Finance 27 Clock Hours

Table of Contents

Chapter Topic Major Areas Covered

Introduction

Chapter 1 Mortgages, of Trust Documents, Procedures, Security Chapter 2 Clauses, Types of Loans, Loan Typical Clauses, Variables Chapter 3 Government’s Role Truth in Lending, Fair Housing Chapter 4 Types of Buyers Buyers & Pre-Qualification Chapter 5 Investment & Taxation Buying & Selling Chapter 6 Short Sales, Loss Mitigation, Foreclosure Buying Short Sales, Loss Mitigation Chapter 7 Ten Techniques to be Aware of Chapter 8 Finance & Escrow Formulas Math, RESPA, and Settlement Chapter 9 Property Evaluation & Appraisal Market Value, Price, Cost Chapter 10 Escrow & and Settlement

Chapter 1

Lien and Title, Mortgage, and Promissory Note

Glossary

Acceleration Clause A clause that accelerates the payments so the full amount of principle and interest becomes due all at once

Adjustable- rate loan The rate of interest that is adjusted periodically according to changes in the cost of borrowing money

Agreement of Sale A type of seller financing where there is no note and the seller keeps legal title until paid in full.

Alienation Clause The same as a “due on sale” clause. This means the loan is not assumable without lender's approval

Amortization A method of repaying the principle and interest of a loan through periodic payments

APR Annual percentage rate. This is the computation of an accurate interest rate of interest figuring in all loan costs

Assignment of Rent Clause If the borrower defaults, the lender can collect the rent from income producing property

Buy Down The payment of additional money to reduce the rate of interest for the borrower

Call Clause A clause that specifies a certain date that the entire balance must be paid in full

Cash flow analysis A method used in qualifying for a VA loan, that determines how much money the borrower has left after expenses and taxes (residual income)

Certificate of No Defense A borrower’s statement of the balance owing on a loan

Contract for A type of seller financing where the seller holds legal title until paid in full

Conventional loan A loan that is not insured or guaranteed by government agencies

Deed of Trust A security instrument that is executed by a Trustor in favor of a beneficiary and is held by a trustee Deed of Reconveyance The instrument that is recorded to give public notice that payment has been made in full

Defeasance Clause A clause that releases the borrower at the end the mortgage

Deficiency Judgment When there is a foreclosure, this allows the lender to recover additional money from the borrower if the sale of the property was not enough to cover the debt

Discount Point A percentage of the loan charged as a fee by the lender to increase the yield on the loan

Discount Rate The rate of interest charged to member banks by the Federal Reserve District Banks

Equity of Redemption The right of the borrower to have a specific amount of time to pay all back payments, charges, fees, and redeem property before a foreclosure sale

Estoppels’ Certificate A borrowers statement of the balance of the loan amount that is owing

Fixed-rate loan A loan that has an unchanging rate of interest

Fully amortized loan The first part of each payment is interest with the balance applied to the principal, paid in level payments

Hypothecation The use of property as security for a loan without giving up possession

Installment Contract A type of seller financing paid in periodic installments

Index A reliable indicator of the present cost of borrowing money

Junior Mortgage A mortgage that is not in a first lien position

Land Contract A type of seller financing, like an installment contract

Loan-to-value ratio (LTV) Determining the amount the lender will loan using a percentage of the property's appraisal or sales price

Margin The amount of difference between the index value on an adjustable rate mortgage and the interest rate the borrower is actually charged.

MIP Premiums. A charge required for an FHA-insured loan.

Mortgage A pledge of property as security

Mortgagee The lender

Mortgagor The borrower

Negative amortization When payments are not sufficient to cover the interest, the unpaid interest that is added back to the loan balance

Non- A loan that does not meet the standards of underwriting in the major secondary market

Novation Substitution of a borrower, or substitution of the note

“Or More” Clause A clause which allows the borrower to make larger payments in advance without a pre-payment penalty

Origination Fee A lender's charge for originating, processing, and any administrative costs

Point One percent of the original loan amount

Power of Sale A clause that gives the mortgagee or trustee to sell the property in case of default

PMI Private Mortgage Insurance – this is an insurance policy that protects the lender when there is increased risk due to low down payment

Prepayment Penalty The amount of money charged as a penalty if the borrower pays off the loan in full before the end of the term

Prime Rate The interest rate that is charged by commercial banks to the highest rated lenders and customers

Purchase Money Mortgage Seller financing in the form of a mortgage

Redlining Illegal practice of refusing to make loans in a specific neighborhoods

Reduction Certificate The lender’s statement of the balance remaining on loan Residual income The amount of income a VA borrower has left after deducting monthly expenses and taxes

Satisfaction Piece An instrument that should be recorded to give public notice that a mortgage has been paid in full

Secondary financing A loan to help pay the down payment or closing costs of another loan

Short Sale The lender allows a property to be sold for less than the amount owed on a mortgage and takes a loss.

Subordination Agreement An agreement that allows for another lien to be put in a position higher than a lien that was recorded prior

Street Rate The average interest rate currently charged in an area

Trustee A neutral third party in a trust that holds legal title under a trust deed

Trustor The borrower under a trust deed. The borrower holds equitable title

Truth in Lending Federal legislation that requires disclosure to the borrower

Warehousing Packaging loans and holding them until they are sold to investors

Lien Theory and Title Theory Many western states are lien theory states. This means that the borrower pledges his/her property as security for the loan, but does not give up possession or legal title to the property. This process is called hypothecation. The mortgage or deed of trust creates a lien that is used as security until the promissory note is repaid, but it does not transfer title. The lender has only the right to foreclose the lien if the borrower defaults. The lien theory is used in most of the United States. The title theory is used in only a few states today. The states are called "title theory" states. In a title theory state, the mortgage or a deed of trust is still considered to be a transfer of legal title to the lender. This means the lender actually holds legal title to the property until the loan is paid in full. Legal title reverts to the owner/borrower, when the loan is repaid. There are very few differences between the foreclosure procedures in title theory states and lien theory states. Both mortgages and Deeds of Trust make the borrower's property the for the loan and both give lenders the power to foreclose if the debt is not paid. The most common documents used in real estate financing are the promissory note and a type of security instrument. The security instrument can be a mortgage or a deed of trust. The security instrument contains the granting clause using words such as "grant, convey, or sell. It also clearly indicates that this particular property is being pledged as security for the loan.

Mortgage The word "mortgage" is a generic term, for a legal document in which a borrower pledges property as security for a debt. The borrower is called the mortgagor and the lender is called the mortgagee. This can seem confusing at times because the meanings seem to be reversed. Use the old real estate rule to help remember the order of these words: --- Words that end in “OR” are the givers, the ones making the payments --- Words that end in “EE” are the receivers, the ones who receive the payments The “MORTGAGOR” is the person who makes/gives the pledge or promise, while the “MORTGAGEE” is the person who receives the payments. The mortgage is the pledge and the note, is the promise to pay the mortgage. They are considered to be “construed together”, which means as if they were one agreement. The note always has precedence over the mortgage if there is any discrepancy in the terms between the two instruments. The borrower should carefully read and understand the terms of the mortgage and note before signing. The mortgage has precedence if the note omits an alienation clause that was included in the mortgage. Although mortgages do not have to be recorded to be valid, recording is the only way the lender and borrower would know the lien exists. The lender should always record the note and the mortgage document immediately after the loan is made. If another person acquires an interest in the property without notice of the mortgage than the person would have priority over the mortgage. Recording gives notice to the world that the lien exists. When the mortgage has been fully repaid, the law requires that a satisfaction of mortgage is recorded and the note should be clearly marked "cancelled."

