The place to start a discussion about real estate financing is with some basic concepts and terminology. For the Real Estate License Exam, you will need to have a good grasp on mortgages, especially the definitions and maybe a little math.
The nuts and bolts of the mortgage process
A buyer and a seller agree on a price and the other terms involved in the sale of a house. The buyer has some of the money in cash, about 20 percent, for a down payment but needs to borrow the rest. The buyer goes to a bank or other lending institution to apply for a loan for the rest of the purchase price of the house.
The lender considers these two things when examining the buyer’s application:
The ability of the buyer to repay the loan, which includes factors like the buyer’s credit and employment history.
The value of the real estate being purchased, which is usually determined by an appraisal. Most work in the appraisal industry involves estimating property values for mortgage purposes. Because property is considered security for the loan, lenders want to be sure that the property can be sold to pay off the loan if necessary.
The lender issues what is known as a mortgage commitment, and on the day of closing, the buyer also closes on the mortgage loan. Closing on the mortgage simply means entering into the final and formal agreement to accept the money and pay it back.
Liens, notes, and a mistake most people make
The two important documents you’ll sign as part of the mortgage process are the note and the mortgage. Definitions are important here for test purposes and basic definitions will guide you to an understanding of each term and choosing the right answers on the exam.
The process of using property as security for a loan is called hypothecation. In real estate circles, that process is accomplished through a mortgage, which is a document prepared by a lender and signed by the borrower that essentially serves as a voluntary lien on a piece of real estate. Liens are financial obligations that are attached to real estate.
Remember through hypothecation the owner of the property voluntarily places a specific lien on the property in favor of the lender without giving up possession of the property. When the mortgage is signed by the borrower, the property is committed as security for the loan. A mortgage lien enables the lender to sell the property after a foreclosure process, to pay off the debt, if the borrower defaults.
The second document that the borrower signs as part of the mortgage loan process is called a promissory note. A promissory note is an agreement to repay a loan according to certain terms and conditions.
A trust deed is used in some locales to secure a mortgage loan. A trust deed also is called a deed of trust. For a deed of trust to work, a third party must be involved. The trustor gives a deed to a trustee. The deed gives title to the property, without the right of possession. This type of title sometimes is referred to as bare or naked title.
The trustee holds the deed until the loan is paid off. The property then is reconveyed back to the trustor. If the trustor doesn’t complete the terms of the loan, the trustee conveys title to the property to the beneficiary for sale to satisfy the debt. There is a common misuse of the word mortgage you should know about for exam purposes.
So, you’re thinking, the buyer goes to the bank and applies for a mortgage. Wrong! Well, then, you say, “The bank gives the buyer a mortgage.” Wrong! “So,” you simply say, “I’m going to get a mortgage to buy my new house.” Wrong, again!
Those are the things most people say, including virtually everyone in the real estate business. Why these commonly used phrases are wrong and the right way to describe the process are the focus of two words that you absolutely need to remember — mortgagor and mortgagee.
The mortgage is a voluntary lien that enables the bank to take the property and sell it, if you don’t pay back what you borrowed. Thus, because you’re giving the mortgage to the bank, you are the mortgagor, and because the bank accepts the mortgage in return for lending you the money, it is considered the mortgagee.
Mortgage loan theories
The differences in how mortgage loans affect property ownership are more theoretical than practical, and so they’ve been boiled down into the three theories in the list that follows. You need to be sure to find out which of the theories your state follows.
The lien theory: Under the lien theory, the mortgagor (borrower) retains both the legal title and equitable title to the property. The mortgagee (lender) is granted a lien on the property. Legal title is the title or ownership that normally transfers in a property sale.
Equitable title gives the holder of the equitable title the right to force the transfer of title when all the conditions of a contract are met. Under the lien theory, the mortgagee must go through the legal process of foreclosure to get legal title to the property to be able to sell it for nonpayment of the debt.
The title theory: In the title theory, the mortgagor gives legal title to the mortgagee but keeps equitable title. Because the mortgagee already has title, gaining possession of the property for sale to repay the debt is more direct than under the lien theory.
The intermediate theory: Based on title theory, the borrower retains title to the property and the mortgage is a lien. If the borrower defaults on the loan, title is conveyed to the lender. Intermediate theory makes the mortgagee go through the foreclosure process before the property can be sold to repay the debt.