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BEFORE THE GREAT DEPRESSION of the 1930s, most real estate loans were straight loans. Borrowers paid the interest in a lump sum at the end of each year. The principal was due at the end of the loan period, which could be as short as one to five years. It’s no surprise that many people lost their homes and farms through foreclosure during these hard times. Real estate financing changed dramatically after the Depression. President Franklin Roosevelt and his New Deal administration brought about amortized loans, Federal insurance for lenders, and established the secondary mortgage market.
Almost all real estate loans today are amortized loans, where the debt is repaid by means of a mortgage. The word “mortgage” is based on the Latin root “mortuus,” meaning death. This is an appropriate etymology, because mortgages allow the debt to be killed off gradually over time, usually a period of about 30 years, through a combination of principal and interest payments. The mortgagor is the borrower, who “kills” the debt. The mortgagee is the lender, whose loan is gradually “killed off.”
Mortgages offer fairly liberal repayment terms compared to the pre-Depression straight loans. At the beginning of the payment schedule the interest portion is large and the principal payments are small. Toward the end of the mortgage term it’s the other way around – the borrower’s payment includes mostly principal and very little interest. The payment formula is complicated, but can be easily computed using a hand-held financial calculator.
In about half of the states, including California, a mortgage is called a deed of trust or trust deed. The mortgagor (borrower) is called the trustor and the mortgagee (lender) is called the trustee. A deed of trust makes it easier for the lender to foreclose than a regular mortgage. Deeds of trust include a power of sale clause which allows non-judicial foreclosure in the event the borrower defaults. In other words, the lender doesn’t have to go to court to get the house back. The property can be sold at auction, called a trustee’s sale. A deed of trust also includes something called a reconveyance clause, in which the lender conveys title to the borrower when the loan has been repaid.
The Lending Vocabulary
Real estate loans include a variety of other legal concepts and a unique lending vocabulary. A promissory note is a promise to pay. It is negotiable, meaning it can be bought and sold. The promissory note includes a prepayment clause and an acceleration clause. The prepayment clause provides for payment of the loan before its due date. Sometimes a prepayment penalty is charged, usually a percentage of the loan amount. The acceleration clause provides for immediate repayment to the lender when the property is sold or demolished, or if the contract is breached in any way. In other words, it allows the lender to call the note.
A mortgage is the instrument which pledges the real estate as security (collateral) for the promissory note. In other words, if you don’t make your payments, the lender gets the house. The mortgage and promissory note act together. You can have a promissory note without a mortgage, but a mortgage without a promissory note has no meaning.
Hypothecation is a legal concept which allows you to put your house up as security for a real estate loan without actually surrendering it. You enjoy all the rights of possession and use and even have the right to sell. This is why people can say they own their house, when if fact they are buying it on the installment plan. Under the title theory of hypothecation the lender holds the legal title and the borrower owns the equitable title. Under the lien theory the borrower holds the legal title and the lender’s mortgage is a lien on the title. The granting clause either conveys title to the lender or creates a lien on the title, depending on which theory is used.
The defeasance clause states the mortgage is null and void when paid in full. A real estate loan can include a number of other optional elements and clauses. It can include covenants (promises) to pay taxes and insurance, to keep the property in good repair, prevent removal (buildings, timber, etc.) and allow re-entry of the lender to the premises for inspection.
The alienation clause, also called the “due on sale” clause, allows the lender to call the note if the borrower sells the property. An alienation clause prohibits a buyer from assuming the mortgage or third party lenders from assuming the debt with a wraparound mortgage. A subordination clause establishes who gets paid first in the event of foreclosure. The first mortgage, as the name implies, is in first position. Second mortgages and home equity lines of credit are usually in second and third position.
The Secondary Mortgage Market – Fannie, Freddy and Ginny
The modern secondary mortgage market emerged out of the Great Depression as part of the national effort to promote economic recovery. The first agency created by the government to help finance real estate was the Federal Housing Administration (FHA). Congress created FHA in 1934 to insure long-term self-amortizing loans. These new types of loans, called mortgages, helped make housing more affordable because buyers could make relatively low uniform monthly payments over a long period of time.
Congress created the Federal National Mortgage Association (FNMA) in 1938, better known as Fannie Mae, to buy these FHA-insured mortgages so lenders would have a steady supply of money to make more loans. Today, Fannie Mae buys mortgages from banks and other loan originators, exchanging them for mortgage-backed securities, which it guarantees. Fannie Mae has been a private, federally-chartered corporation since 1968. In fact, it is the largest corporation in the United States with $351 billion in assets (1997).
The Government National Mortgage Association (GNMA or Ginnie Mae) was created in 1968 when Congress split Fannie Mae into two organizations. Like Fannie Mae, Ginnie Mae purchases FHA, Veterans Administration (VA) and conventional loans. Unlike Fannie Mae, Ginnie Mae is a government agency and does not issue its own securities.
The Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) was created by Congress in 1970. Freddie Mac is a government agency which buys mostly conventional mortgages with funds which come from the sale of mortgage-backed securities.
These are the major players in the secondary mortgage market. There are also a wide variety of other organizations, institutions and private individuals who purchase mortgages and provide a steady flow of money for home loans.
The Primary Mortgage Market
The primary mortgage market consists of all the institutions and individuals who originate loans. The four main types of mortgage lenders today are savings and loans, commercial banks, mortgage companies and mortgage brokers. Private lenders can also be an important source for real estate loans.
Until recently, savings and loans (called S&Ls or thrifts), originated the majority of all residential loans. They fund these loans by using their depositors’ money, and also by selling the loans to Fannie Mae and Freddie Mac on the secondary mortgage market.
Commercial banks were the first mortgage lenders. Like S&Ls, they get money from their depositors. But, unlike S&Ls, commercial banks have traditionally focused on shorter term, higher interest loans such as business loans, construction loans and interim loans. In the 1990s commercial banks began doing more long-term residential loans.
Mortgage companies, also called mortgage bankers, became the largest source of residential real estate loans in the 1990s. They don’t get their money from depositors like S&Ls and commercial banks do. A mortgage banker is more of a middleman between home buyers and large investors such as insurance companies and pension funds. Mortgage companies also provide their services to commercial banks and S&Ls.
Licensed mortgage brokers, relative newcomers to the mortgage lending industry, now originate nearly half of all mortgage loans. The mortgage broker does not actually loan money, but takes the borrower’s application, processes it and attempts to find the best deal for the borrower from a pool of S&Ls, banks and mortgage companies they work with. Mortgage brokers may also order credit reports, real estate appraisals, home inspections and pest reports.
Private lenders who make cash loans secured by real estate to borrowers (typically with damaged credit) are called hard money lenders. These loans are usually short-term with high interest rates and balloon payments. They are often made by private investors through a mortgage broker. Private money can be an important source of funds for some borrowers, but there have been abuses by some lenders. Congress passed the Home Ownership and Equity Protection Act of 1994 to help protect borrowers from losing their homes by requiring private lenders to pay more consideration to the borrower’s ability to repay.
Other primary mortgage lenders include insurance companies, credit unions and even sellers.
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Chet Boddy, Real Estate Appraisal, Sales and Consulting
43300 LR Airport Road, #59, Little River, CA 95456
707-937-4011, office
707-937-4818, fax
chet@chetboddy.com
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Copyright © 2002 Chet Boddy, All Rights Reserved
Chet Boddy is a Certified General Real Estate Appraiser, Realtor“ and real estate consultant who has lived on the Mendocino Coast since 1976. Look for this and other real estate columns on Chet’s web site at www.chetboddy.com
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