand clauses protect the lender from a business whose prospects have slipped significantly and therefore force them to pay back the loan since their ability to continue to pay the loan has worsened. While pure demand clauses are more rare in residential loans, they are usually referring to two other types of demand clauses which don’t allow the lender to call the loan due at any time even if you continue paying your mortgage. The other types of demand clauses, called acceleration clause and due-on-sale clause, allow the lender to call the loan due when another event occurs first. We’ll look at each as we examine the mortgage contract.

The Mortgage While the note sets the terms of the payments due to the lender, the mortgage contract grants the lender an interest in the property. The mortgage contract is a security instrument. A security instrument pledges an asset such as real property as security for the debt. There are different ways for a mortgagor, (grantor/borrower) to grant the interest in the property to the mortgagee (lender). The concept is the same regardless of how it is granted, since in all cases the mortgagor is using the property as collateral. There are two main legal theories used to convey property to the lender as collateral, and different states use different theories.

Title Theory States versus Lien Theory States Lien theory and title theory have to do with how title is held as security for a loan. Each type of theory has special considerations on who will hold title and how foreclosure proceedings would take place if they were to become necessary. In title theory states, the borrower does not actually keep title to the property during the loan term. The seller gives the buyer/borrower a deed to the property, but when the borrower signs the mortgage for the loan, the borrower gives the title back to the mortgage holder. The lender then holds title to the property, as security only, until all loan payments have been made. During that time, the borrower has the right to possession of the property, and the lender delivers the deed back to the borrower only after the loan obligation has been satisfied.

In a lien theory state, the buyer holds the deed to the property during the mortgage term. The buyer promises to make all payments to the lender and the mortgage becomes a lien on the property, but title remains with the buyer. The lender's lien is removed once all loan payments have been completed. Foreclosure proceedings in a lien theory state may be more difficult for the lender than in a title theory state, due to the fact that the buyer is holding title to the property and not the lender.

Deed of Trust In Washington state, we use what is known as a Deed of Trust, another type of mortgage theory. When the seller gives title to the property, the buyer will sign a document known as a Deed of Trust (a security instrument), which will assign a third party to hold title and have the ability to foreclose if obligations are not met. The lender is the designated beneficiary of the Deed of Trust. When the loan has been paid off, the lender will release the borrower of the conditions in the Deed of Trust, through

reconveyance. A Deed of Reconveyance clears title and the lender’s interest in the property.

There is a lot of confusion when it’s asked if Washington State is a title theory or lien theory state. Washington, because it uses deeds of trust, is more closely associated with title theory because title is transferred to another party, even if that party is not the lender. In a lien theory state the borrower maintains possession of title. Washington does allow mortgages to serve as liens. Foreclosure through the court system is almost never used since the deed of trust contains a power of sale provision allowing for the disposition of the property by the trustee, which is faster and less costly.

Deed of Trust Process

Equitable Title A Deed of Trust is a setup where a trustee holds legal title and the borrower who “owns” the property is under contract to pay the mortgage back. The “owner” or borrower would

have an equitable interest in the property. They would enjoy the increase in value to the property if there were any as well as the rights to sell the property. The trustee may hold the legal interest in the property but wouldn’t see any gains from appreciation or be able to enter into contracts for sale as long as the borrower followed the contractual provisions set in the mortgage.

The difference between equitable and legal interests found with a Deed of Trust are also found when a property is put under contract.

Example: A buyer is under contract with a seller to purchase a 5 acre property. The buyer is in this case holding an equitable interest in the property. Any appreciation, or rezoning would be to the benefit of the buyer provided they followed all the provisions in the contract. After fulfilling the provisions of the contract, the buyer would receive title.

We’ve just talked a bit about legal and equitable title, but there’s another term that is closely related called marketable title. Marketable title, is title that is clear from ownership and lien claims, which could prevent the transfer of title to another party. It’s another way of saying clear title, which is necessary to sell a property to another party.

Description of the Property The mortgage will include a description of the property. The description must be a legal description, and cannot be an address.

Insurance Clause Lenders require borrowers to keep homeowners insurance which protects against loss by fire, tree damage, windstorm etc. Maintaining insurance helps the lender since any loss to the value of the property would be detrimental to the collateral they are receiving. The term PITI was used earlier, principal, interest, taxes and insurance, when referencing the type of payments made by the borrower.

Escrow Clause An escrow clause sets up an escrow agreement between the lender and the borrower to collect money for paying taxes and insurance and lasts for the entire term of the loan. Also included can be homeowner association fees or condo association fees. The key to the escrow agreement and the insurance clause is it is designed to protect the lender’s collateral and debt position. If the house burns down without insurance the lender won’t have a property with the same value that it originally lent money for. If the taxes are not paid, the government can force the sale of the property, and they are in a senior position to mortgage debt.

Acceleration Clause An acceleration clause in a mortgage or deed of trust requires the balance of the loan to become due immediately. This is exercised if regular mortgage payments are not made or for breach of other conditions of the mortgage or deed of trust. The entire principal sum balance is “called in” and becomes due and payable. Examples of this would be not making payments as agreed or the failure to pay property taxes or insurance.

Due-on-Sale Clause This is also referred to as an alienation clause. This clause in a mortgage or trust deed allows the lender to call the loan immediately due and payable in the event the owner sells the property or transfers title or interest to the property. Most loans today contain an alienation clause, which means title cannot transfer and a buyer cannot purchase, subject to an existing loan, without triggering a due-on-sale clause. So if a borrower sells a property, the loan must be paid off at that time. If there is no alienation clause, a buyer may be able to assume the loan or take the loan “subject to.”

Subject to or Assuming a Mortgage or Deed of Trust Assumption is an agreement under which the buyer of a property takes over the seller's liability for payment of installments (on the existing mortgage on the property), usually to save the closing costs or the higher interest rates of a new mortgage. The buyer of the property becomes primarily liable and the original seller of the property remains secondarily liable for payment of the mortgage unless released in writing by the lender.

“Subject to” is a transfer of real estate where the purchaser agrees to take over monthly payments of principal and interest, but does not assume personal liability for the obligation. If the purchaser defaults, the lender must attempt to collect the debt from the original borrower. It should be noted here that the lender could still foreclose on the property. There are benefits to the buyer who purchases a mortgage “subject to.” including no loan costs, quicker closing, no qualification process with the lender, and the ability to purchase with bad credit.

If a property is sold and the purchaser is going to assume the loan, the lender will be asked to provide a signed document known as a Certificate of Reduction, which states the loan balance, the date of maturity and the interest rate on the loan. The Certificate of Reduction ensures the purchaser has all necessary information regarding the loan and its terms. The Certificate of Reduction is requested by the current borrower.

Virtually all mortgages now contain a due-on-sale clause to protect the bank from having another party paying the loan or assuming it.

Hazardous Substances Clause and Preservation and Maintenance Clause Following the theme of all mortgage clauses, the real purpose is protection for the lender. The lender wants to ensure the borrower doesn’t do anything to greatly devalue the property which is security for the loan. Having hazardous substances on the property would result in devaluation as would not taking regular care of the property. Preservation and maintenance requires the borrower to keep the property in more or less the same condition it was when it was purchased.

Subordination Clause A subordination clause allows another loan to have a higher priority, usually first position, than the existing loan. Subordination is the act of yielding priority. Usually the date the lien was recorded establishes priority. A subordination clause will change this priority. This clause is common when purchasing vacant land with the intent of improving the land. Usually the lender for the construction portion will insist on being placed in first position.

Defeasance Clause A defeasance clause in a mortgage or deed of trust provides for the cancellation of the lender’s interest when the debt has been paid in full. The instrument used to do this differs from a mortgage and a deed of trust. In a mortgage, a document called a satisfaction of mortgage is used to release the mortgage. In a deed of trust, the deed of reconveyance is used to release the lien.

Types of Mortgages

Conventional Mortgage Loans Forms of Conventional Mortgages Conventional loans are any loans which are not from or guaranteed by the government. This includes seller financing. The loans can be fixed or adjustable rate mortgages and still be classified as a conventional mortgage. Conventional loans are typically not assumable. A conventional mortgage is granted based on the borrower's credit history, income, and down payment.

Conventional loans come in two types, conforming and nonconforming. What makes a loan conforming is it meets the standards set by the secondary market purchasers Fannie Mae and Freddie Mac. This is a huge contributing factor to Fannie Mae and Freddie Mac’s power in the mortgage market. Conventional loans can have various down payments, all the way to 95% or greater LTV. When a borrower has a 20% or more down payment, the borrower would most likely have negotiated a conventional uninsured loan. Uninsured meaning private mortgage insurance was not needed. A modern creation allows for loans to go over 80%, known as private mortgage insurance.

Private Mortgage Insurance Private mortgage insurance is an insurance product which pays the lender in the event there are losses associated with the loan. The policy premiums are paid by the borrower because their loan to value ratio is below 80%. The greater the risk in the loan because of deficiencies in down payment, credit, and capacity the higher the rate is on the mortgage insurance. Once the borrower has made enough principal payments to reduce the LTV to 80%, the private mortgage insurance can be removed.

