Page 1 - Financing Study Guide for the Real Estate License Exam
As a real estate agent working on straight commission, you don’t get paid until the transaction closes. To close the transaction, the buyers need to obtain the necessary funds to purchase their home. Very few people pay cash for real estate. Instead, buyers borrow money. Part of a real estate agent’s job is to help his or her client understand the different mortgages and types of lenders.
Big Terms and Ideas
This guide will cover the various mortgages a buyer can get, how mortgages work, and the primary and secondary markets for lending.
A mortgage is a voluntary lien placed on real estate by a lender in exchange for giving the borrower funds to buy the real estate. The borrower is called the mortgagor because they are giving the mortgage, and the lender is called the mortgagee because they are receiving the mortgage.
A note is the part of a mortgage that describes the terms and conditions of repaying the mortgage loan. Also known as a promissory note, lien note, or borrower’s note, the note describes the amount of the loan, the interest rate being paid, and the term of the loan.
Two types of title are legal and equitable. Legal title refers to the actual ownership of the real property. Equitable title refers to a person’s right to obtain full ownership of the property. Under title theory, the borrower/mortgagor retains equitable title and gives legal title to the lender/mortgagee until the loan is paid in full or the property is sold.
Lien theory means that the borrower/mortgagor keeps both legal and equitable title to the real property. The lender/mortgagee is given the right to place a lien on the property. Foreclosure by the lender under the lien theory takes longer because the borrower holds both legal and equitable title. The lender has to go through the court system to foreclose, get legal title, and sell the property.
FICO score is a credit rating used by almost all consumer lenders. It is used to measure the risk a lender is taking by making a loan to a borrower. FICO scores range from 300 to 850 and determine the interest rate a borrower will pay. A high credit score means low risk to the lender and a lower interest rate to the borrower. Credit reports from credit reporting agencies are used to calculate FICO scores.
Classification of Mortgage Loans
Just as with people, mortgages come in all shapes and sizes. There’s a mortgage available for any type of transaction. Your job as a real estate agent is to make your client aware of the choices.
Also known as Veterans Affairs mortgages, this type of loan is available to people who have served in the armed forces in war or peacetime, spouses of veterans, cadets in military academies, and employees of certain government agencies. The biggest benefits to a VA mortgage are a lower interest rate, $0 down payment required, and no mortgage insurance premium.
This type of loan is insured by the Federal Housing Administration. FHA loans can be a good choice for first-time homebuyers. The borrower can make a lower down payment—as low as 3.5%—and can ask the seller to pay for closing costs. FHA loans are easier to qualify for, but the borrower does have to pay an upfront mortgage insurance premium and also a monthly premium.
Unlike VA or FHA mortgages, a conventional mortgage is not guaranteed by the federal government. Because of this, there may be higher interest rates on a conventional mortgage and it may be a little harder to qualify for. Conventional mortgages come with fixed or adjustable interest rates and require a down payment of at least 3%.
A subprime mortgage is good for borrowers who can’t qualify for a conventional mortgage due to credit problems or low credit scores. This type of mortgage is also known as an ARM, or adjustable-rate mortgage. Although subprime mortgages have higher interest rates they can be a good way for a buyer to get into a home and build up their credit before refinancing.
Purchase Money Mortgage
Purchase money mortgages are also known as seller financing, seller carrybacks, or as a seller carrying the note. They are used in transactions where the buyer cannot qualify for a traditional mortgage, if the seller has a difficult property sale and a lot of equity, or if the seller wants to defer paying capital gains taxes.
Construction Loans and Permanent Mortgages
Construction loans are short-term loans with higher interest rates used to finance the building of a home or other property. Once the property is built, the owner uses a permanent mortgage to pay off the construction loan. Construction loans are also known as self-build loans.
Mortgage loans come in all shapes and sizes. Real estate agents should remember that there is literally a type of loan for any real estate transaction and needs of the buyer.
Term loan—Term loans can last anywhere from 1 to 30 years and have specific payment amounts that are paid on a specific schedule. Term loans can be short-term construction loans or business loans, VA or conventional mortgages, or subprime loans.
Amortizing loan—An amortizing loan is a term loan with fixed monthly payments made up of both principal and interest. The principal is paid off over the life of the loan, or amortized over the life of the loan. At the end of an amortized loan, the principal is paid in full and the mortgage is paid off.
Balloon payment loan—A balloon payment loan is one that is not fully amortized. This means that at the end of the term of a balloon payment loan there is a final big payment due—or a balloon that needs to be popped. This type of loan is often used in commercial real estate or purchase money mortgages.