Lenders prefer the deed of trust because it is easier to foreclose if there is default. The period of time between notice of default and foreclosure is short, and there is no period for redemption. The purpose of the deed of trust is the same as the mortgage. Both are specific liens used to secure the note until the loan is paid in full. The deed of trust and the note are considered to be “construed together” as if they are one document. The mortgage involves two parties, the mortgagee and the mortgagor. But the deed of trust involves three, the Trustor (borrower), the beneficiary (lender) and a third party called the trustee. During the loan the Trustor holds equitable title. The trustee holds legal title to the property until the loan is paid in full and then executes and records a deed of release and reconveyance and the note is then cancelled. If the loan is not paid as agreed, the trustee's role is to handle the foreclosure. The deed of trust’s basic purpose is to establish the lender’s right to foreclose if necessary. For one reason or another, home buyers don’t read every last word on a loan document, but there are those rare occasions when you will encounter someone who reads every single word on every single page. But just as a caution, that intense reading is often followed by an intense series of questions from that home buyer. Usually, one question that arises is “what is a trustee and what are they doing on my deed of trust?” Probably the most critical issue with a trustee is that they possess the “power of sale.” This is a clause in the document that gives the mortgagee or trustee the right to sell the property in case of default. The deed of trust is a document that is filed in the public records, and it is basically the security behind the home buyer’s loan.

There are three parties listed on a deed of trust: • The Trustor or borrower • The Trustee, which is an entity that holds "bare or legal" title • The Beneficiary, which is the lender

The deed of trust characteristically identifies the following:

• Acceleration and alienation clauses • Inception and maturity date of the loan • Late fees • Legal description of the property being used as security for the mortgage • Legal procedures • Original loan amount • The parties involved • Provisions of the mortgage and requirements • Riders, if any, regarding such clauses as prepayment penalties or terms of an adjustable rate mortgage

A deed of trust contains a trustee --- a mortgage does not. So what exactly is a trustee? This is basically an independent third-party that represents neither the borrower nor the lender. Most generally, the trustee is the title company that holds the power of sale in case of a default. They also reconvey the property once the deed of trust has been paid in full. In the event of a default, it is usually the trustee that files the Notice of Default. In most instances, the trustee will rely on a Substitution of Trustee, wherein they substitute another trustee to handle the foreclosure issues. A 90-day period in the public records and then a 21-day publication period are required, after which the trustee can sell the property without any court proceedings. The borrower is given every opportunity during the 90-day filing period to redeem their property by making up all their back payments and paying any trustee fees. But once the property is sold by the trustee at a trustee’s sale, it is final and cannot be reversed.

Promissory Notes A promissory note is a written promise from the borrower (maker), to the lender (payee) to pay a loan under certain terms. The note documents the original loan amount, interest rate, if it's fixed or variable, amount of each payment, due dates, and the maturity date. The note will also outline any penalties or consequences of a breach or default, such as late charges, acceleration clauses, etc. The promissory note is secured by the deed of trust and is the evidence of the debt. There are five things to remember about promissory notes:

• The promissory note is a promise to pay, signed by the borrower in favor of the lender. • It contains the terms of the loan including the interest rate and payment obligations. • The promissory note is generally not recorded. • When the loan is paid, the promissory note is marked "paid in full" and returned to the borrower, along with a recorded Reconveyance Deed. • During the term of the loan, the lender retains the promissory note.

Where the buyer is concerned, they should review the following items before signing the deed of trust and the promissory note:

• Address of property • Interest rate (and the rider, if adjustable) • Payment amount • Prepayment penalties, if any • Principle balance of the loan • Spelling of trustors names

Review Lien Theory refers to the borrower pledging their property as security for the loan, but they do not relinquish possession or legal title to the property. The process is often referred to as hypothecation. The mortgage or deed of trust creates a lien that is used as security until the promissory note is repaid. The lender can only foreclose on the lien if the borrower defaults. The title theory is used in only a few states today. In a title theory state, the lender actually holds legal title to the property until the loan is paid in full. Legal title reverts to the owner/borrower, when the loan is repaid. The most common documents used in real estate financing are the promissory note and a type of security instrument such as a mortgage or a deed of trust. The word "mortgage" is a generic term, for a legal document in which a borrower pledges as security for a loan. The mortgage is the pledge and the note is the promise to pay the mortgage. The note always has precedence over the mortgage if there is any discrepancy in the terms between the two instruments. The borrower is referred to as the mortgagor, and the lender is referred to as the mortgagee. The purpose of the deed of trust is the same as the mortgage. Both are specific liens used to secure the note until the loan is paid in full. The deed of trust and the note are considered to be “construed together” or treated as if they are one document. The deed of trust is not really a deed, and a deed of trust does not transfer “title” to the trustee. It merely creates a lien during the term of the loan, and the Trustor keeps full title.

A deed of trust contains a trustee --- a mortgage does not. A trustee is an independent third-party that represents neither the borrower nor the lender, and is oftentimes the title company. In the event of a default, it is usually the trustee that files the Notice of Default. If a Notice of Default has been filed and foreclosure is imminent, the borrower can redeem their property by making up all their back payments and paying any trustee fees at any time during the 90-day filing period. This 90-day period is accompanied by a 21-day publication period. The trustee cannot sell the property until both of these periods have expired. A promissory note is a written promise from the borrower to the lender to pay back a loan under certain terms. The promissory note is secured by the deed of trust and is the evidence of the debt.

There are certain things that hold true with a promissory note. The promissory note is a promise to pay, signed by the borrower in favor of the lender. It contains the terms of the loan including the interest rate and payment obligations. The promissory note is generally not recorded. When the loan is paid, the promissory note is marked "paid in full" and returned to the borrower, along with a recorded Reconveyance Deed. During the term of the loan, the lender retains the promissory note.

Chapter 2 Clauses, Loans, and Variables

The following terminologies are typical finance clauses, types of loans, and various other terminologies that you may encounter within contracts. Please be sure that you are familiar with their meanings. Acceleration clause This is a clause that calls the total mortgage due upon default - can be triggered by failure to make loan payments as agreed in the note, or by breach of a provision in the security instrument, such as failure to pay property taxes.

Alienation clause (due-on-sale) Important clause, since the lender can call the entire balance due when borrower sells the property. It can make the debt non-assumable and eliminate the possibility of a new buyer taking over an existing loan without the lender’s approval. If there is no alienation clause, the loan can be assumed without the lender's approval.

Assume and Agree to Pay Same as above, but the purchaser has a personal liability to the lender. If there is a default, the buyer is liable to the lender but if the buyer can not or does not cure the default, the seller is liable for the payment.

Assumption Clause This clause can allow another person to take over the mortgage without the lender’s approval. If lender approval is required, and a new debtor assumes the mortgage, or the original contract is substituted with a new contract, it is called novation. If a purchaser assumes an existing loan and the seller requires novation, then the purchaser becomes the mortgagor and the original mortgagor is free of the loan. When this happens, the interest rate on the loan could be increased.