Borrowers who need loans that are larger than an 80% LTV sometimes have a second loan to finance the difference between 80% LTV and the amount they can bring in cash. The second loan must take a junior (lower priority) position after the first primary mortgage. It is a way for the buyer to finance some of the downpayment and possible closing costs. The primary lender will require the borrower to be able to handle the financial obligations of both loans to be able to lower the default risk and will also require the second loan to have no prepayment penalty. The reason for no prepayment penalty is the first lender will want to be able to foreclose on the property and sell it without having to deal with a contractual provision that the buyer entered into with the secondary lender.

Adjustable Rate Mortgages Adjustable rate mortgages have payments that fluctuate over the life of the loan due to changes in the interest rate. Lenders find this particularly helpful in managing interest rate risk. Interest rate risk is created by changes in the interest rate over time. If rates rise from 5% to 7%, and the lender made a lot of loans at the 5% rate, it would have a negative impact on the quality of the loans that were made. The loans would be outstanding at 5%, yet if they had the money in hand, they would be able to get a higher yield on the investment for no additional risk. Also, deposits are paid on interest rates that are current, and if rates rise, the interest rate on the money outstanding may become insufficient to cover the prevailing rates paid on deposits.

Government Sponsored Mortgage Programs FHA Insured Loans FHA Loans are insured through the Federal Housing Administration, which is a section of HUD. FHA loans traditionally offer more flexible guidelines when it comes to approving borrowers with somewhat lower credit scores. FHA loans require a portion of the mortgage insurance premium to be paid at the time of closing – this amount is added to the loan amount and amortized over the term of the loan. The balance of the mortgage insurance is paid monthly by the borrower and is always paid based on the loan balance. The insurance is not paid in a lump sum like a title policy, but is paid incrementally along with monthly mortgage payments. Conventional mortgage insurance only covers the lender for part of the losses, while FHA insured loans will protect any lender from all losses. Until recently, FHA loan limits were often too low to make the program feasible in high cost areas, but changes enacted by Congress have raised the loan limits, making FHA loans an attractive option for many buyers – especially those with limited funds for down payment or lower credit scores. FHA loans do allow for non-occupant co-borrowers. FHA loans are assumable by a qualified buyer.

VA Guaranteed Loans VA Loans are guaranteed by the Veterans Administration and are made available to veterans who can show they have met the service requirements necessary to be eligible for the program. VA guaranteed loans are made by private lenders, such as banks, savings and loans, or mortgage companies to veterans for the purchase of a home, which must be for their own personal occupancy. The VA doesn’t put up any money or lend, it instead covers any losses due to default to the lender based on a graduated scale relative to purchase price. If the loan does go to foreclosure, the entire loan balance is not covered.

If the loan is approved, VA will guarantee a portion of it to the lender. Using the VA program, a veteran can finance 100% of the purchase price if the appraisal values the home for the purchase price. VA financed homes are issued a certificate of reasonable value when they are appraised, which is good for six months. If the amount of the certificate of value is less than the purchase price the veteran will need to put a down payment large enough to cover the difference between the sales price and the appraised value. This means the loan-to-value ratio is 100, higher than or matching some of the best loan programs available. If the seller of the home is willing to pay the

buyer’s closing costs, a veteran is may be able to purchase with no cash out of pocket. Underwriting guidelines are established by the VA and generally require the total debt to income ratio (including all recurring debts plus housing expense) to not exceed 41% of the borrower’s gross income. Only the veteran and his or her spouse may be on the loan. Veterans are afforded a specified amount of money which the VA will finance, after which the remaining loan amount above the VA limit wouldn’t be VA guaranteed. VA loans are assumable by another qualified veteran, or if the buyer is not a veteran, the veteran eligibility benefits can remain with the house. Assumption is fraught with complications, needing lender release in some cases, and can carry risk to the seller if they assumption isn’t handled properly.

USDA Programs The mission of the USDA is “To increase economic opportunity and improve the quality of life for all rural Americans.” Their housing program addresses the need for single family homes and multi-family homes as well as health and other community facilities. The USDA offers loans through their Section 52 loans.

Section 52 loans are primarily used to help low-income individuals to purchase homes in rural areas. Funds can be used to build, repair, renovate or relocate a home or to purchase and prepare sites, including providing water and sewage facilities.

Applicants for loans may have an income of up to 115% of the median income for the area. There are income limits for this program. Families must be without adequate housing, but be able to afford the mortgage payments, including taxes and insurance. In addition, applicants must have reasonable credit histories. The loan term is 30 years.

Rural Housing Direct Loan is another loan offered through the USDA, which is directly funded by the government. These loans are available for low and very low income households. Applicants may obtain 100% financing to purchase an existing dwelling, purchase a site and construct a dwelling, or purchase newly constructed dwellings located in rural areas. Mortgage payments are based on the household's adjusted income.

Other Mortgage Types and Uses

Purchase Money Mortgage A purchase money mortgage is a loan given from a seller to a buyer to finance the home. The purchase money mortgage is usually used when a buyer cannot qualify for a loan through traditional mortgage companies.

A purchase-money mortgage might be offered by the seller as an incentive to purchase a property. This can be used in situations where the buyer is assuming the seller’s mortgage, and the difference between the balance on the assumed mortgage and the sales price of the property is made up with seller financing.

A purchase-money mortgage is a note secured by a mortgage or deed of trust given by a buyer, as borrower, to a seller, as lender, as part of the purchase price of the real estate. In any event, the seller should always see that he or she receives enough cash to more than pay the cost of foreclosing the mortgage and to more than cover any depreciation in the property, accrued interest and unpaid taxes.

Wraparound Mortgages Wraparound mortgages are a form of seller financing where the seller will take a junior (secondary) debt position after a primary (first position) loan is in place, such as a bank mortgage. The wraparound mortgage is in addition to the first loan which has the first rights of repayment. Wraparound is key in the definition, since the seller takes a note from the borrower which is for the amount of any existing debts as well as any additional amount the seller is providing. The borrower will then make all payments to the seller, who will then pay any superior loans. This is done when the seller maintains the loan on the property. A due on sale clause can prevent a wraparound mortgage because transferring title with the due on sale clause in place requires the mortgage to be paid off prior to transfer.

Installment Contracts An installment contract is an agreement between a buyer and seller of property in which the buyer makes payments toward full ownership (as with a mortgage). However, in an installment contract, the title or deed is held by the owner until the full payment is made. As in a standard mortgage, there is an agreed upon price and payment schedule, but the payments are often not amortized evenly, so that a large balloon payment may be required to complete the purchase. This is also known as an installment purchase contract, installment sale agreement or land contract.

Land contracts were used quite a lot in the early 80s when rates rose above the usury rate. It was a way for buyers and sellers to come to an agreement to sell a property

under interest rates that were lower than offered by banks at the time. There are risks with all loans, but special care should be taken with land contracts (installment contract) since they involve individuals rather than large institutions experienced in writing and enforcing lending contracts.

Sale and Leaseback In a sale and leaseback situation, an owner sells a property, then immediately leases it back from the new owner. This arrangement allows the original owner to have full use of the property, while their capital is not being tied up. This capital may be used for other activities, which may have more advantages.

Example: The Dhenrider Company wants to expand its research and development in the area of heating and HVAC energy efficiency for “green” buildings. Their hopes are to have the first truly efficient product on the market and to be a leader in this technology. The company is short on capital and without additional funds cannot continue their research and development. They sell their building and land to an investor, who leases the building back to the company. The company is now a tenant and has freed up a great deal of capital for research. The company also has had the advantage of not disrupting business activities, since they did not need to move their facility.

Package Mortgage A package mortgage is a loan for the purchase of the home including personal property, such as furniture and appliances. This allows the homeowner to spread out the cost of the items for the life of the loan rather than paying for them in cash up front. It’s also cheaper since the interest rates on package mortgages are typically lower than can be found for personal loans.

Home Equity Loan A home equity loan is a loan based on the value of the owner’s equity (home value - loan amount) in a home. Typically home equity loans have a fixed interest rate that is given in a lump sum and then paid off monthly over time like a mortgage. The limits on the home equity loan are based on the amount of equity in the home and the loan to value that the lender will allow.

Example: If a lender allows a maximum LTV of 80% after granting the loan, a borrower who has $250,000 equity in a house that is worth $600,000 would be able to borrow how much?

As with all of real estate math problems, it’s important to identify the information you have, what information you’re able to get from it, and the final goal. What information do we have?

We know: Maximum LTV: 80% Value of the home: $600,000 Current equity: $250,000

Option 1: Information we can determine based on what we know:

1. With maximum LTV and home value we can determine the maximum debt the bank will allow.

2. Home value and current equity will allow us to find out the current debt on the property.

Final goal, total amount that can be borrowed: The current total debt less the maximum debt the bank will allow will give us the amount that can be borrowed.

Step 1: Maximum total debt = .80 x $600,000 Maximum total debt = $480,000 Step 2: Current debt = $600,000 - $250,000 Current debt = $350,000 Step 3: Amount available to borrow = $480,000 - $350,000 Amount available to borrow = $130,000

Option 2: Information can we determine from what we know:

1. LTV is the lender’s contribution amount, if we take the remainder, 20% we know that is the maximum debt percentage the borrower can have.