First and Junior Mortgages
A first mortgage is a prior or senior loan. Junior mortgages are in second place to the first mortgage—or subordinate to it—and only get paid off after the first is paid in full. Because of this, junior mortgages usually have higher interest rates and shorter loan terms. If a borrower defaults, the first mortgage is first in line to be paid if the property is foreclosed on.
Home Equity Line of Credit
A home equity line of credit is a type of junior mortgage. Lenders will offer a home equity line of credit based on the difference between the mortgage balance and the fair market value of the home. Equity lines of credit can be used for things like making home repairs, installing a swimming pool, or paying off credit card debt. They are different from home equity loans in that the home equity credit amount is available but is not necessarily drawn on by the homeowner.
A budget mortgage combines principal, interest, property taxes, and insurance into one fixed monthly payment. VA loans, conventional loans, and subprime loans are all examples of budget mortgages. They’re convenient for the borrower because the same payment is made each month and also good for the lender because the taxes and insurance premium are being accrued monthly.
When someone sells a home fully furnished, the buyer will often use a package mortgage. This type of mortgage is secured by both the real estate and the personal property in the home. One of the drawbacks to a package mortgage is that the furnishings cannot be sold without the lender giving the OK because the furnishings are part of the loan collateral.
A chattel mortgage is a loan made on a movable piece of property. In real estate, a good example of a chattel mortgage is a loan made to purchase a mobile home and a lot. The mobile home is personal property—and personal property is also known as chattel. A car loan is another example of a type of chattel mortgage.
If a buyer purchases several pieces of real estate at the same time under a single loan, the buyer would use a blanket mortgage. It is more convenient than the buyer having to take out multiple loans for multiple properties. A real estate developer who buys a tract of vacant land and subdivides it into smaller lots would also use a blanket mortgage.
An open-end mortgage allows a borrower to add to the principal amount of the loan over a period of time. This type of mortgage combines features of a traditional loan and a home equity loan. A borrower buying a house with an open-end mortgage could borrow against the equity in the house by adding the equity amount to the original principal balance of the loan.
Flexible Payment Mortgage
A flexible payment mortgage is the opposite of a budget mortgage. With a flexible payment loan, the borrower can make different payment amounts each month. It is a good option for buyers who want to pay off their loan early if a traditional loan has a prepayment penalty. The drawback is, if the borrower consistently makes a lower payment each month, the mortgage will take longer to pay off and the borrower will end up paying more in interest.
A wraparound loan—also known as a wrap—wraps a new loan around an existing loan. For example, if a house was originally sold with seller financing, the current homeowner could sell the house to a new buyer without paying off the seller’s note. If this happens, the original seller note would move from being a First mortgage to a Junior or second-position mortgage.
A swing loan is used for short-term or emergency funding and usually has a term of less than 1 year. Swing loans are also known as bridge loans, gap financing, or interim financing. In real estate, a swing loan could be used by a buyer to purchase property and then refinance it with a conventional mortgage at a later date.
A bridge loan—also known as a swing loan or gap loan—is used to provide temporary financing until a buyer can qualify for a conventional loan. A bridge loan would be used if a seller is selling its current house and needs money to buy a new one before closing and getting the sales proceeds from the current house.
A gap loan—also known as a bridge loan, a swing loan, or gap financing—is a short-term loan used to provide funds between buying a second property and selling the first property. If a buyer finds a deal on a new home that is too good to be true, the buyer would use a gap loan to buy the new home while marketing the first home for sale.
Construction loans—also known as self-build loans—are short-term, higher interest rate loans used to finance the construction of a property. Once the property is built, the construction loan is paid off by selling the property or refinancing it with a conventional loan. Developers that build homes “on spec” usually use construction loan financing because they plan on selling the spec home quickly.
Home Equity Loan
A home equity loan is a type of junior or second position loan. If homeowners have a lot of equity built up in their property, they would take out a home equity loan to borrow against their equity. Home equity loans are different from home equity credit lines because, with the equity loan, the borrower gets all of the money upfront. Sometimes, borrowers have enough equity built up that they can use a home equity loan to help purchase another piece of property.
A land contract is another word for seller financing. A land contract can be used for any type of real estate, not just land. The idea behind a land contract is that, similar to traditional mortgages, the legal title to the property does not transfer to the buyer until the loan is paid in full.
If homeowners want to sell their home now but still live in the home until a later date, they would use a sale-leaseback agreement and pay rent to the new owner. Sale-leaseback agreements are good for real estate investors who want to buy property with immediate rental income, or for sellers who want to cash out and take their time looking for a new place to live.