Call clause This clause basically means that the mortgage is called as being due after a specific time. For example, a mortgage that is amortized over 30 years, so that the payments would be lower, but the borrower must pay off the entire balance at the end of 10 years.

Deed of Reconveyance This type of dead basically releases the deed of trust lien, when the Trustor has paid the loan in full. The deed of reconveyance is recorded to clear the title.

Defeasance Clause Used in title theory states the defeasance secures the return of the borrower's title upon repayment. It has no purpose in lien theory states because title is not given up.

Late Payment Penalty If there are to any charges for late payments, they must be stated clearly in the documents. Courts will not enforce excessive late charges. Late charges are not considered interest so they are not deductible from income taxes.

Lock-in Clause A lock-in clause does not allow the borrower to pay off early so that the lender is not deprived of expected interest.

“Or More” Clause This clause is oftentimes written into the mortgage so as to allow the prepayment of the entire mortgage without penalty. Absence of this clause automatically creates a prepayment penalty. The clause should be placed in any contract after the payment amounts on a loan if the borrower has right to prepay the loan

Pledge Clause All security instruments must express the purpose of instrument and clearly state that the property is being pledged as security for the loan. This can also be called a mortgaging or the granting clause. The words "grant, convey, sell," may be used.

Power of sale Clause This clause permits the mortgagee or the trustee to place the property on sale in the event of default.

Prepayment Penalty This is a monetary penalty for paying off the mortgage prior to maturity date. If the promissory note says “payment of $500.00 or more” the words "or more" mean that a prepayment is allowed and there would be no penalty.

Priority of Financing Instruments The first to record has the highest priority. Because property can be used as security for more than one loan, from different lenders, the priority of the lien is established by the date of recording. This priority of loans is often referred to as a “first” mortgage, “second” mortgage and so on. The liens are not marked with numbers, so the priority depends on the date of recording. There is an exception if a subordination agreement appears in the records.

Prohibition of assignment This clause gives the mortgagee the right to sell without judicial procedure.

Satisfaction of Mortgage Release the mortgage lien. Lender delivers to the borrower after the loan is paid in full. The satisfaction is recorded to clear the title.

Statement of Balance Due The lender can provide a reduction certificate to show the exact amount still remaining on the debt. Sometimes the holder of the loan will wish to sell the loan to an investor. The investor could ask the borrower to give a statement of the balance owing. This statement is referred to as an Estoppel certificate.

Subordination Subordination clauses give certain liens lower priority than another lien that is to be recorded in the future. This is also used to give a higher priority position or “first” mortgage position to a lien even though it will be recorded after the first lien. The subordination clause is commonly used when a person borrows money to purchase unimproved land to build on. In order to get a construction loan to build a home, the construction loan must have a “first” mortgage, or lien position. However, there are potential problems if the seller “carries back a second”, to help a buyer. If the buyer to takes out loan and then defaults, or files for bankruptcy, the seller would be left with a huge debt on his/her own property. The seller must be made aware of the risk of being placed in a second position.

Subordination Clause A subordination clause states that a certain lien will have lower priority than another lien that will be executed in the future. This can be used to give a higher priority position or first lien position to a lien even though it will be recorded after the first lien. The subordination clause is commonly used when a person borrows money to purchase unimproved land. In order to get a construction loan to build a home, the construction loan must have a first lien position.

“Subject To” Clause When there is an alienation clause, the buyer could sell the property "subject to" the loan. When a buyer takes a property "subject to" an existing loan, he is actually under no definitive obligation to pay the loan but the property remains secured by the lien of the seller's original loan. The new buyer then risks losing the property to foreclosure if the original borrower defaults on the loan.

Types of Loans In addition to the various clauses and terminologies encountered in contracts, you also need to be familiar with the different types of financing, loans, and mortgages that exist. Listed below are the majority of these that you will generally encounter in your endeavors. Types of loans are determined by their specific terms. The specific terms will be contained in the mortgage, deed of trust or owner financed security instrument.

Amortized Loan Amortization is a method of repaying the principle and the interest of a loan through periodic payments over a specified length of time. An amortized loan makes it possible for the borrower to pay interest and principle in level payments. Each payment is the same amount each month, bi-weekly or annually, with the first part of the payment applied to the interest and the second part applied to the principle. Example: Sam has an amortized loan of loan of $90,000 at 9.5% interest, with a monthly payment of $756.77. Sam’s first month's payment will be divided into principle and interest as follows: Monthly payment $756.77 Paid on interest $712.50 Paid on principle $ 44.27

The second month, the principle will be $89,955.73. The original loan principle amount was $90,000. But $44.27 was paid to the principle last month. So the next month payment will be:

Monthly payment $756.77 Paid on interest $712.15 Paid on principal $ 44.62 Now the remaining principle is $89,911.11 This is an example of a 30-year loan. At the end of 30 years, the loan will be paid in full. This is figured as a fixed rate of interest so each loan payment will usually be the same.

Partially Amortized Loan There may be times that the purchaser will need the benefit of the level payments that a fully amortized loan can offer. But if the seller cannot or will not accept payment over many years as with the fully amortized loan, there are some alternatives that may satisfy both buyer and seller. Although these alternative loans are common when the seller is financing the property, lenders seldom use them for residential loans. The first is called the partially amortized loan. This loan has level payments that would pay off the loan in a certain number of years. But instead of making the payments until the loan is paid in full, the entire balance is payable on a certain date as a balloon payment. Some of each monthly payment is applied to the principle until the due date. Let’s say that the loan is amortized over 30 years, to keep payments low for the buyer. But the seller wants to be paid in full in no less than 5 years. Five years is not long enough to pay off the entire principle. Example: Karen borrows $85,000 from the lender at 10.25% with level payments of $761.69 per month. This loan is amortized as though it would be fully paid in 30 years (if this were a fully amortized loan). But, since this is a partially amortized loan, the principle balance will become due and payable in full at the end of 5 years. This means that Karen will make payments of $761.69 each month, but at the end of 5 years, she will make a final payment of $82,221.48. This is the amount of principle that will be due and payable.

Term Loan or “Interest Only” Loan This loan is also referred to as a “straight loan”. It is the payment of the interest only on a weekly, monthly or yearly basis. At the end of the term, the full principle amount of the loan becomes due and must be paid in full. The date of the end of the term is called the maturity date. Balloon loans of today originated from the term loan. The only difference between the interest only and the partially amortized loan is that no part of the monthly payment is applied to the principle. Example: Just as above, Karen borrows $85,000 from the lender at 10.25% with level payments of $761.69 per month. She has the same 30-year amortization and the principle balance will become due and payable in full at the end of 5 years. But this is an interest only loan, which means that at the end of 5 years, she will pay the entire principle balance of $85,000 in full. The monthly payments were the cost of borrowing the money and nothing was applied to the principle.

Negative Amortization When the level payments are not sufficient to cover the interest due, the shortage is added to the remaining principle. This makes the principle balance increase. This sometimes occurs because of a miscalculation of the monthly payment or if the interest rate is increased without a corresponding increase in the amortization. This results in a deficiency that is added back to the loan principle balance. Buyers and sellers must be made aware of any loan that is negatively amortized. Example: Karen took out the same loan of $85,000, but her monthly payment was set at $675. This will not cover any part of the principle, nor will it cover the interest on the loan. This means that each month the interest that was left unpaid would be added to the principle. At the end of 5 years Karen would owe MORE than $85,000.

