32 terms

Real estate financing usually involves five phases: (1) application, (2) analysis, (3) processing, (4) closing, and (5) servicing

The lending process begins by having the prospective borrower

complete a lender's loan application. A loan application form requests information about the borrower's financial status, such as level and consistency of income, personal assets, existing debts, and current expenses

complete a lender's loan application. A loan application form requests information about the borrower's financial status, such as level and consistency of income, personal assets, existing debts, and current expenses

the loan application form also asks for data concerning the

property, including its location, its age, the size of the lot, and any

existing improvements.

property, including its location, its age, the size of the lot, and any

existing improvements.

Once the application is completed, the lender reviews the form

and uses it as a screening device to determine whether the prospective

borrower and the subject property appear to meet the lender's

requirements.

and uses it as a screening device to determine whether the prospective

borrower and the subject property appear to meet the lender's

requirements.

If it becomes obvious that the borrower or the property

is unacceptable for a loan, the lender informs the applicant. If

it appears that the borrower and the property might be acceptable,

the analysis phase begins

is unacceptable for a loan, the lender informs the applicant. If

it appears that the borrower and the property might be acceptable,

the analysis phase begins

Analysis involves an in-depth appraisal of the property and a

professionally compiled credit report on the prospective borrower.

professionally compiled credit report on the prospective borrower.

After the appraisal and credit report are completed (and assuming

both are favorable), the lender presents the terms and cost of

financing to the borrower.

both are favorable), the lender presents the terms and cost of

financing to the borrower.

The borrower may accept, reject, or

attempt to negotiate the financing terms with the lender. Assuming

an agreement is reached, the processing phase begins.

attempt to negotiate the financing terms with the lender. Assuming

an agreement is reached, the processing phase begins.

Processing involves drawing up loan papers, preparing disclosure

forms regarding loan costs, and issuing instructions for the

escrow and title insurance company.

forms regarding loan costs, and issuing instructions for the

escrow and title insurance company.

Each lender establishes its

own processing pattern in view of its special in-house needs.

own processing pattern in view of its special in-house needs.

Once the loan package has been processed, the closing phase

begins. Closing the loan involves signing all loan papers and then,

in conjunction with the other terms of the sale, transferring the

property.

begins. Closing the loan involves signing all loan papers and then,

in conjunction with the other terms of the sale, transferring the

property.

In southern California, an independent escrow company,

the escrow department of a title company, or (in some cases) the

broker handles the entire escrow.

the escrow department of a title company, or (in some cases) the

broker handles the entire escrow.

In much of northern California,

once the loan papers are signed, they are forwarded to the escrow

department of a title insurance company, which closes the sale.

once the loan papers are signed, they are forwarded to the escrow

department of a title insurance company, which closes the sale.

After the title has been transferred and the escrow is closed, the

loan-servicing phase begins. Loan servicing refers to the recordkeeping

process once the loan has been placed

loan-servicing phase begins. Loan servicing refers to the recordkeeping

process once the loan has been placed

Many lenders do

their own servicing, while others pay independent mortgage companies

to handle the paperwork.

their own servicing, while others pay independent mortgage companies

to handle the paperwork.

The goal of loan servicing is to see

that the lender makes the expected yield on the loan by promptly

collecting and processing the loan payments with minimum cost.

that the lender makes the expected yield on the loan by promptly

collecting and processing the loan payments with minimum cost.

When money is borrowed to purchase real estate, the borrower agrees

to repay the loan by signing a promissory note, which outlines the

terms of repayment and sets the due date.

to repay the loan by signing a promissory note, which outlines the

terms of repayment and sets the due date.

The promissory note is legal evidence that a debt is owed. The types of promissory notes in general

use are the straight note, installment note, and negative amortized note.

use are the straight note, installment note, and negative amortized note.

The straight note is frequently referred to as an interest-only note.

Under a straight note, the borrower agrees to pay the interest,

usually monthly, and to pay the entire principal in a lump sum on

the due date.

Under a straight note, the borrower agrees to pay the interest,

usually monthly, and to pay the entire principal in a lump sum on

the due date.

For example, if you borrow $100,000 for 30 years at

10 percent interest rate using a straight note, the monthly payments

would be $833.33 per month. The $833.33 payments cover just the

monthly interest.

10 percent interest rate using a straight note, the monthly payments

would be $833.33 per month. The $833.33 payments cover just the

monthly interest.

Thus, 30 years hence, on the due date, you must

pay back the entire $100,000 principal. In other words, the payments

were only large enough to cover the monthly interest and did not

reduce the $100,000 principal.

pay back the entire $100,000 principal. In other words, the payments

were only large enough to cover the monthly interest and did not

reduce the $100,000 principal.