2. With the borrower’s debt percentage and home value, we can determine the minimum amount of equity the homeowner can have.

Final goal, total amount that can be borrowed: The current equity in the property less the minimum amount of equity the bank will allow will give us the amount that can be borrowed.

Step 1: Borrower’s maximum debt percentage = 1 - .80

Borrower’s maximum debt percentage = .20 Step 2: Borrower’s minimum equity amount = $600,000 x .20 Borrower’s minimum equity amount = $120,000 Step 3: Amount available to borrow = $250,000 - $120,000 Amount available to borrow = $130,000

There’s more than one way to determine some answers. It’s important to recognize your options with the information you have and decide how it can assist you in reaching your end goal.

Home Equity Line of Credit A home equity line of credit is a loan that can be drawn on based on the equity in a house. The line of credit is a set amount that can be drawn from much like a credit card. Home equity lines of credit are also referred to as open-end mortgages because they can be drawn on multiple times, whereas home equity loans are a type of closed mortgage since the loan is made in one lump sum. When you take money from the line of credit and then pay it off, meaning no money from the line of credit is being used, you will still have the loan amount available to use much like your credit card credit limit. The loan typically has a variable interest rate and will fluctuate based on the market rates. When the loan term is up, all outstanding balances must be paid off.

Reverse Mortgage A reverse mortgage is a loan based on the equity the borrower has in the home, where the borrower receives monthly payments from the lender rather than a lump sum. Also called reverse annuity mortgages, borrowers must be 62 or older. The mortgage is paid off when the owner passes away or sells the property. Reverse mortgages are helpful because the give access to equity in the home that may be needed for health, or just general expenses, while providing income in a form that matches the monthly time frame of most expenses.

Blanket Mortgage A blanket mortgage is a single mortgage that covers more than one parcel of real estate, a mortgage that is secured by several structures or numerous parcels. A blanket mortgage is often used to finance proposed subdivisions, cooperatives or development projects.

This type of loan, a blanket mortgage, allows a developer to sell properties individually after completing a development. The blanket mortgages are typically taken out to cover the costs of purchasing and developing land that developers plan to subdivide into individual lots.

Graduated Payment Mortgage A type of fixed rate mortgage in which the payment increases gradually from an initial low base level to a desired, final level. Payments increase in steps each year until the installments are sufficient to amortize the loan.

In a graduated payment mortgage, only the low initial rate is used to qualify the buyer, which allows many people who might not otherwise qualify for a mortgage to own a home. This type of mortgage payment system may be optimal for young homeowners as their income levels gradually rise to meet higher mortgage payments. Graduated payment mortgages are a form of negative amortization since the loan payments in the early part of the loan are insufficient to cover the interest charges and therefore the loan balance increases.

Construction Loans A construction loan is an interim loan covering construction and development costs, secured by a mortgage on the property financed. Funds are advanced at specific stages of construction, in so-called progress payments, with a portion held until completion of the project. For example, a certain percentage of a building has been leased, or other criteria have been met. Construction loans which give money to the builder at defined increments (draws), are commonly referred to as open-end mortgages, like some home equity loans. Construction financing is paid off from the proceeds of a permanent mortgage by an institutional lender, for example, a life insurance company or pension fund or bank. Open-end mortgages also allow the borrower the ability to pay off the loan at any time without penalty. Open mortgages are very similar because they also allow the borrower to pay off the loan before the end of the loan term, however, they do not allow multiple draws on the loan amount and instead it comes in a lump sum.

Some lenders have made construction loans on speculation. Many of these construction loans financing speculative real estate developments have, as a result, become long-term permanent mortgages on the books of the original lender.

Construction loans are often variable rate loans with interest rates charged based on a spread above the prime rate (index). The contractor and the lender set a schedule for

the contractor to get money, based on construction progress. Loan charges are based upon the loan amount outstanding not the total amount which will be loaned.

Option ARM An option ARM is an adjustable rate mortgage that allows the borrower to choose the payment they want to make to the lender. The loan payment options include a minimum payment (insufficient to cover all interest), an interest only payment, a 30 year fully amortizing payment, or a 15 year fully amortizing payment. Ideally, it gives the borrower options so they can choose the payment based on their financial ability. However, these loans caused a lot of problems when housing prices dropped, since the minimum payment option is a negative amortization option.

Personal Lines of Credit Personal lines of credit allow a borrower to access funds using a checkbook or ATM. After the credit limit is established, there are no additional fees associated with accessing the account. Often times, these lines of credit bear a lower interest rate than credit cards and some banks base the monthly payments on the actual amount that you use. Personal lines of credit are unsecured debt which don’t use real property to secure the debt like a home equity line of credit.

The Borrower’s Mortgage Loan Decisions Borrower’s face a large set of options when choosing a mortgage. There are level payment loans (fixed rate mortgages), variable rate mortgages (ARM loans), interest only loans (balloon payment mortgages), term length, amortization schedules, prepayment penalties, down payment, discount points, origination points, and of course interest rate. That’s a lot to consider for a borrower, so the borrower will need to prioritize. The two main factors borrower’s usually consider are monthly payment amount and initial costs such as down payment, buydown (discount points), and closing costs (origination fees).

Monthly Payment For determining a monthly payment, there are a few factors to consider relating to interest rates. The largest determining factor is monthly payments, once down payment and loan size are calculated.

Economic Outlook Figuring out the length of time the borrower plans to remain in the home will help because if the borrower is planning on being in the home for 30 years, that will mean something different as opposed to 7 years. ARM loans have low initial rates for the first 3 to 5 years and that could be an opportunity to take advantage of the low fixed rates at the beginning of the loan. Fixed mortgages usually carry a higher interest rate because the lender is exposing themselves to interest rate risk over a long period of time. Adjustable rate mortgages are lower in rates because they have the opportunity to change based on the index and maintaining a margin for the lender.

Mortgages are published with an APR attached to them, which means Annual Percentage Rate or more simply, rate on the mortgage including all costs. This matters when discussing how long a borrower will own the home. APR is skewed to favor high fee low interest rate mortgages because the APR puts the fees in the cost of the loan but assumes the mortgage is kept for the entire term. If the fees are spread out over the entire loan term as opposed to the typical loan timeline of 7 years or less, then the APR would rise since the fees would be absorbed regardless of how long the mortgage was kept.

If the borrower is looking at receiving a boost in income over the next few years, but finds current payments tight, an ARM loan may be perfect because it allows the borrower to have low initial rate and then be able to absorb any potential rate increases due to the prospective improvement of their income. On the opposite end of that same spectrum, if the borrower is going to be retiring soon, they may want the predictability of a fixed mortgage.

Projected growth rates for property values is important because if the borrower perceives an uptick in growth and therefore value in the home, the increase could greatly change their equity position. If equity in the home climbs quickly enough, it will allow the borrower to refinance at more favorable rates. The borrower could potentially get a home equity loan, so the need for cash would be lower if they have that option of tapping equity value.

Initial Costs If a borrower has the funds to put into the home, it’s leads to a choice of how much to put down. The answer will usually be determined by figuring out the alternatives they have for the money. If there are alternatives which are more beneficial in terms of earning income, then it can make sense to go with a lower down payment. However, choosing a lower down payment increases the risk to the lender and will result in higher

rates and possibly mortgage insurance requirements depending on how little money is put down. Also, the larger down payment will lower the monthly payments since the loan amount will be less and the higher down payment loans are often given more favorable interest rates. Mortgages with low down payments increase the risk to the lender and are usually connected with higher overall costs.

Default / Foreclosure

Lenders protect themselves as much as possible through the underwriting process, the promissory note, and the mortgage. Even with careful underwriting processes, loan default does happen. Mortgage default is certainly not something a borrower would like to go through either, because it destroys credit and they lose a house or business.

Default When a borrower doesn’t meet the obligations set forth in the promissory note, they are in default. This doesn’t necessarily mean they have missed principal and interest payments. A borrower can be in default if they are not maintaining insurance as provided in the note. If the borrower is not paying the mortgage interest and principal, usually for longer than 60-90 days, the lender will send official notice to the borrower of default and begin the proceedings to foreclose. Before the 60-90 day mark, the borrower will be assessed late fees after the initial payment grace period has passed. After 10 days or so if the payment still hasn’t been made, the lender can elect to notify the credit agencies of default. Approximately 45 days after default, the lender will likely pass it on to a collection agency.

Given the number of steps prior to official foreclosure action as well as late fees and collection costs incurred by the lender, the amount owed will simply increase as time goes on. It is always best to deal with default early and speak with the lender and collection agencies, to help stave off further losses for the borrower and also harm to their credit. Lenders prefer to have payments rather than homes and will sometimes work out payment plans. Following the financial crisis in 2008-2009, the state of Washington passed laws to specify the procedures lenders must use when borrowers are in default. They include notification requirements, as well as timelines that must be adhered to in order to protect borrowers.