Seller Financing The seller can provide the financing for a purchase using a security instrument called the land contract. This is also called an installment contract, , contract for deed, or contract of sale. The buyer normally pays a down payment in cash and asks the seller to "carry," or “carry back” a contract or note and deed of trust for the entire purchase price or a portion of the purchase price. The parties involved in an installment, or land contract are the vendor (the seller) and the vendee (the buyer). The vendee agrees to pay principal and interest in installments. The seller or vendor actually holds legal title until the balance has been paid in full. Many sellers use the "installment contract for deed”, because there is no transfer of title until the entire balance is paid. The buyer and seller must determine what will happen if the seller dies or becomes incapacitated during the term. The seller usually signs a deed naming the purchaser as grantee, and places it in escrow with instructions to deliver it to the purchaser when the contract has been paid in full. During the term of the loan, the purchaser, or vendee has equitable title, which means that the purchaser can assign the rights, pledge any interest and use the property. It is a common for a seller to finance his/her own property. This usually happens when the seller owns the property free and clear. If there is an underlying loan on the property, the seller usually remains solely responsible. One of the biggest advantages to the buyer is that an installment contract is an easy way to get financing. The seller does not require loan applications, loan expenses or the long wait of loan approval. Installment contract terms and interest rates are negotiated and often can be more favorable than the institutional lender. The seller has the advantage of holding the title until the final installment has been paid. The seller is the lender, so if there is a default in the payments, the seller/lender must follow state procedures in order to either collect the amount due or repossess the property. If the purchaser defaults, the contract is breached and if not cured the purchaser forfeits the property. This can be an advantage to the seller, if the seller is in first position. It is not true that a seller in “second” position can just take the property back if the buyer defaults and pick up the payments on the first loan. If the seller is carrying a “second” mortgage or deed of trust, the seller risks a loss of the balance owing and the property. If the buyer defaults on the first mortgage, it could be foreclosed. The seller would have to pay off the first mortgage or possibly lose everything. State law governs the of real property under default, and each state will vary. It is uncommon for a deficiency judgment to be allowed under an installment contract for deed, land contract, installment contract or agreement of sale.

Potential Problems with Seller Financing The seller can provide the financing for a purchase using a security instrument called the land contract. This is also called an installment contract, real estate contract, contract for deed, or contract of sale. The buyer normally pays a down payment in cash and asks the seller to "carry," or “carry back” a contract or note and deed of trust for the entire purchase price or a portion of the purchase price. The parties involved in an installment, or land contract are the vendor (the seller) and the vendee (the buyer). Remember what we said earlier regarding the difference between the words that end in “OR” versus the ones ending in “EE.” The vendee agrees to pay principal and interest in installments. The seller or vendor actually holds legal title until the balance has been paid in full. Many sellers use the "installment contract for deed”, because there is no transfer of title until the entire balance is paid. The buyer and seller must determine what will happen if the seller dies or becomes incapacitated during the term. The seller usually signs a deed naming the purchaser as grantee, and places it in escrow with instructions to deliver it to the purchaser when the contract has been paid in full.

During the term of the loan, the purchaser, (or vendee) has equitable title, which means that the purchaser can assign the rights, pledge any interest and use the property. It is common for a seller to finance his/her own property. This usually happens when the seller owns the property free and clear. If there is an underlying loan that still exists on the property, then the seller usually remains solely responsible. One of the biggest advantages to the buyer is that an installment contract is an easy way to get financing. The seller does not ordinarily require loan applications, loan expenses or the long wait of loan approval. Installment contract terms and interest rates are negotiated and often can be more favorable than the institutional lender. The seller has the advantage of holding the title until the final installment has been paid. Since the seller is considered to be the lender, the seller/lender must also follow state procedures in order to either collect the amount due or repossess the property should the buyer default on their payments. If the purchaser defaults, the contract is breached and if not cured the purchaser forfeits the property. If the seller is in the first position, this gives them a definite advantage. However, there are potential problems if the seller “carries back a second” to help a buyer. It is not true that a seller in “second” position can just pick up the payments on the first loan and take the property back if the buyer defaults. If the seller is carrying a “second” mortgage or deed of trust, the seller risks a loss of the balance owing and the property. If the buyer takes out a loan and then defaults, or files for bankruptcy, the loan could be foreclosed and the seller would be left with a huge debt on his/her own property. The seller would have to pay off the first mortgage or possibly lose everything. “Equity skimming” is a well-known scheme that takes advantage of seller financing. The buyer offers to purchase the property, sometimes at an inflated price, but there is a very real danger in the scheme. The buyer most often does not have strong credit or verifiable income, so he/she would need a large down payment. Many lenders will make “no income verifier” loans when there is a large difference between the value of the property and the loan amount. This buyer usually does not have a down payment, so he/she persuades the seller to loan the purchaser an amount of money from the equity at the closing of the sale, to use as a down payment. Often the buyer will ask for additional money, supposedly to make improvements to the home and property. The buyer may convince the seller that the improvements will give the seller more security because it will become more valuable. However, the buyer now has much of the equity from the sale. Sometimes the buyer will resell the property, but will not apply any of the proceeds to the second contract being held by the seller. If this is actually an “equity skimming” scheme, the buyer does not make any payments on the new loan. And should this transpire, the loan will be foreclosed. The seller would not be paid, because they hold a second contract behind the new loan. The only way for the seller to protect their loan would be to pay off the entire first loan. However, this is usually not beneficial because the property was purchased at an inflated price. There are many variations of “equity skimming” schemes, but in general they all put the seller an increased risk. It is good practice to be aware of these schemes. Although there are cases where these arrangements work out for both buyer and seller, the seller must be made aware of the risk of being placed in a second position.

Types of Mortgages The following information sheds a little light on the different types of mortgages that exist and may be encountered based on scenarios depicted by the examples listed.

Purchase Money Mortgage A purchase money mortgage could mean any loan to purchase property that gives the lender a mortgage on the property as security. Bob goes to the bank and borrows $95,000 to buy a . He gives the lender a mortgage on the house for $95,000. More commonly, "purchase money mortgage,” means a mortgage from the buyer to a seller, in a seller-financed transaction. Much like a land contract, the buyer pays a down payment, and then the buyer gives the seller a mortgage on the property and pays the entire amount in installments. The seller can give the same terms of credit to the buyer as under a contract, and can hold the legal title until the buyer has paid the balance in full. Example: Barbara buys a house from Fred for $100,000. She pays $20,000 down and signs a note and purchase money mortgage in favor of the seller for the $80,000 balance. Barbara will make monthly installments at 9.5% interest over the next 20 years. The purchase money mortgage is a “soft money” loan, meaning the borrower is given credit rather than cash. A “hard money” loan is when a borrower gives the lender a mortgage and is given cash, rather than credit. The purchase money mortgage is a pledge of the property as security and the note is a promise to pay the debt. If default occurs the seller must follow the regulations for foreclosure under a mortgage, which means that the redemption period of a mortgage will apply. Although the normal mortgage permits a deficiency judgment, a purchase money mortgage has an anti-deficiency judgment clause. The seller cannot sue for any additional amount if the value of the property is not enough to cover the balance owing. However, a “second” position mortgagee is allowed to pursue a deficiency.