Proof: $100,000 × 10% $10,000 ÷

12 months $833.33 per month. Ten percent is used for illustration

purposes only. Actual interest rates will vary.

12 months $833.33 per month. Ten percent is used for illustration

purposes only. Actual interest rates will vary.

The second and by far the most common type of real estate promissory

note is the installment note. An installment note requires payments

that include both principal and interest.

note is the installment note. An installment note requires payments

that include both principal and interest.

If you borrow

$100,000 for 30 years at 10 percent interest payable at $877.57

per month, including both principal and interest, you will find that

at the end of 30 years, the entire debt is liquidated.

$100,000 for 30 years at 10 percent interest payable at $877.57

per month, including both principal and interest, you will find that

at the end of 30 years, the entire debt is liquidated.

Each monthly

payment of $877.57 includes the monthly interest due and reduces a

portion of the $100,000 principal. By the time the due date arrives

30 years hence, the entire principal has been paid back.

payment of $877.57 includes the monthly interest due and reduces a

portion of the $100,000 principal. By the time the due date arrives

30 years hence, the entire principal has been paid back.

An installment

loan that includes principal and interest of equal installment

payments that liquidate the debt is called a fully amortized loan.

loan that includes principal and interest of equal installment

payments that liquidate the debt is called a fully amortized loan.

Under a fully amortized loan, no large balloon payment must be

paid on the due date of the loan, as the loan is completely paid off.

paid on the due date of the loan, as the loan is completely paid off.

One variation of the installment note is to have monthly payments

that are large enough to pay the monthly interest and reduce

some of the principal, but the monthly principal portion is

not sufficient to entirely liquidate the debt by the due date.

that are large enough to pay the monthly interest and reduce

some of the principal, but the monthly principal portion is

not sufficient to entirely liquidate the debt by the due date.

Thus,

on the due date, the remaining unpaid principal must be paid in a

lump sum, often referred to as a balloon payment. Any payment

more than twice the lowest payment amount is called a balloon

payment.

on the due date, the remaining unpaid principal must be paid in a

lump sum, often referred to as a balloon payment. Any payment

more than twice the lowest payment amount is called a balloon

payment.

One hundred thousand dollars for 30 years at 10 percent

interest payable at $850 per month would require a balloon

payment of $62,325.20 on the due date.

interest payable at $850 per month would require a balloon

payment of $62,325.20 on the due date.

Why? Because the $850

per month was enough to cover the monthly interest ($833.33), but it was not enough to cover the monthly interest and all of the

monthly principal, which would have taken $877.57 per month

per month was enough to cover the monthly interest ($833.33), but it was not enough to cover the monthly interest and all of the

monthly principal, which would have taken $877.57 per month

Thus, the difference over the 30-year life of the loan comes to

$62,325.20, which must be paid on the due date in the form of a

balloon payment. Loan payments and balloon payments can be

calculated using financial tables or financial calculators.

$62,325.20, which must be paid on the due date in the form of a

balloon payment. Loan payments and balloon payments can be

calculated using financial tables or financial calculators.

Finally, some borrowers sign negative amortized promissory

notes. Negative amortized means that the loan payment does not

cover even the monthly interest.

notes. Negative amortized means that the loan payment does not

cover even the monthly interest.

Each month this shortage is added

to the principal owed, resulting in an increased loan balance, which,

in turn, incurs additional interest.

to the principal owed, resulting in an increased loan balance, which,

in turn, incurs additional interest.

As mentioned above, a $100,000

loan at 10 percent payable interest would be a monthly payment of

only $833.33 = $100,000 × 10% ÷ 12 mo.

loan at 10 percent payable interest would be a monthly payment of

only $833.33 = $100,000 × 10% ÷ 12 mo.

If a borrower paid only

$750 per month, the difference between the interest-only payment

of $833.33 and the $750 payment would be $83.33.

$750 per month, the difference between the interest-only payment

of $833.33 and the $750 payment would be $83.33.

Each month

this additional $83.33 amount would be added to the $100,000

loan and begin to accrue interest.

this additional $83.33 amount would be added to the $100,000

loan and begin to accrue interest.

If this continued for 30 years, the borrower would still owe a

balloon payment of $288,373.99 on top of paying $750 per month

for 30 years!

balloon payment of $288,373.99 on top of paying $750 per month

for 30 years!

The total paid would be $750 × 360 payments = 30 years ×

12 = $270,000 $288,373.99 balloon payment, for a grand total of $558,373.99 to pay off a $100,000 negative amortized loan payable

for $750 permonth at 10 percent over 30 years!

12 = $270,000 $288,373.99 balloon payment, for a grand total of $558,373.99 to pay off a $100,000 negative amortized loan payable

for $750 permonth at 10 percent over 30 years!