Foreclosure

Once a default has reached a point where the lender needs to exercise their rights set forth in the security instrument (mortgage or deed of trust), the next step is foreclosure. Foreclosure is the process of forcing the sale of property, the collateral for the loan, in order to recover the money they are owed. The borrower pledged the asset to the lender as security for the loan, and now the lender’s route to recovering the funds is the sale of the asset. Foreclosure clears all ownership interests that are junior to the party foreclosing, as well as the borrower. This means it is important that all junior liens are notified of the action by the senior lienholder. Junior liens can initiate a foreclosure action but do not take priority in debt recovery, but subordinate to taxes and senior first mortgages.

Loans are foreclosed through two routes, judicial foreclosure (typically a mortgage) and nonjudicial foreclosure (typically a deed of trust). Judicial foreclosure is foreclosure through the court system. The lender files suit to force the sale of the property to recover the debt. This option is available in all states, but not used in all states.

Washington state has a right of redemption when a property is foreclosed under a judicial proceeding. The right of redemption period is 8 months allowing the borrower to redeem (regain possession), if all costs related to the foreclosure, debts, and fees are paid. The period is 8 months provided the lender did not seek a deficiency judgment. A deficiency judgment is a judgment against the borrower for the difference between the amount owed and the proceeds from the sale of the property. If a deficiency judgement is sought and granted to the lienholder (lender), the right of redemption period extends to 1 year.

The court will issue a final judgement in granting the property to the lender, which sends the property to auction via a sheriff’s sale. A sheriff’s sale is a public auction to sell property based on the orders of the court. The highest bidder wins, and is given a certificate of sale, which isn’t the deed to the property because of the redemption period granted to the borrower. After the redemption period has expired, then a deed is issued to the winning bidder. The lender is allowed to bid in order to protect what they view as value in the property so they can be given the property and sell it outside of an auction.

Non-judicial foreclosure is most common in Washington state because of the rights given to the lender. Non-judicial foreclosure is accomplished through the outlined process in a deed of trust outside the court system. A deed of trust allows the trustee to sell the property in order to satisfy unpaid debt, because the deed includes a power of sale clause. A trustee’s sale is quicker than a judicial foreclosure and also less

expensive. While it is faster for the lender to recover funds through the sale of the asset, there are still protections for the borrower to allow them time to pay off the debts owed and avoid losing the property. Also, there are required notification periods which won’t allow the property to be sold until the notification requirements are met.

The first step in a nonjudicial foreclosure in Washington is the Notice of Pre-Foreclosure Options, which states what you would imagine, the borrower’s options to avoid foreclosure. The options afforded the borrower can include requesting a loan modification or possibly forfeiture of the property in order to satisfy the debts, known as a deed in lieu of foreclosure.

After 30 days following the initial attempts or contact from the lender regarding pre-foreclosure options, a Notice of Default is given. The notice of default may include information about the same options in the pre-foreclosure notice, but will also include information about the eligibility for a Washington program called the Foreclosure Fairness Mediation. The department of commerce states, “The Act requires lenders to notify homeowners, prior to initiating foreclosure, of the availability of foreclosure counseling and the potential for mediation, and to participate in mediation with homeowners who have been referred to the Mediation Program.” The purpose of the program is the assist borrowers in avoiding foreclosure whenever possible. Washington Revised Codes of Washington (RCW) contain specifics of what is required to be stated in the notice as well as the initial contact with the borrower and the notice of trustee’s sale.

If the borrower doesn’t exercise their rights to enter the mediation process, or no agreement is reached, the trustee will file a Notice of Trustee’s Sale. The notice makes the foreclosure a public record and the trustee notifies all other lienholders. The notice of trustee’s sale must be given at least 90 days prior to sale and can be possibly longer if required by Washington statute. The sale through a trustee is different than a judicial foreclosure because it is final and doesn’t allow for the borrower to exercise a right of redemption. On the other hand, the lender cannot seek a deficiency judgement under a trustee’s sale if the sale proceeds do not fully satisfy the debt.

Nonforeclosure Responses to Default Loan Modification A loan modification is a plan that the borrower makes promising to pay reduced payments or get a plan in place where they can pay back missed payments over time.

It’s often cheaper for the lender and the borrower. The lender doesn’t have to go through the trouble of foreclosure and the borrower doesn’t have to have a foreclosure and further missed payments on their credit report. This is also called a loan workout or mortgage modification.

Deed in Lieu of Foreclosure A deed in lieu of foreclosure grants the title to the lender to satisfy the debt. However, the lender doesn’t necessarily forfeit the right to seek a deficiency judgment, so language stating the lender is foregoing that option will be necessary. The lender assumes the title to the property including all existing liens. A lender will make sure to have a complete title search done on the property so they are aware of what debts may come with the property. The advantage is any protracted foreclosure proceedings and the public will not see the lender foreclosing on the property which can aid in public relations. The deed in lieu of foreclosure does not save the borrower’s credit.

Short Sales A short sale is when the amount owed is greater than what the property can be sold for in the current market. You might often hear the term “upside down” used to describe this situation. Sometimes the lender will negotiate and take less for the loan than is owed. As a real estate professional, you will want to be sure that you know if a sale will be a short sale. Being the professional you need to know the “short sale” process for a buyer is prolonged when compared to a typical purchase.

The benefit to lenders is that a short sale often carries less loss than conducting a foreclosure action, putting the home up for auction and (if there are insufficient bids) paying a broker to market and sell the property. If it is a short sale, or the possibility of one, you will want to specify in both the listing and the purchase and sale agreement that the listing is “subject to all underlying lien holder approval.” Let’s look at an example of the importance of specifying “subject to all lien holder approval.”

Example: Matt, who is the listing broker for the Browns, knows that the Browns’ property will be a short sale. He forgets to put this in the listing.

Mary, who is a buyer’s broker, brings a full price, non-contingent offer to the seller. The Browns attempt to get approval from their lender for a short sale, since they owe $350,000 and the list price and offer are for $299,000. Their lender refuses to take less than they owe, so they cannot sell to Mary’s clients. Mary sues for a commission from the Browns, since she brought the Browns a ready, willing and able buyer.

In a short sale transaction there are usually at least three parties, the sellers, buyers and the lending institution(s) that may approve of the short sale.

The real estate licensee has a statutory responsibility to their client which is the seller, not the bank(s). This relationship has all of the duties and responsibilities required for any client.

While the bank is not the licensee’s client, the licensee, by law, has the duty to deal fairly and honestly with all parties in a transaction, just as with all transactions. A licensee must not be involved in any practice which is deceptive to any lender(s).

When a Lender Approves of a Short Sale they may set conditions to the sale including:

1. The seller cannot receive any proceeds from the sale including a sales

commission, a negotiator’s fee, or any sum that is not disclosed to the lender. 2. The sale isn’t being “flipped” to another buyer. In this instance a broker may

discover the price the lender is willing to accept is below the market value of the property and will sign a deal for the lower amount while simultaneously looking for another buyer who will pay the true market value. Once a buyer is found the broker will arrange for a closing to take place at the same time and make money on the difference between the amount the lender takes and the sales price to the new buyer who is paying market value. It is important that brokers disclose all terms of the transaction. It could be considered a violation of Washington State law to mislead a lender, permit a party to make a false statement to a lender, or misrepresent or conceal any offers from the lender.

3. The property is listed for sale at a fair price. Properties listed which are a short sale can’t be listed for more or less than fair market value because at high prices it will discourage buyers or low to compel the lender to believe the value of the property is lower than it is. This falls under a broker’s duty to deal honestly and in good faith with all parties to a transaction. In addition, a broker may not knowingly commit, or be a party to, any material fraud, misrepresentation, trick, or scheme, whereby any other person lawfully relies upon the word, representation or conduct of the broker. Brokers who deceive lenders are breaching their duties.

Under Washington law, only a few qualified types of people can negotiate a short sale. They are loan originators, attorneys and real estate brokers. Loan originators need to be licensed under the Mortgage Broker Practices Act (MBPA) or Consumer Loan Act (CLA). Real estate licensees can negotiate a short sale when conducted as part of a

real estate transaction by a licensed real estate broker and the broker is not receiving money for their work as a short sale negotiator. The broker must be licensed under the CLA or the MBPA, if the real estate broker is paid separately for the short sale negotiation. This does not extend to unlicensed assistants. Real estate attorneys are free to negotiate short sales with no additional licensing.

Reasons for Short Sales A short sale can occur for many reasons, let’s look at some examples.

A Decline of the Market Value of a Property

Example: The Jollys bought their home in 2007 for $600,000, putting down 5% for a down payment and the seller paying all the closing costs. In 2009, they want to sell their home, but their home has decreased 12% in value from when they purchased it in 2007. The Jollys owe $579,000 (what they paid minus their down and 2 years of mortgage payments), yet the value of their home is only $528,000. If the Jollys were to sell right away, it would be a short sale.

Negative Amortization on a Loan

Example: Mr. and Mrs. Brown were not aware that the loan that they had on their home was a negative amortization loan. The payments that the Browns were making were not enough to cover the interest being charged on the loan. In turn, the principal on the balance grew each month. Prices in the housing market had been stable, so while the value of their home remained the same, the loan balance increased. This would make for a short sale if the Browns had to sell immediately.