Blanket Mortgage A blanket mortgage is one mortgage that covers two or more parcels of real estate as security at the same time. This is often used when a buyer invests in several lots in a subdivision for the purpose of development. Rather than separate loans on each parcel the builder can secure the loan on the lots as a group. However, the blanket mortgage can also be used to purchase one property using more than one parcel of real estate as security for the loan. This type of loan typically has a clause that allows for the release of lien on the individual lots, or lot releases, as they are sold or the release of the lien on a secured parcel as the debt is reduced. Wording of the release clause is particularly important to a developer of many lots. The terms will usually establish a schedule that allows the lender to charge more for the release each lot than each lot actually sold for. This is because not all lots have same value and the better lots tend to sell first. This enables the lender to protect the investment by having more security on the remaining lots so that the entire balance owing will be paid in full before last lot is sold. Example: Donna bought thirty building lots and borrowed the money giving a single mortgage for $ 750,000 as security. She begins building and selling the homes. The lot price is $25,000 each. The terms of the loan allow for the release of each lot with each payment she makes of $31,250. This is a .

Lot Release Lot releases require a payment of more than 100% of the value of the released parcel. As in the example above, a blanket mortgage covering thirty lots totaling $750,000, may contain a release clause requiring a payment of $31,250 for each lots release. If the amount were calculated evenly each lot would be released for $25,000. But to provide the lender security it is common to require at least 125 % of the actual value to be paid before release. Lot release clauses are not the same as subordination agreements. Rather than allowing a priority over another lien, the lot release actually removes the lien from the parcel.

Wraparound Mortgage / Deed of Trust Wraparound mortgages are often used when a buyer cannot qualify for a new loan, and by lenders that hold loans on property. It is important that the terms of the wraparound clearly state that one person will make both payments at the same time. If the person responsible for making the underlying mortgage payment does not perform, a default and/or foreclosure will result. In 1982, the Garn Act was passed, which made “due on sale” clauses enforceable. It is extremely important to make sure that the underlying mortgage does not contain an alienation clause before entering into a . The purchaser will often offer the seller more money or other incentives for accepting the wraparound mortgage because the seller gives up al or some of the cash at closing and must take the risk that the purchaser will not default. However, the seller can benefit by receiving extra interest on both the underlying and the carry back portion. Example: Don is selling his home for $150,000 and he owes $60,000 on his existing mortgage with an interest rate of 7%. Brittany wants to buy Don’s home but she cannot qualify for a new loan because of a lack of credit. Brittany offers to give Don $30,000 in cash, if he will agree to a wraparound mortgage in the amount of $120,000. She is paying the full price of $150,000 by giving Don $30,000 in cash, $60,000 by including the existing contract amount, and the balance of $$60,000 as the carry back portion. Brittany will be paying 10% on $120,000. Don will still be responsible for paying the monthly payments on the $60,000 mortgage, but it’s at only 7%. Don will make 3% interest on his existing mortgage from Brittany’s payments and the full 10% from his carry back portion. The extra interest that Don will collect on his existing mortgage is called Arbitrage. Arbitrage results from the difference between two interest rates. For example, if a person borrows money at 8% and loans it to someone else at 12%, the income that results between the two interest rates is called arbitrage.

Graduated Mortgages

Growing Equity Mortgage – GEM This is a mortgage that combines a fixed interest rate with annually increasing monthly payments that allows the borrower to pay off the principle in much less time than a regular amortized loan. This is because the increases are applied directly to the principle building the home’s equity at a faster rate. The payments can increase according to a mutually agreeable schedule or they can be based on an index.

Graduated Payment Mortgage –GPM Graduated Payment Mortgages are amortized loans with monthly payments that are very low at the beginning of the loan. This is a way for younger borrowers who have just begun professional careers and expect their income to substantially increase in the future, to purchase a more expensive home. A graduated payment loan interest rate can be either fixed or adjustable and most require a type of budget payments. The FHA 245 loan has the advantage of payments that start lower than the level payment of an amortized loan. The rate of interest, graduation and the term of the graduation periods are fixed for the life of the loan. The first years of the loan have payments that are lower than fixed payment loans. The borrower should be aware that these payments are often so low that negative amortization results. This means if the borrower sells the home during the period of making lower payments, the balance owing on the loan could have increased.

Adjustable Rate Mortgage-ARM The rate of interest on the adjustable-rate mortgage is determined by changes in a floating index. The rate is adjusted at specific periods according to those changes. When the rates increase rapidly negative amortization can result because the payments start out low. If rates continue to increase after the initial period, the borrower has the risk that the payments will increase. However, if the rates decrease, so will the monthly payments. VA also offers a graduated payment loan program, which closely resembles the FHA 245 graduated payment loan.

General Consumer Protection Guidelines A readily available index that is beyond the control of the lender must be used. The ARM will be quoted at a starting interest rate, which is often lower than the street rate. The index is used to measure the increase or decrease of the interest on the payment on the adjustment dates. The starting rate is adjusted according to the terms of the mortgage. If the index increases, the borrower's payment increases. If the index goes down so does the borrowers payment. The index must be beyond the control of the lender. Although most plans call for changes once a year, interest rates can be changed as often as the lender and borrower agree upon. The margin, which may be added to the index rate to adjust the loan's interest rate, must be stated in the mortgage. Margins range from 2% to 3.5%. How often this adjustment may occur is governed by the adjustment period. No overall interest rate or payment caps over the life of the loan are required, but the 6% lifetime cap is commonly used and a 2% annual interest cap is the most common. The term cap means to stop or limit something. This can be a “periodic” cap, which limits the increase or decrease of the interest rate within the adjustment period. It can also be a “life of loan” cap, which means the interest rate has a specific limit no matter how high the index becomes. A common life of loan cap is 6% interest. Payment caps limit the amount of the payment. This is often used to make it appear that the borrower is getting a real bargain. Because the monthly payment is limited to a certain percentage of increase, the margin and adjustment periods can raise the amount needed to cover the interest payment, which results in negative amortization. There may be no prepayment penalty or fees charged for adjusting the payments. The borrower may refinance the ARM (to a fixed or an ARM) without penalty. The lender must notify the borrower at least 30 days prior to any change in the borrower's payment. While lenders are discouraged from offering huge discounts as an attraction, the lender can charge the borrower any interest rate that they both agree on during the initial adjustment period. Lenders may qualify the borrower using the first year mortgage payment with a 20% down payment. If the down payment is less than 20%, the borrower must qualify for the interest rate of the first adjustment payment. The lender must give the borrower a complete disclosure of all terms of the adjustable rate mortgage. Once the initial adjustment period is over, most lenders allow the borrower to convert to a fixed rate.

