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Understanding Mortgage Debt: Laws, Rights, and Effects on Home Ownership and Businesses

This chapter explores the intricate dynamics of mortgage debt and its profound effects on households, businesses, and investors. Key elements include the structure of mortgage loans, various interest rates (fixed and adjustable), and the implications of prepayment rights. Additionally, it discusses the impact of mortgage debt on home ownership, enabling more families to buy homes and allowing businesses to allocate cash more effectively. We also cover default consequences, foreclosure processes, and alternatives to foreclosure that can mitigate financial loss.

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Understanding Mortgage Debt: Laws, Rights, and Effects on Home Ownership and Businesses

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  1. Chapter 10 Real Estate Finance: The Laws and Contracts

  2. Some Effects of Mortgage Debt • More households can own their home • Businesses can use their cash for core activities • Investors can leverage and diversify investments • Homeowners can obtain credit on better terms than consumer debt (home equity credit lines) • Tax favored • Longer term • Lower interest rate

  3. Two Elements of aMortgage Loan • Note: Exact terms of the financial obligation • Mortgage: Pledges the property as security for the note

  4. The Note – Interest Rates • Fixed rate • 365-day interest (daily rate is 1/365 of annual rate; contrasts with commercial mortgage loans at 360-day interest • Monthly charge is 1/12 of stated annual rate • Adjustable rate • Index rate: Market-determined rate beyond control of either borrower or lender • U.S. Treasury Constant Maturity Rate • Thrift institution Cost of Funds Index • LIBOR • Home mortgage rate index

  5. The Note – Interest Rates (continued) • Adjustable rate (continued) • Margin: Lender’s markup • 200 to 300 basis points (bp) • Average is extremely stable at 277 - 278 bp • Change Date: Date that interest rate changes each time • New index rate commonly is the last published rate 45 days, for example, before the change date • Teaser rate: Initial, temporarily reduced interest rate

  6. The Note – Interest Rates (continued) • Adjustable rate (continued) • Interest rate caps: Limit on changes in interest rate charged • Periodic • Lifetime • Important question: Does cap apply to the teaser rate? • Payment caps: Limit on payment changes rather than interest rate changes • Can result in negative amortization: Unpaid interest added to the balance

  7. Payments • Always in arrears (end of month) • Virtually always monthly • Various arrangements for fixed-rate loan: • Level payment • Partially amortized (term for amortization, term to maturity, balloon loan) • Interest only nonamortizing; sometimes called a “bullet” loan • Negative amortization

  8. The Note: Right of Prepayment • Traditional: No right of prepayment unless explicitly provided • Modern statutory case: Right of prepayment unless explicitly prohibited • Loans with right of prepayment: • All “conforming” and FHA/VA loans • Home equity credit lines

  9. The Note: Right ofPrepayment (continued) • Loans with restricted right of prepayment: • Subprime home loans • “Jumbo” home loans • Most income property mortgage loans • Prepayment penalties (percentage of outstanding balance; yield maintenance; defeasance)

  10. The Note: Right ofPrepayment (continued) • Loans with restricted right of prepayment: • Subprime home loans • “Jumbo” home loans • Most income property mortgage loans • Prepayment penalties • Percentage of outstanding balance • Yield maintenance • Defeasance

  11. The Note: Other Terms • Nonrecourse loan: No personal liability • Exculpatory clause • Single-purpose, single asset, bankruptcy remote entity for borrower • Demand clause: Right of lender to require prepayment • Inclusion of mortgage clauses by reference

  12. Mortgage • Mortgagor: Borrower • Mortgagee: Lender • Title vs. lien theory • Title theory: Mortgage a temporary transfer of title • Lien theory: Mortgage a lien • Historic difference was lender’s claim to rents and possession in case of default

  13. Important Mortgage Clauses • Description of the property • Insurance clause • Escrow clause • Acceleration clause • Due-on-sale clause • Hazardous substances clause • Preservation and maintenance clause

  14. When Things Go Wrong • Default: Failure to meet requirements of the note or mortgage • Technical default: Any violation of terms • Substantive default: Three missed payments (90 days)

  15. Nonforeclosure Responses to Default • Counseling and consumer debt reorganization • Temporary reduction of payments • Assisted sale • Deed in lieu of foreclosure • Advantages: quick, quiet, cheap • Disadvantages: other liens remain; bankruptcy can nullify and wipe out mortgage

  16. Foreclosure • Legal process of terminating all claims of ownership and all liens inferior to foreclosing lien • Risk of failing to notify a claimant • Presence of superior liens • Costly and time consuming • Distressed sale • Importance of lien priority • Recourses of the defaulted mortgagor • Equity of redemption • Statutory right of redemption

  17. More Foreclosure (continued) • Deficiency judgment: Judgment against mortgagor for unrecovered balance • Example: • Net foreclosure auction price: $100,000 • Remaining loan balance: $120,000 • Deficiency judgment: $20,000 • Judicial foreclosure vs. power of sale • Judicial foreclosure: Court-administered public auction • Power of sale: Public auction conducted by trustee or mortgagee (preferred by lenders)

  18. Power of Sale States

  19. Bankruptcy • Possible threat to lender’s ability to foreclose • Three forms of bankruptcy • Chapter 7: Liquidation • Chapter 11: Court supervised “workout” • Chapter 13: Wage-earner’s proceeding • No form of bankruptcy can set aside a mortgage lien • Chapters 11 and 13 can result in delays • Soldiers and Sailors Relief Act of 1940

  20. Acquiring Property with Existing Debt • “Subject to” borrower does not sign mortgage note • No personal liability for mortgage loan • Property still is subject to the mortgage • Assumption: Buyer adds signature to note • Personal liability for loan • Property subject to mortgage

  21. Debt without a Mortgage

  22. Laws Regulating HomeMortgage Lending • Equal Credit Opportunity Act • Federal Truth-in-Lending Act (TILA) • Real Estate Settlement Procedures Act (RESPA) • Other laws • Home Ownership and Equity Protection Act • Home Mortgage Disclosure Act • Community Reinvestment Act

  23. Race Color Religion National Origin Sex Marital Status Age Source of income (public assistance or part time) Equal Credit Opportunity Act Prohibits discrimination in lending by:

  24. Federal Truth-in-LendingAct (TILA) • Statement of Annual Percentage Rate (APR) • Cost of borrowing • Computed as yield to maturity • Disclosures: • Demand clause • Assumability • Variable rate • Late charges • Prepayment charge • Right of rescission for 3 days for non-purchase, non-business home mortgage loans

  25. Real Estate SettlementProcedures Act (RESPA) • Applies to almost all standard home mortgage loans • Requires: • Standard format closing statement (HUD-1) • Presentation of HUD booklet explaining HUD-1 • Good-faith estimate of closing costs within 3 days of applying • Closing statement (HUD-1) available for inspection 24 hours before closing • Prohibits kickbacks from closing service vendors

  26. Other Laws Regulating HomeMortgage Lending • Home Ownership and Equity Protection Act • Targeted at abuses in subprime lending • Subprime: Loan to a borrower not qualifying for standard “prime” financing • Level of APR triggers certain requirements • Disclosure of fees • Prepayment fee for only 3 years • No balloon payment for 5 years • No negative amortization • No pattern of lending to households with inadequate income • Home Mortgage disclosure Act • Community Reinvestment Act

  27. End of Chapter 10

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