Refinance of Greater than 100% of the Market Value

Example: Housing prices had been rising at a staggering 17% per year over the past few years. The Andersons decided to refinance and pull all of their equity out of their residence so that they could purchase a vacation home. The lender allowed them to refinance 125% of the appraised value of the home since the market was so great and prices were rising so rapidly. Shortly after they refinanced, there was a sharp decline in market values, which left the Andersons “upside down” with their mortgage.

Lack of Time to Absorb Closing Costs

Example: The Smiths bought their home in January. They paid 3% in closing costs. Because of health reasons, they want to sell in April of the same year. Their closing costs to sell will be approximately 3% plus a real estate commission of 5.5%, for a total

of about 8.5% in selling fees. Their home appreciated in value at about 6% a year (½% per month). They owned the home for 4 months. ½% x 4 = 2% appreciation, which does not cover their closing costs.

Attached Judgement to be Satisfied

Example: The Millers purchased their home for $300,000. A few months later, they were in an auto accident and had no auto insurance.

The other party in the accident was awarded a judgment against the Millers for $180,000, which attached to their property. The market had been stable and the value of the Miller's’ home was still at $300,000, but in addition to the $270,000 (the balance remaining on the Millers’ loan), they also owed $180,000 on the judgment that was attached to the property. It would be a short sale if the Millers decided to sell right way.

Short sales are very complex and require specific knowledge regarding the process. As a broker, you should remember to not act outside of your area of expertise.

Lender’s are not in the business to do anything but make money, so any concession they make to avoid foreclosure has to have a dollars and cents reason for them to do so. Keep in mind emotional reasons, while very real and difficult, are not going to sway a lender to allow one of the non-foreclosure options.

Regulation

Equal Credit Opportunity Act The Equal Credit Opportunity Act (ECOA) ensures that all consumers are given an equal chance to obtain credit. Consumers who apply for credit will still have to qualify with considerations such as income, expenses, debt and credit history. It prohibits lenders from discriminating due to a person’s sex, marital status, age, race, national origin or even if the person received public assistance.

Financing Legislation Predatory Lending If a borrower gets involved in a transaction that isn’t what they expected, then the loan process has become predatory. Many people can commit predatory lending including lenders, real estate brokers, mortgage brokers, contractors and attorneys. The products that are sold to people who are the victim of predatory lending are not inherently bad

products, but are predatory if they are giving them out disguised as something else. Here are common predatory lending practices cited by the Washington state Department of Financial Institutions:

● Equity Stripping - The lender makes a loan based upon the equity in the

borrower's home, whether or not they can make the payments. If they cannot make payments, they could lose the home through foreclosure.

● Bait-and-Switch Schemes - The lender may promise one type of loan or interest rate but without good reason, give the borrower a different one. Sometimes a higher (and unaffordable) interest rate doesn't kick in until months after the borrower has begun to pay on the loan.

● Loan Flipping - A lender refinances a loan with a new long-term, high cost loan. Each time the lender "flips" the existing loan, the borrower must pay points and assorted fees.

● Packing - A borrower receives a loan that contains charges for services they did not request or need. "Packing" most often involves making the borrower believe that credit insurance must be purchased and financed into the loan in order to qualify.

● Hidden Balloon Payments - The borrower believes they have applied for a low rate loan requiring low monthly payments only to learn at closing that it is a short-term loan that will have to be refinanced within a few years.

Uniform Commercial Code The Uniform Commercial Code (UCC) Program operates under a Washington State law governing commercial transactions. UCC offices support commerce by giving lenders a central place for notices regarding personal property pledged as collateral for loans. In the event the debtor declares bankruptcy, a filing with UCC legally establishes the lender as a preferred creditor in relation to other lenders who file against the same collateral.

The UCC Program files UCC financing statements, agricultural liens and various federal liens. The office also provides certified searches of its records. The UCC doesn’t however guarantee the accuracy of the filings by creditors as to whether they have a legal right, there is collateral involved, or that the records are correct. It’s not free to access the UCC records, and helps covers costs of the program.

Truth In Lending Act (Regulation Z) The Truth in Lending Act (TILA) is a law designed to protect the public as it relates to consumer credit. The main purpose of TILA is to make clear all of the costs and fees associated with loans in a standardized format and with required disclosures. Consumer loans are for personal, family or household use. Essentially, transparency in lending is what it’s all about.

In general, the regulation applies to businesses or individuals who extend, or offer to extend, credit as follows:

● When the credit is offered or extended to consumers. ● When the credit is subject to a finance charge or is payable by a written

agreement in more than four installments. ● When the credit is primarily for personal, family or household purposes. ● When the loan balance is under $54,600.00 or is secured by an interest in real

property. By requiring a standardized format, it makes it more difficult for lending institutions to hide fees and costs associated with loans. In addition, comparing one loan to another becomes simpler by making the disclosures the same.

The law requires the interest rate cap (maximum rate) to be clearly stated for ARM loans. It also imposes some limits on home equity loans and establishes sets rate caps that can be charged during the term of the loan.

The right of rescission in certain real estate lending transactions is regulated by Regulation Z, are portion of the TILA law. In real estate transactions, Regulation Z and TILA provide the guidelines for the following:

1. Right of Rescission 2. Advertising Disclosure Requirements 3. Disclosure Requirements for ARM Loans 4. Early and Final Regulation Z Disclosure Requirements

Right of Rescission The right of rescission is granted to borrowers who are pledging their primary residence as collateral for the loan. The right of rescission is available for 3 days after the borrower signs the loan paperwork, delivery of the notice of right to rescind or delivery of all material disclosures, whichever occurs last. When more than one consumer in a

transaction has the right to rescind, the exercise of the right by one consumer shall be effective for all consumers. Rescission rights can last up to 3 years if the lender fails to provide necessary disclosures and paperwork. Rights of rescission are designed for refinancing loans and home equity loans, since the right doesn’t extend to purchases.

Lenders are required to deliver two copies of the notice of the right to rescind and one copy of the disclosure statement to each consumer entitled to rescind. The notice must be on a separate document that identifies the rescission period on the transaction and must clearly display the retention or acquisition of a security interest in the borrower’s primary residence, the borrower’s right to rescind the transaction and how the borrower may exercise the right to rescind with a form for that purpose.

The consumer may modify or waive the right to rescind if the consumer determines that the extension of credit is needed to meet a personal financial emergency. To modify or waive the right, the consumer must give the lender a dated written statement that describes the emergency, specifically modifies or waives the right to rescind and bears the signature of all of the consumers entitled to rescind.

Advertising Disclosure Requirements If a lender advertises directly to a consumer, TILA requires the advertisement to disclose the credit terms and interest rate. If an advertisement states specific credit terms, it may state only those terms that actually are offered by the lender. If an advertisement shows the rate of interest, it has to be as an annual percentage rate (APR) using that term. If the annual percentage rate is increased after consummation, the advertisement must state that fact. The advertisement may not state any other rate, except a simple annual rate or periodic rate that is applied to an unpaid balance. This may be stated in conjunction with, but can’t stand out more than the annual percentage rate.

Disclosure Requirements for ARM Loans If the annual percentage rate on a loan secured by the consumer’s principal dwelling is subject to potential increases after consummation, and the term of the loan exceeds one year, TILA requires additional adjustable rate mortgage disclosures to be provided, including:

● A loan program disclosure for each variable rate program in which the consumer

expresses an interest. The loan program disclosure shall contain the necessary information as prescribed by Regulation Z.

● The booklet titled Consumer Handbook on Adjustable Rate Mortgages, published by The Federal Reserve Board or a suitable substitute.

TILA requires loan servicers to provide subsequent disclosure to consumers on variable rate transactions in each month an interest rate adjustment takes place.

Early and Final Regulation Z Disclosure Requirements TILA requires lenders to make certain disclosures on loans subject to the Real Estate Settlement Procedures Act (RESPA) within three business days after their receipt of a written application. This early disclosure statement is partially based on the initial information provided by the consumer. A final disclosure statement is provided at the time of loan closing. The disclosure is required to be in a specific format and include the following information:

1. Name and address of creditor 2. Amount financed 3. Itemization of amount financed (optional, if good faith estimate is provided) 4. Finance charge 5. Annual percentage rate (APR) 6. Variable rate information 7. Payment schedule 8. Total of payments 9. Demand feature 10. Total sales price 11. Prepayment policy 12. Late payment policy 13. Security interest 14. Insurance requirements 15. Certain security interest charges 16. Contract reference 17. Assumption policy 18. Required deposit information

Real Estate Settlement and Procedures Act (RESPA) The Real Estate Settlement and Procedures Act (RESPA) was first passed in 1974 and was established to protect consumers during residential real estate financing transactions. Its main purpose is to inform homebuyers as to the estimated and actual costs of settlement services (the fees and services involved in completing the lending transaction) and to eliminate unscrupulous practices that can increase the cost of

settlement services, including kickbacks and referral fees for services provided by the affiliated companies. RESPA is administered by the Consumer Financial Bureau. RESPA regulates the settlement procedures in federally related loans, and first and second liens for the purchase or refinancing of one-to-four family dwellings. A contract for deed is also known as a land contract or seller financing. RESPA does not cover loans that are seller financed.