The following is an example of an Adjustable Rate Mortgage and assumes a beginning interest rate of 8.25%. Beginning interest rate 8.25% Margin 2.00% Lifetime cap 5.00% Adjustment period 1year

1st year Index is 8.25% Margin is 2.00% Interest rate is 10.25% 2nd year adjustment: Index is 7.00 % Margin is 2.00% Adjusted interest rate is 9.00%

3rd year adjustment: Index is 8.50% Margin is 2.00% Adjusted interest rate is 10.50%

4th year adjustment Index drops to 9.25% Margin is 2.00% Adjusted interest rate is 11.25%

5th year adjustment: Index rises to 11.00% Margin is 2.00% Adjusted interest rate is 12.75% (2.00% cap)

The Lifetime Cap of 5.00% means that the interest rate will never be over 13.25%. (8.25% + 5.00 % = 13.25% cap)

Personal Line of Credit The personal line of credit is a revolving credit loan that is secured by the borrower’s home, credit cards, or other security. Borrowers can use the money for any purpose desired at relatively low interest rates. The loan is based on the borrower's ability to repay as well as the amount of equity. The line of credit will be a percentage (usually 75%) of the appraised value of the home minus the balance owed on the existing mortgage. The lender also will set a fixed period of time that the borrower can use the money without renewal. The lender can then renew or terminate the credit line. Some lines of credit are repaid in periodic payments, balloon payments or a clause calling for the entire amount on a certain date. Lenders can require a minimum amount of each draw, minimum outstanding balance or an initial advance when the line of credit is set up. These types of loans are usually at variable interest rates, rather than fixed rates.

Open End Mortgage The open-end mortgage is much like a line of credit at a bank that is available to be continuously used and repaid up to a maximum limit. This allows the borrower a pre-approved arrangement to use a certain amount of the lender’s money. Example: Roxanne has an open end mortgage at World Bank for $100,000. She borrows $45,000 to purchase a fixer home, leaving credit of $55,000 available. She remodels the fixer home with her own money and sells it for $70,000. Roxanne pays the bank $45,000, plus interest for the time it was used, and now has $100,000 available credit. As long as her record of repayment is good, the open end will allow additional borrowing to take place. The open-end mortgage can be written to allow the same interest rate as the original mortgage or can contain a re-negotiation clause to allow a change of interest rate.

Construction Loan Construction loans are intended to finance the cost of building a home or the development of a subdivision or other project. Like the open end mortgage, the lender and borrower establish the total amount of money that will be made available on the line of credit as well as how much money can be drawn against the credit line for each phase of building. As the development progresses, the costs are paid by draws from the total loan amount. Obligatory advances are payments that the bank is obliged to provide at specific stages throughout the building process. However, the borrower does not make regular payments on the loan. Instead, construction loans are usually non-amortized, short-term loans which require only the periodic payment of accrued interest which is typically at a higher rate of interest. These loans are to be paid in full at a preset maturity date. Interest is computed and paid only on the amount of money that has been drawn out rather than on the entire amount of available credit. Most lenders will require the borrower to qualify for a takeout loan which will be the permanent financing that will completely pay off the construction loan at the project’s completion. The lender may also provide an interim loan to carry the property until permanent financing is arranged.

Permanent or Take Out Loans The permanent loan is a fixed rate or variable interest rate loan made to purchase the home. When the builder completes the home, the builder can "take out" a new loan, amortized over a long period, with a good interest rate, to help attract a buyer. But most often the borrower will apply for permanent financing through the lender. Reverse Mortgage The reverse mortgage, also called the reverse annuity mortgage, can be beneficial to people over 62 years of age with mortgages that are nearly paid off. The lender and borrower can enter into an agreement in which the lender gives back the money in equal installments that was paid by the borrower to reduce the principal. Unlike the open-end mortgage, which is made in lump sums, the reverse mortgage is distributed in regular monthly payments like the payments the mortgagor made to the lender. This type of loan is not designed, to help a person to acquire real estate, but to enable the older person who already owns real estate, to convert some of the existing equity into cash. Equity is the cash value difference between the property's present market value minus all liens, mortgages and other . Instead of reducing the balance it now increases while providing the borrower with additional income to use as desired. The reverse mortgage has been a helpful resource for those over the age of 62, by allowing them to use the equity in their property. The unpaid balance of this type of loan is repaid if the property is sold, or when the mortgagor dies. During the term of the reverse mortgage, there is no obligation to pay any principal, interest or other fees. These payments may be used to supplement the person’s income, or any other use. Eligibility is based on the borrower's age, amount of equity and the interest rate charged.

FHA VA & Conventional Loans The residential real estate market has traditionally offered three basic types of loans. These are FHA, VA and conventional loans. However, there are now many different versions of these loans making it necessary for the real estate professionals to have knowledge and understanding of all types of mortgages. The lending institutions will explain these different loan services to the customer, but the agent must be able to advise the borrower of the choices that are most advantageous for their situation. FHA and VA loans provide government protection for the lender against a major loss if the borrower defaults. Although they don’t loan money to the borrower, they do guarantee or insure the loans made by private lenders. Conventional loans are loans that are not federally insured or guaranteed. Because there is not as much government regulation, the lender has more freedom to set lending policies that are subject only to the limitations of the lender's business charter and the laws of the state.

FHA In 1934 The Federal Housing Administration was founded to stimulate new construction and employment, by insuring lenders against losses on new and existing home loans. FHA protected itself as well as the lender by requiring the loans to be amortized over 20 years with the maximum term currently set at 30 years or 40 years for multifamily housing. FHA insured loans require the use of an amortized budget payment loan schedule and require an impound account for taxes and insurance premiums. Payments are usually made monthly. Authorized appraisers must also inspect the homes, and the ability of the borrower to repay the loan must be investigated. FHA encourages lenders to make loans that they might not otherwise be interested in making. Example: Lester borrowed $56,000 on an FHA loan from the bank to buy a home. Lester lived in the home and made payments for 11 years. He then lost his job and defaulted on the loan. Lester still owed $48,000 but at the foreclosure sale the property brought only $45,000. FHA insurance paid the lender the $3,000 loss claim. FHA charged the borrower for insurance to cover the entire loan. This charge is called mortgage insurance premium, or MIP. The buyer can pay the entire MIP premium at closing or finance the premium in the loan amount. If this charge is to be financed it could affect the borrower’s ability to qualify because this would increase the monthly payments. The formula to calculate MIP is by multiplying the amount of the loan by .03661 if MIP is paid at closing or by .03800 if MIP is financed. Down payments for the standard FHA 203b loan are minimal, allowing the buyer to purchase a home without a large amount of cash. In 1992, HUD allowed FHA loan applicants to finance up to 100 % of closing costs eliminating a limit of only 57 % that was in effect since July 1991and also announced the new maximum FHA loan limit. The limit was changed to become 95 % of a city’s median home price, or 75 % of the maximum loan amount allowed by and , whichever was lower. The down payment formula changed to 3 percent of the first $25,000 of the loan amount, then 5 % of the amount between $25,001 and $125,000 and 10 percent of the loan amount above $125,000, but many areas have maximum loan limits lower than $125,000. The maximum loan amount cannot exceed the FHA insurance limit unless the buyer will pay the difference in cash. The purchaser may not legally borrow any of the cash needed to close the sale. A junior loan may be added after origination but it will not be covered under the FHA policy. The maximum amount of FHA insurance is determined nationally by Congress but it is locally adjusted by the FHA based local market conditions. The down payments on the graduated payment loans (FHA 245) are higher. One of the requirements of approval for loans insured by FHA or guaranteed by the Veteran's Administration is for the property to be inspected by a qualified appraiser. The appraisal is made for FHA loan insurance purposes, so they tend to report a different value than a true market value appraisal. Provided that the sale price or the appraised value is below the FHA insurance limit, the lower amount will be the maximum amount that FHA will insure. The FHA 203b is the most widely used loan. FHA programs also include: • 245A and 245B • GEM • FHA ARM • FHA 234c for • FHA 221d for rehabilitation • FHA 203K, a variation of the 221d • FHA PLAM (Price Level Adjusted Mortgage) Until December 1990, FHA loans were made to investors as well as owner occupants, but at that time investor FHA loans and assumptions were discontinued. FHA Title II insured loans are used to purchase residential . FHA Title I loan is available to make repairs and improvements on existing homes and construct other types of buildings. Title III was originally designed to create the secondary mortgage market but has since been eliminated. In 1988, the management of HUD’s programs was challenged because of numerous resulting from default. This challenge brought about a movement in 1989 to overhaul HUD policies. Until recently, FHA loans did not allow the buyer to pay any part of the discount points and required the federal government to dictate the interest rate on the loans. Since late 1983, the FHA has allowed the interest rate to float with the market. The borrower and lender negotiate and lock in the interest rate at the time of loan application.