Of course, in the

real world, most people do not stay in a home and pay for 30 years.

real world, most people do not stay in a home and pay for 30 years.

They usually sell or refinance long before 30 years, and the balance

owed on a negative amortized loan is far less than that illustrated

above.

owed on a negative amortized loan is far less than that illustrated

above.

But the lesson learned is that a negative amortized loan is

one where a loan balance grows each and every year prior to payoff.

one where a loan balance grows each and every year prior to payoff.

Most real estate lenders qualify a borrower for either a fixed interest

rate or an adjustable rate loan.

rate or an adjustable rate loan.

The fixed interest rate is the

traditional real estate loan where the interest rate does not change

over the life of the loan.

traditional real estate loan where the interest rate does not change

over the life of the loan.

Under the adjustable rate plan, the rate

may move up or down. Therefore, the monthly payment may decrease

or increase over the life of the loan.

may move up or down. Therefore, the monthly payment may decrease

or increase over the life of the loan.

Adjustable rate loans, usually called adjustable rate mortgages

or ARMs, have the following characteristics:

or ARMs, have the following characteristics:

ARMS: 1. They are usually offered at a lower initial interest rate than traditional

fixed interest rate loans

fixed interest rate loans

ARMS : 2. Once the initial interest rate is established, the rate is tied to some

neutral index, which is beyond the control of the lender or the

borrower.

neutral index, which is beyond the control of the lender or the

borrower.

3. The index is usually a government index. Examples are the One Year

Treasury Spot Index, the Treasury 12-Month Average Index,or the

11th District Cost-of-Funds Index.

percent.

Treasury Spot Index, the Treasury 12-Month Average Index,or the

11th District Cost-of-Funds Index.

percent.

Other indexes used are tied to

certificate of deposit or CD rates, prime rates, or even a European

rate known as the London Inter bank Offered Rate or LIBOR .

certificate of deposit or CD rates, prime rates, or even a European

rate known as the London Inter bank Offered Rate or LIBOR .

The distance between the actual rate paid by the borrower and the index

is called the margin. A typical margin is 2 percent to 3 percent

is called the margin. A typical margin is 2 percent to 3 percent

4. Although not required,most lenders place a cap on how high the

rate can climb.Atypical cap is 5 percent or 6 percent; therefore, if

the initial interest rate is 6 percent, the maximum it can rise to is

11 percent or 12 percent.

rate can climb.Atypical cap is 5 percent or 6 percent; therefore, if

the initial interest rate is 6 percent, the maximum it can rise to is

11 percent or 12 percent.

5. The adjustment period can vary,with some lenders adjusting the

rate at six-month, one-year, or three-year intervals.

rate at six-month, one-year, or three-year intervals.

6. The maximum increase or decrease per period is established in

the lender's contract, with a maximum change of 1 percent per

six-month adjustment period being typical.

the lender's contract, with a maximum change of 1 percent per

six-month adjustment period being typical.

7. If the interest rate increases because of a change in the index, in

some cases, the borrower may have the option of (a) increasing

the monthly payment so the term of the loan remains the same or

some cases, the borrower may have the option of (a) increasing

the monthly payment so the term of the loan remains the same or

(b) maintaining the same monthly payment and increasing the

term of the loan.

term of the loan.

Usually, themaximumtermto which a 30-year

loan may be extended is forty years.Once a forty-year term is

reached, any increase in interest rate must increase the monthly

payment.

loan may be extended is forty years.Once a forty-year term is

reached, any increase in interest rate must increase the monthly

payment.

If the interest rate drops below the initial rate, the borrower

can continue the existing payments (which will shorten the

term) or decrease the monthly payments.However, in recent

years, fewer lenders are offering this feature.

can continue the existing payments (which will shorten the

term) or decrease the monthly payments.However, in recent

years, fewer lenders are offering this feature.

8. The borrower must be given advanced notice prior to a change

in rate.

in rate.

9. Some ARMs may be negative amortized loans. This means the

payments may not cover the annual interest. The unpaid interest

is added to the principal,making the loan larger. This can cause

some problems in later years.

payments may not cover the annual interest. The unpaid interest

is added to the principal,making the loan larger. This can cause

some problems in later years.

10. Some lenders offer a convertible feature that allows the borrower

to convert an ARM loan to a fixed interest rate loan or a fixed rate

loan to an ARM.

to convert an ARM loan to a fixed interest rate loan or a fixed rate

loan to an ARM.

The conversion is only offered during a certain

"window period," usually fromthe beginning of the second year

through the end of the fifth year.

"window period," usually fromthe beginning of the second year

through the end of the fifth year.

The borrower may be required

to meet credit standards at the time of the conversion and is usually

required to pay extra fees.

to meet credit standards at the time of the conversion and is usually

required to pay extra fees.

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