RESPA Disclosures The Real Estate Settlement Procedures Act (RESPA) requires lenders to provide home buyers with additional disclosures to inform them about the types of services that will be provided as part of the transaction and the costs involved with those services. Disclosures detail such things as settlement cost, lender servicing, escrow practices and business relationships between different settlement providers.

The initial disclosures are as follows:

1. The Good Faith Estimate along with the “Buying Your Home – Settlement Costs

and Helpful Information Booklet” (HUD) 2. ARM Disclosure 3. Servicing Transfer Disclosure 4. Initial Escrow Account Statement 5. Affiliated Business Arrangement Disclosure

These initial disclosures must be given to the homebuyer within three business days of the application for a loan.

The Good Faith Estimate The good faith estimate provides an estimate of the settlement costs and names of all required service providers. These estimates include all prepaid and escrow items as well as lender charges.

Certain fees listed on a good faith estimate are used to calculate the annual percentage rate (APR). These fees are added with the regular interest payments to come up with a total cost. This total is then converted to a percentage (APR) and is considered to be the true cost of borrowing money to purchase or refinance a home.

Along with the good faith estimate, the lender must also supply a booklet published by the Department of Housing and Urban Development, called the “Buying Your Home – Settlement Costs and Helpful Information Booklet.” This booklet explains all of the costs

indicated on the good faith estimate and gives the borrower a clear understanding of all the costs they will incur.

At the closing of the loan, a final settlement statement will be given to the borrower that lists the actual costs of each charge. This is called the uniform settlement statement or HUD 1.

0MB ApprovalNo. 2502..0265

Purpose

Shoppingfor your loan

Important dates

Summary of your loan

This GFE gives you an estimate of your settlement charges and loan terms if youare approved for this loan.Formore informat on, see HUD's Special Information Booklet on settlement ctlarges,your Truth•in..Lending Disclosures. and other consumer informat on at www.hud.gov/ espa.Ifyou decide youwould like to proceed with this loan, contact us.

Only youcanshop for the best oan for you.Compare this GFE withother roanoffers, so you can find the best loan.Use the shopping chart on page 3 to com pa re all the offers you receive.

1.The interest rate for this GFE tS available through .After this time,the interest rate, some of yourloan Orgiinat on Charges,and the monthly payment sho\!VY"I below can change unt lyou lock your interest rate.

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4. You must lock the interest rate at east days before settlement.

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Escrow account information

Summary of your settlement charges

Some lenders require an escrow account to hold funds for pay ng propeay taxes or otherproperty- re ated chargesin additionto your monthly amount owed of sI I. Do we requireyou to have an esaow account for your Joan? 0 No,you do not have an escrow account.You must pay these charges directly 'Nhen due. D Yes, you have an escrow account. It may or may not coverall of these charges.Ask us.

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ARM Disclosure Whenever a borrower applies for or inquires about an adjustable rate mortgage, RESPA requires a separate disclosure be given along with the Consumer Handbook on Adjustable Rate Mortgages. The adjustable rate program disclosure provides detailed information about an adjustable rate mortgage, including the terms of a sample loan and historical examples.

Servicing Transfer Disclosure This disclosure statement explains that the lender may transfer servicing of the loan to another lender. The statement must be presented to the borrower(s) at application or within three business days of application.

Initial Escrow Account Statement RESPA requires that an initial escrow account statement be prepared for all loans that have an escrow account (i.e., an account used for property taxes and hazard insurance). This statement itemizes escrow expenses for the first 12 months of the loan and is presented to the borrower at closing.

Affiliated Business Disclosure An Affiliated Business Arrangement Disclosure is required for all transactions where RESPA applies. Any settlement service provider who gives a referral and has an ownership or other beneficial arrangement with the referred provider must disclose the relationship.

Whoever gives the referral is also responsible to make the disclosure before or when the referral is made. The disclosure has to notify the consumer and describe the relationship between the parties as well as estimate the costs using the services of the referred party. Lenders are exempt from this disclosure in certain cases involving persons representing the lender’s interest, such as referring a borrower to an attorney, credit reporting agency, or appraiser.

Federal Flood Insurance Programs Congress created the National Flood Insurance Program (NFIP) in 1968 to help financially protect people from loss during floods. The NFIP offers flood insurance to homeowners, renters, and business owners if their community participates in the NFIP. Participating communities agree to adopt and enforce ordinances that meet or exceed Federal Emergency Management Agency (FEMA) requirements to reduce the risk of flooding. The key component is the NFIP is protecting against loss by requiring higher

flood protection standards. The NFIP program is administered by FEMA, which works with private insurance companies to offer flood insurance.

Profit from Selling Real Estate When real estate increases in value and later sold, the profit is known as a capital gain. A capital gain is the difference between the cost to acquire the asset, also known as the basis, and the sales price of the asset less some allowed costs. The government taxes capital gains (profit from asset value increases) at two different rates depending on the length of time the asset was owned and what it was used for. Capital gains come in two forms, short-term (one year or less) and long-term (more than one year). The tax rate for long-term capital gains is lower than the short-term rate.

The basis (cost basis) for capital gains purposes is the purchase price plus the settlement and closing costs. This includes taxes (e.g. sales tax, excise tax, or real estate tax) and any fees paid (e.g. real estate brokerage fees, legal fees, recording fees, accounting, transfer fees, or installation fees). Depreciation must be factored in to reach the adjusted basis, which the IRS uses as the cost number for the property. For example:

Sales price less costs: $1,100,000 Original purchase price less costs: $895,000 Depreciation total: $75,000 Adjusted basis: $820,000 Capital gain: $280,000

As shown in the above example, the depreciation is factored into the basis of the property for the purpose of calculating the capital gain. The example is based on an investment property. Personal homes are not often depreciated because of rules prohibiting it except in certain cases and even when allowed the depreciation amount is taxed differently by the IRS.

There are exemptions for paying capital gains for homeowners selling their principal residence. Current exemptions are for $250,000 for individuals and $500,000 for married persons selling their principal residence. Any depreciation on a principal residence is not eligible for the exemption.

In the unhappy situation of a capital loss when selling real estate, it can be used to offset gains and lower the tax owed to the government. Tax losses have limitations on the amount that can be deducted in a given year, however, the money which was unable to be claimed might be able to be applied in the future. Always consult tax professionals and advise your clients to do the same.

Gains and losses are sometimes taxable at a later date then when they happen. This is the difference between a recognized gain and a realized gain. A recognized gain or loss is when it actually applies to taxes. A realized gain or loss is when the party actually gains or loses money. In most cases the timing is the same. However, sometimes this isn’t true. As an example, with a tax deferred exchange, a property owner may have a realized gain or loss when they exchange a property for another, but will not recognize the gain or loss for tax purposes until the new property is sold.

Tax on Involuntary Conversions An involuntary conversion occurs when property is destroyed, stolen, condemned, or disposed of under the threat of condemnation and the owner receives other property or money in payment, such as insurance or a condemnation award. Involuntary conversions are also called involuntary exchanges.

Since the involuntary conversion will likely result in a gain or loss on the property which was destroyed, stolen, condemned etc. the IRS allows the deferment of the tax owed or lost if the money is used to either construct or purchase a replacement property. Any money not used to replace the property is taxable if it is a gain and needs to be paid in the year it was realized. Let’s look at an example.

Example: Suppose you bought a house on the lake for your personal use at a cost of $480,000. You made no improvements or additions to it. When a storm destroyed the house this January, the cabin was worth $1,250,000. In March, the insurance company paid you $830,000. You had a gain of $350,000 ($830,000 − $480,000).

After choosing to rebuild the home, the construction cost was $800,000. Since this is less than the insurance proceeds, you would need to include $30,000 ($830,000 − $800,000) in your income. You can choose to postpone reporting the remaining $320,000 gain.

Note: Always verify with a tax professional or the IRS regarding rules for calculating and determining tax liability. Tax rates and allowable exceptions can change year to year and many are specific to certain persons and financial situations.

1031 Exchange When an investment property or business is sold and the owner makes money, there is typically tax owed to the IRS. Section 1031 of the Internal Revenue Code, allows the owner an exception from paying tax at the time of the sale if the owner reinvests the money into a similar property or business. The delay in the payment of taxes is a process known as a 1031 exchange, named after the section of the IRS code. The property or business that is purchased to replace the sold property or business must be similar, what is known as “like-kind”. The tax owed by the owner making the exchange doesn’t go away, it is deferred to a later date.

Many owners of business and investment property can qualify to set up an exchange exchange, including individuals, corporations, partnerships, limited liability companies, trusts and other tax paying entities.

Properties must be exchanged under Section 1031, the most basic being a simultaneous swap of one property for another. Deferred exchanges (which are not immediate), are allowed but more complex. Deferred exchanges give the owners greater time in acquiring a like-kind property.

A 1031 exchange is not a case of an owner selling a property and then using the proceeds to purchase another. In that case the owner would be liable for taxes. To qualify as a deferred exchange, the sale of the property and the purchase of another must be mutually dependent parts of an integrated transaction to exchange property. Because of the inherent complexity, exchange facilitators are often used.