Discount Points Lenders make money by charging interest, fees and discount points to borrowers. Discount points are fees charged by most lenders to increase their financial yield or profit, on a loan. Lenders charge interest to borrowers on the principal during the entire term of the loan, plus they can charge points on the face value of the loan, which is paid up front. As a result, the lender is willing to "discount" the loan, which really means that the lender will charge a lower interest rate. Because the borrower pays the lender a lump sum at closing the borrower gets the advantage of a lower interest rate that translates into a lower monthly payment. In 1983, FHA ruled that either the buyer or the seller as negotiated could pay discount points. Prior to this, only the seller could pay this cost, making it less appealing to sell on FHA terms. The purchase agreement should clearly state whether seller or buyer would be responsible for paying the discount points. This amount can be paid in cash at closing, or it can be financed into the loan. One point equals one percent of the mortgage face amount. Example: One point on an $80,000 loan is $800. On a loan of $80,000, if the lender charges 1 point, the charge will be $800. But over the life of the loan this extra charge will increase the income to the lender by roughly 1/8 – 1/6 of 1 % of the loan, making the interest rate higher. By charging discount points, the lender increases the effective interest rate and increases the profit, or yield. Loan discounts are usually paid at the time the loan is originated, but they can also occur if the note is sold to an investor. Most often the discount is collected in cash at closing or it is deducted from the loan proceeds. Example: Doreen borrows $85,000 at 8% interest for 30 years from Country Bank. Country Bank charges her 2 discount points that she must pay at closing. Doreen does not have cash to pay the points in cash, so she has it deducted from the loan proceeds. $85,000 x .02 = $ 1,700. The lender keeps $1,700. $85,000 - $ 1,700 = $83,300. But the borrower pays back $85,000. The borrower is signing a note to pay back more money than the actual cash advanced by the lender. The seller will pay back $85,000, although the lender already took $1,700 of it. The balance owing is not $83,300. It is still $85,000. Formula: Loan amount x % of discount = $ amount of points charged. Borrower pays back original amount, not the discounted amount. The lender makes additional income from the loan, which increases the yield.

VA Discount Points As of 1992, the VA deregulated interest rates. This means that like an FHA or conventional loan, the interest rate is a floating rate that is not set by VA policy. Either the borrower or the seller can now pay the discount points.

Conventional Discount points Conventional loans are not under any legal regulations that limit the points the lender can charge, but nearly all conventional loans are charged one or two points of the face amount of the loan. Competition to make loans is the biggest influence over the amount of points charged. Not all loans are charged discount points, but they have become increasing popular. As an estimate, it could take about 6-8 discount points to increase the lender's yield on a 30-year loan by 1%. This means that if the lender wants to offer an interest rate that is 1% below market the lender might charge 6-8 points to make up the potential loss. This is only a ballpark estimate and should not be used as a rule. This type of discount point is called a “buydown”. Buydowns reduce the interest rate so a seller, builder, or the buyer may pay the additional points at closing to lower the interest rate for a period of time. The buy-down can be permanent or temporary. Permanent buy-downs allow the borrower to pay a lower interest rate and lower the monthly payment for the duration of the loan. Temporary buy-downs lower the interest rate and monthly payment, but only during a few years. A temporary buy-down is similar to a graduated mortgage payment, because it works well for borrowers that expect to be able to afford a higher payment but need a little more time to get their career established. When the seller pays buy downs it can mean that the price of the home was increased to cushion the cost, or that the seller simply wants to add an incentive for a buyer to buy their home. The seller may also be willing to pay discount points on the buyer's loan in order to help the buyer qualify for financing. Example: Rod is buying a home from Kate. His sale is contingent on obtaining financing. Rod has been pre-qualified for the loan amount of 87,000 at 10% interest over 30 years. The lender’s interest rate is 11%. At this rate of interest, Rod cannot qualify for the loan. Kate wants the house sold, so she offers to “buy down” the interest rate to 10% so that Rod will qualify. It takes 8 points to reduce the rate by one point. She offers to pay points and the lender agrees to lower the rate to 10%.

Loan Origination Fees The loan origination fee, service fee, or loan fee is the amount paid for originating the loan, administration and processing of the loan. This fee is typically 1 % of the loan amount and is usually paid for by the borrower. The origination fee is charged in virtually every residential loan transaction and is considered to be a closing cost that is paid at closing. Example: Sandra borrows $150,000. The lender charges an origination fee of 1.75% of the loan amount. Sandra will pay $2,600 in origination fees to the lender at closing. The term “discount” is also used to describe a reduction in value when selling a note. A note with a face value of $15,000 and an interest rate of 10% over five years might be “discounted” to $12,000 so that it can be sold for cash to an investor.