When completing a deferred 1031 exchange, there are time limits for when the transaction must be completed or the owner will owe taxes. First, the limit is 45 days from the original properties sale to identify properties to acquire. The property identification must be in writing and delivered to the seller of the replacement property or a qualified intermediary. Notice to an attorney, real estate broker, or accountant does not satisfy the requirement. All replacement properties must be legally described in the identification. The IRS has specific rules regarding the number and value limits of the identified properties. Second, the exchange must be completed (property received) within 180 days from the original properties date of closing.

Receiving or taking control of cash in the transaction before the exchange is complete can disqualify the transaction from being eligible for a 1031 exchange. In order to meet

the requirement, a person or corporation cannot act as their own intermediary or facilitator.

While not a part of the IRS code, a common 1031 exchange term is boot. Boot is a word which means, “in addition to”, and it represents any money or cash equivalent the owner performing the 1031 receives, even if it is the reduction of debt. Boot is taxable since it is not like-kind property.

Tax Credits The government, in an effort to encourage investment in certain sectors will offer tax credits to businesses and individuals. A tax credit is a dollar for dollar reduction in tax owed for each dollar invested. A tax credit is contrasted by the more common tax deduction, which is the reduction in taxable income. While each dollar invested lowers the amount owed in taxes by a dollar with tax credits, each dollar invested when deducted will decrease the taxpayer's income. For example, let’s look at the effect of a tax credit versus a tax deduction on an investment of $20,000 when the taxpayer makes $400,000 per year who without any deduction or credit would owe $112,000 in taxes given a 28% tax paid on income.

Tax Credit: $112,000 in taxes is reduced by $20,000 leaving a total tax owed of $92,000. Tax Deduction: $400,000 in income is reduced by $20,000 leaving $380,000 of taxable income. At 28%, the total tax owed would be $106,400.

As you can see, the difference is significant. A tax credit is very valuable.

The government has a program to incentivise investors to rehabilitate property in poor condition and will offer a tax credit for those participating in the program. Also, they have program for those who invest in low-income housing which provides tax credits. Always check with an accountant and/or the IRS regarding qualification for any tax related programs to ensure compliance with all rules.

Tax Deductions for Repairs Income can be reduced by the amount spent on repair for properties that are for investment. The definition of repair as the IRS terms it is the important part. For tax purposes there are two types of things you can do to your property when you do work on it, a repair or an improvement. A repair is meant to keep a property in good working order, essentially keeping things as-is. Improvements as a contrast are considered capital expenditures, as a court ruling states:

“Capital expenditures, in contrast, are for replacements, alterations, improvements, or additions that appreciably prolong the life of the property, materially increase its value, or make it adaptable to a different use.”

It’s all about making the property better than it used to be. Even making a property the same as it was before, but changing its useful life, is considered an improvement. Improvements, as capital expenditures are eligible to be depreciated, just like the building itself because of their larger expense and lengthy useful life.

Financing Real Estate Key Terms

Treasury Department - is in charge of minting (creating) money, and acts as the country’s money manager, paying employees of the government and collecting taxes.

Federal Reserve System (“The Fed”) - is the central banking system of the United States.

Monetary Policy - The Federal Reserve is tasked with a goal of maximum employment, stable prices, and moderate long-term interest rates. It does this through monetary policy, which it implements to control the cost of credit in the country.

Collateral - is something which is offered as security for the loan, and in the event of default, the borrower forfeits the item to the lender. When there is collateral as security for the loan, it is also referred to as a secured debt.

Secured Debt - is backed by an asset, such as real estate.

Unsecured Debt - is not secured by real property, as with most credit card debt.

Leverage - is how much money is borrowed versus the borrower's contribution, which magnifies gains and losses.

Equity - refers to the owner’s portion of the property value. To calculate it, you would take the current market value and subtract the amount of the mortgage on the property.

Loan-to-Value ratio (LTV) - Lenders measure the percentage put down by the borrower to the total value of the property with what is known as Loan-to-Value ratio (LTV). It is the amount of the loan as a percentage of the total value of the property.

Primary Market - Where borrowers looking for real estate loans and those who originate (create) loans come together.

Mortgage Underwriting - is the process of assessing the risk of making a loan.

Bank Run - is a panic where many depositors for fear of there not being enough funds available to receive their own, all attempt to withdraw at the same time.

Savings and Loans (Thrifts) - A savings and loan is a federally regulated institution that operates in many ways like a bank and credit union.

Credit Unions - Credit Unions are owned by the members, the customers of the credit union. The concept is the credit union can offer rates that are better than those of a bank since there isn’t a need to make a profit for investors, since the customers are the owners.

Commercial Banks - Commercial banks offer a large range of services, including taking deposits and making loans. The loans given out are often business loans and the deposits also come from businesses. Commercial banks deal primarily with business accounts.

Annuity - is a set of payments made at fixed intervals.

Ginnie Mae (GNMA) - Ginnie Mae is a government corporation, and operates under the Department of Housing and Urban Development. It’s job is to make housing affordable for low to moderate income households.

Fannie Mae - Created in 1938, as part of the New Deal, it is a government sponsored enterprise and it aims to increase the number of loans given out through secondary market operations. Fannie Mae originally was the entire secondary mortgage market.

Freddie Mac - Freddie Mac has essentially the same goal as Fannie Mae, to increase the liquidity and size of the secondary mortgage market. It does this the same way Fannie Mae does which is by buying conforming loans (those which meet their underwriting standards) from primary market participants. Freddie then securitizes some of the loans for sale in the markets.

Prequalification - is for borrowers who have had a conversation with a mortgage lender, telling them the details of their financial situation.

Underwriting - is the process of risk assessment the lender does to determine if making a loan is worth the risk.

Credit - Credit focuses on the borrower's history of repaying debts. If the borrower is consistent in timely payment of debt and managing their balances, they will be seen as a good credit risk.

Capacity - Capacity is how able the borrower is to payback their loan. Lender’s figure this out by examining income, employment, and how much debt they currently have.

Income - The amount of income a borrower receives is always critical in determining their capacity to repay a loan.

Employment - Not all income is created equal. Stability of the income the borrower receives is important to the lender. If a borrower is self employed in a commission based job, income is likely more inconsistent and therefore not valued the same as a full time job given the same amount of time employed.

Current Debt - How much debt is too much. Regardless of the amount of income generated, if it is already being paid out to other sources, it’s unavailable to pay back new debt. To determine if the borrower is within acceptable limits of debt, lenders use guidelines for the ratio of debt to income of the borrower.

Housing Expense Ratio = Monthly housing expense / Total monthly income

Total Debt Ratio = Monthly debt / Total monthly income

Collateral - is the property that is being purchased with the mortgage.

Mortgage - is actually what pledges the property to the lender in the event the borrower defaults.

Term of the Loan - The length of time until the loan is either due or paid off

Principal - is the amount of the loan outstanding, or the total amount remaining on the loan. Also known as the loan balance.

Fixed Rate Mortgage - has the same interest rate for the entire life of the loan.

Adjustable Rate Mortgages (ARM) - have interest rates that fluctuate at specified times throughout the mortgage life. The common vernacular is an “ARM” loan, an acronym for adjustable rate mortgage.

Loan Amount - is the term used when referring to the total amount borrowed (aka initial principal amount).

Interest - Interest is the rate charged on the loan, the cost of borrowing the money.

Usury - is the act of charging illegally high interest rates on debt.

Adjustable Rates - ARM loans start with an initial rate which is the interest rate charged when the loan is started.

Hybrid ARM - When a rate is fixed for a certain period of the ARM loan it’s more commonly known as a Hybrid ARM. The hybrid term is because it is fixed for a specified term then adjustable thereafter.

Index - is the predefined existing financial rates used as a benchmark.

Margin - is the amount over and above the index, the lender’s profit or markup.

Interest Rate Caps - An interest rate cap limits the size of the interest rate increase which can happen when it adjusts.

Payment Caps - A payment cap is a maximum monthly amount that can be added to the payment when the rate adjusts on a mortgage. Usually represented in percentage. terms.

Initial Rate Cap - is the amount the rate can increase the first time it adjusts.

Periodic Rate Cap - sets a limit on the increase that can occur from one adjustment period to the next.

Discount Points - There’s a way to get a lower mortgage rate, and that requires the borrower to pay an upfront fee, called discount points. First, it’s helpful to understand what a point is. A point represents one percent of the loan amount. On a $700,000 loan, a point is $7,000. Discount points allow the borrower to pay a fee, and in the case of 1% of the value of the loan, it would be 1 discount point in exchange for the lender lowering the rate on the note. The amount of interest rate discount given for paying 1 discount point will vary, but generally is ⅛ to ¼ of a percent. By paying 2 discount points, the rate can by ¼ to ½ of a percent or more.

Origination Fees - are fees charged by the lender for putting the loan together. Amortization - is the payoff of debt on a regular schedule, over the life of the loan, usually with fixed payments.

Negative Amortization - This happens when the payment made is insufficient to cover the interest due for the period, thereby increasing the total loan amount due.

Right of Prepayment - This grants the borrower the right to pay off part or the entire loan before the term on the note.

Prepayment Penalties - are charges that occur when a borrower pays off their mortgage early.

Open Mortgages - Are loans, which do not have prepayment penalties.

Lock-in Clause - will not allow a borrower to pay off a loan early. It is differentiated from a prepayment penalty in the following way: with a prepayment penalty, the borrower is penalized when paying off a loan early. With a lock-in clause, the borrower is prohibited from paying off the loan early.

Demand Clause - A note containing a demand clause allows the lender to call the loan due at any time during the loan term. This means they can demand the borrower pay back the entire loan prior to the loan term.

Title Theory State - the borrower does not actually keep title to the property during the loan term.

Lien Theory State - the buyer holds the deed to the property during the mortgage term.

Deed of Trust - In Washington state, we use what is known as a Deed of Trust, another type of mortgage theory. When the seller gives title to the property, the buyer will sign a document known as a Deed of Trust (a security instrument), which will assign a third party to hold title and have the ability to foreclose if obligations are not met. The lender is the designated beneficiary of the Deed of Trust. When the loan has been paid off, the lender will release the borrower of the conditions in the Deed of Trust, through reconveyance. A Deed of Reconveyance clears title and the lender’s interest in the property.

Marketable Title - is title that is clear from ownership and lien claims, which could prevent the transfer of title to another party.

Equitable Title - A Deed of Trust is a setup where a trustee holds legal title and the borrower who “owns” the property is under contract to pay the mortgage back. The “owner” or borrower would have an equitable interest in the property.

Insurance Clause - Lenders require borrowers to keep homeowners insurance which protects against loss by fire, tree damage, windstorm etc.

Escrow Clause - An escrow clause sets up an escrow agreement between the lender and the borrower to collect money for paying taxes and insurance and lasts for the entire term of the loan.

Acceleration Clause - An acceleration clause in a mortgage or deed of trust requires the balance of the loan to become due immediately.

Due-on-Sale Clause - This is also referred to as an alienation clause. This clause in a mortgage or trust deed allows the lender to call the loan immediately due and payable in the event the owner sells the property or transfers title or interest to the property.

Assumption - is an agreement under which the buyer of a property takes over the seller's liability for payment of installments (on the existing mortgage on the property), usually to save the closing costs or the higher interest rates of a new mortgage.

“Subject To” - is a transfer of real estate where the purchaser agrees to take over monthly payments of principal and interest, but does not assume personal liability for the obligation.

Certificate of Reduction - If a property is sold and the purchaser is going to assume the loan, the lender will be asked to provide a signed document known as a Certificate of Reduction, which states the loan balance, the date of maturity and the interest rate on the loan.

Subordination Clause - allows another loan to have a higher priority, usually first position, than the existing loan. Subordination is the act of yielding priority. Usually the date the lien was recorded establishes priority. A subordination clause will change this priority.

Defeasance Clause - in a mortgage or deed of trust provides for the cancellation of the lender’s interest when the debt has been paid in full.

Conventional Loans - are any loans which are not from or guaranteed by the government. This includes seller financing. The loans can be fixed or adjustable rate mortgages and still be classified as a conventional mortgage. Conventional loans are typically not assumable. A conventional mortgage is granted based on the borrower's credit history, income, and down payment.

Private Mortgage Insurance - is an insurance product which pays the lender in the event there are losses associated with the loan. The policy premiums are paid by the borrower because their loan to value ratio is below 80%. The greater the risk in the loan because of deficiencies in down payment, credit, and capacity the higher the rate is on the mortgage insurance. Once the borrower has made enough principal payments to reduce the LTV to 80%, the private mortgage insurance can be removed.

Adjustable Rate Mortgages - Adjustable rate mortgages have payments that fluctuate over the life of the loan due to changes in the interest rate. Lenders find this particularly helpful in managing interest rate risk. Interest rate risk is created by changes in the interest rate over time.

FHA Loans - are insured through the Federal Housing Administration, which is a section of HUD. FHA loans traditionally offer more flexible guidelines when it comes to approving borrowers with somewhat lower credit scores. FHA loans require a portion of the mortgage insurance premium to be paid at the time of closing – this amount is added to the loan amount and amortized over the term of the loan.

VA Loans - are guaranteed by the Veterans Administration and are made available to veterans who can show they have met the service requirements necessary to be eligible for the program. If the loan is approved, VA will guarantee a portion of it to the lender. Using the VA program, a veteran can finance 100% of the purchase price if the appraisal values the home for the purchase price.

Purchase Money Mortgage - is a loan given from a seller to a buyer to finance the home.

Wraparound Mortgages - are a form of seller financing where the seller will take a junior (secondary) debt position after a primary (first position) loan is in place, such as a bank mortgage.

Installment Contract - is an agreement between a buyer and seller of property in which the buyer makes payments toward full ownership (as with a mortgage).

Package Mortgage - is a loan for the purchase of the home including personal property, such as furniture and appliances.

Home Equity Loan - is a loan based on the value of the owner’s equity (home value - loan amount) in a home. home equity line of credit is a loan that can be drawn on based on the equity in a house.

The Line of Credit - is a set amount that can be drawn from much like a credit card.

Home Equity Lines of Credit - are also referred to as open-end mortgages because they can be drawn on multiple times, whereas home equity loans are a type of closed mortgage since the loan is made in one lump sum.

Reverse Mortgage - A reverse mortgage is a loan based on the equity the borrower has in the home, where the borrower receives monthly payments from the lender rather than a lump sum.

Blanket Mortgage - is a single mortgage that covers more than one parcel of real estate, a mortgage that is secured by several structures or numerous parcels.

Graduated Payment Mortgage - A type of fixed rate mortgage in which the payment increases gradually from an initial low base level to a desired, final level. Payments increase in steps each year until the installments are sufficient to amortize the loan.

Construction Loans - A construction loan is an interim loan covering construction and development costs, secured by a mortgage on the property financed.

Option ARM - An option ARM is an adjustable rate mortgage that allows the borrower to choose the payment they want to make to the lender.

Default - When a borrower doesn’t meet the obligations set forth in the promissory note.

Foreclosure - is the process of forcing the sale of property, the collateral for the loan, in order to recover the money they are owed.

Judicial Foreclosure - is foreclosure through the court system. The lender files suit to force the sale of the property to recover the debt.

Deficiency Judgment - is a judgment against the borrower for the difference between the amount owed and the proceeds from the sale of the property. If a deficiency judgement is sought and granted to the lienholder (lender), the right of redemption period extends to 1 year.

Non-Judicial Foreclosure - is most common in Washington state because of the rights given to the lender. Non-judicial foreclosure is accomplished through the outlined process in a deed of trust outside the court system.

Notice of Pre-Foreclosure Options - states what you would imagine, the borrower’s options to avoid foreclosure. The options afforded the borrower can include requesting a loan modification or possibly forfeiture of the property in order to satisfy the debts, known as a deed in lieu of foreclosure.

Loan Modification - is a plan that the borrower makes promising to pay reduced payments or get a plan in place where they can pay back missed payments over time. It’s often cheaper for the lender and the borrower.

Deed in Lieu of Foreclosure - A deed in lieu of foreclosure grants the title to the lender to satisfy the debt.

Short Sale - is when the amount owed is greater than what the property can be sold for in the current market.

Equal Credit Opportunity Act - The Equal Credit Opportunity Act (ECOA) ensures that all consumers are given an equal chance to obtain credit. Consumers who apply for credit will still have to qualify with considerations such as income, expenses, debt and credit history. It prohibits lenders from discriminating due to a person’s sex, marital status, age, race, national origin or even if the person received public assistance.

Predatory Lending - If a borrower gets involved in a transaction that isn’t what they expected then the loan process has become predatory. Many people can commit

predatory lending including lenders, real estate brokers, mortgage brokers, contractors and attorneys.

Uniform Commercial Code - The Uniform Commercial Code (UCC) Program operates under a Washington State law governing commercial transactions. UCC offices support commerce by giving lenders a central place for notices regarding personal property pledged as collateral for loans.

Truth in Lending Act (TILA) - is a law designed to protect the public as it relates to consumer credit. The main purpose of TILA is to make clear all of the costs and fees associated with loans in a standardized format and with required disclosures.

Right of Rescission - is granted to borrowers who are pledging their primary residence as collateral for the loan. The right of rescission is available for 3 days after the borrower signs the loan paperwork, delivery of the notice of right to rescind or delivery of all material disclosures, whichever occurs last.

Real Estate Settlement and Procedures Act (RESPA) - was first passed in 1974 and was established to protect consumers during residential real estate financing transactions. Its main purpose is to inform homebuyers as to the estimated and actual costs of settlement services (the fees and services involved in completing the lending transaction) and to eliminate unscrupulous practices that can increase the cost of settlement services, including kickbacks and referral fees for services provided by the affiliated companies.

RESPA Disclosures - The Real Estate Settlement Procedures Act (RESPA) requires lenders to provide home buyers with additional disclosures to inform them about the types of services that will be provided as part of the transaction and the costs involved with those services.

The Good Faith Estimate - The good faith estimate provides an estimate of the settlement costs and names of all required service providers. These estimates include all prepaid and escrow items as well as lender charges.

Capital Gain - is the difference between the cost to acquire the asset, also known as the basis, and the sales price of the asset less some allowed costs.