VA In 1944 the Veterans Administration guaranteed financing to encourage lenders to make loans to help World War II veterans buy homes. The United States Congress enacted the "Servicemen's Readjustment Act”, also called the GI Bill. Congressional legislation has been updated several times to include veterans of more recent conflicts. These loans have a government-backed guarantee with easy loan qualification, low interest rates and, as low as a zero down payment. To be eligible for a VA loan, the veteran must have a certificate of eligibility. Eligible veterans include: • Persons in active duty for a minimum 181 days • Honorably discharged veterans that served in certain war times • Unmarried spouse of veteran whose death was service connected • Spouse of a veteran listed as missing in action or a prisoner of war for 90 or more days In 1992, the VA included those that served at least 6 years in the Reserves or National Guard, however, they are charged a higher funding fee and eligibility is to expire seven years from 1992. The veteran should contact any regional VA office to determine if he or she is eligible. The entitlement is good until it has been used but it can be reinstated if the original loan is fully paid, or if the new purchaser is also an eligible veteran with unused entitlement rights and assumes the loan which would release the original veteran. VA loans are made to veterans to buy single family homes, manufactured homes and lots, residential condo units, or new construction homes. However, if the home is less than one year old, it must meet the current VA standards for construction. New construction requires the builder to furnish the veteran with specific warranties as to the construction. They are also for remodeling, repairs, alteration or making improvements to a home, or improving a manufactured home or the lot for the home. Refinance loans are limited to $144,000 and may be used to refinance an existing home. The VA almost never directly loans money to the purchaser. It gives the lender a government guarantee against a loss caused if the veteran defaults. When a veteran defaults and the property is sold at foreclosure, VA will pay the lender’s loss if the proceeds are insufficient to cover the loan balance and expenses. Formula: Guarantee limits = 60% x original loan or $46,500, whichever is less. The limits of the guarantee change from time to time. Example of the VA loan guarantee: Andrew, an eligible veteran borrowed $75,000 to buy a home under a VA loan. After eight years of making payments he defaulted on the loan. At the time of default the loan balance was $69,000. The property was sold at a public auction foreclosure sale under market value for only $59,000. The lender's entire loss would be covered by the VA guarantee because 60% x $75,000= $45,000 But $59,000 minus $45,000= $14,000 loss. Either the 60% or the lump sum of $46,500 is enough to cover the loss. FHA insures the whole loan amount, but the VA guarantees only the top portion of a loan. Currently, the maximum amount of guarantee available on a VA loan is $46,000. This is also the maximum eligibility available, but eligibility limit has little to do with the loan amount. The $46,000 certificate of eligibility allows a veteran to buy a home up to $184,000 with nothing down. There is no actual maximum loan amount set by the VA. However, lenders can set a limit on the loans that they originate. The maximum loan amount is based on the veteran's ability to repay the loan and the CRV appraised value of the property. VA guaranteed loans are currently set at 30 years for city properties or 40 years for rural homes. There is no prepayment penalty on VA loans at this time, so they can be paid off in whole or in part at any time. VA loans use a monthly amortization budget payment that include a reserve or impound account. An amount of money is included in each payment for taxes and insurance and it is held in this account until they become due. They are then automatically paid from the reserve (impound) account. This protects the lender from foreclosure due to non-payment of taxes or losses from non- payment of insurance. The CRV or Certificate of Reasonable Value is the VA appraisal. A VA approved appraiser must complete the appraisal. The VA will accept an appraisal that was done by an FHA approved appraiser. Much like the FHA appraisal, the CRV is not an actual market value appraisal more like an opinion of the property’s condition and current market value trends. If work is required, the repairs must be as a condition of the VA loan. The seller usually pays for any work requirements up to a certain dollar amount as stated in the purchase agreement. If the sales price is higher than the appraised value, the veteran may withdraw, and receive a full refund of the earnest money or down payment. However, the veteran may still go through with the sale if the seller is willing to lower the selling price to equal the CRV, or by the veteran paying the difference in cash. Although VA does not normally lend money directly to the veteran, there is an exception available to the disabled veteran for the purchase of a specially adapted home. Conventional A conventional loan is any loan that is not insured by FHA or guaranteed by the VA. This gives conventional loans more flexibility in finance policies, such as loan terms and conditions. There is no set maximum loan amount. The lender usually determines the maximum loan amount based on the appraised value and the borrower's financial strength. The maximum terms are often set by the lender’s charter or state law and are often as long as 30 years or more. With no government insurance or guarantee, a conventional loan has a higher risk and usually requires a larger down. A typical down payment would be 10-25% down. However, the “loan to value ratio” (LVR) can be as high as 95 percent. The payment of private mortgage insurance “PMI” by the borrower is an insurance policy for the lender. This private mortgage insurance has the same purpose as the FHA mortgage insurance (MIP). The payment of PMI buys insurance to the lender if there is a deficiency after the property is sold at a public foreclosure auction. Sometimes the lender will allow the PMI to be canceled when loan balance is less than w 80 percent LVR. Although most conventional loans are amortized with monthly payments on the principal and interest, others may require budget payments that include taxes and insurance paid from an impound or reserve account. This further protects the lender by making sure that the property is not foreclosed due to non- payment of taxes or loss from non-payment of insurance. The loan application is subject to an appraisal. If the purchase price is higher than the appraised value, the lower figure is used in computing the LVR. Effective July 1, 1991, real estate appraisals for "federally related transactions" must be done by appraisers that are certified or licensed by the state. All FHA, VA or government-backed or assisted loans, and all loans that will be sold to FNMA, GNMA, FHLMC or any federally controlled secondary market, and any lender that makes over $1 million dollars in residential loans per year is “Federally related”. This description includes virtually every type of loan. Conventional loans are seldom assumable and most do not have any prepayment penalty. "Loan origination" or "service" fees, are usually one to four points and can be paid by the buyer or seller. It is always wise to question “suspicious” fees such as “doc fees”, meaning document preparation, or loan processing, warehousing or underwriting review fees. Many lenders will remove the fees if the borrower complains.

Qualifying For a Loan The agent can help to get the loan processed quickly by letting the borrower know what the lender will need. The lender will require certain information concerning the applicant such as: 1. Social Security number 2. Borrowers addresses (last seven years) 3. Rental history including name of (s). 4. Employers (last two years) 5. Dates of employment. 6. Gross monthly income 7. Last two pay stubs and W-2's (last two years) 8. Self-employed or commission (last two year's signed and dated tax returns plus current P&L statement and balance sheet) 9. Pension income verification 10. VA loan DD214 (discharge papers) and Certificate of Eligibility 11. Verification of alimony or child support payments 12. Divorce decrees 13. Names, addresses, account numbers, balances, and monthly payments of all open loans. 14. Names, addresses, account numbers and balances of all bank accounts. 15. Information on owned real estate 16. All current debts 17. All current assets An old, but often used “rule of thumb” is to allow 25% of the buyer’s monthly income as the new loan monthly payment, as long as the buyer has no major debts. FHA currently allows a 29% housing and a 41% debt ratio but this is always subject to change. Bankruptcies, repossessions, and can affect the buyer’s ability to qualify. However, after a period of time, if the buyer has a good explanation and good credit since the problem, the lender may agree to accept the borrower. If this is not possible, the borrower may wish to apply for a “hard money” loan.

Underwriting Process Lenders care about three main things: 1. Can you afford to repay this loan? (your income) 2. Have you repaid debts in full and on time before? (your credit) 3. What happens if you can’t or don’t repay the loan? (value of the property used for security) If the lender is very secure about #1, then #2 and #3 may be less important. If the lender is not very secure about #1 or #2, the lender may be much more concerned about #3. The lender loans money for a fee. This fee is “interest”, which is the cost of borrowing the money. If a borrower has an excellent record of repaying debt, and has enough income to pay his/her ongoing bills including the new mortgage payment, the lender may be more willing to make a higher loan amount, or offer lower interest rates. A borrower who may not have a spotless credit record, or who may have marginal income may have to pay a higher interest rate, or may qualify for a lower loan amount in relationship to the value of the property. This is because the lender is taking more risk, so # 3 (value of the secured property) may become much more important. A lender may take the added risk of making a loan if the secured property has a large equity, and/or if the lender is paid a higher interest rate for the loan. The decision whether or not to make the loan will depend on these three main concerns, but also on a number of factors used for the qualification process. Although, lenders are careful to evaluate the buyer’s capability of repaying the loan, the lender must also make sure that in case the buyer does default, that the value of the secured property would bring adequate proceeds to pay the debt if sold in a foreclosure sale. Because the wide majority of all loans are sold on the secondary market, virtually all lenders use the underwriting standards of Fannie Mae, Freddie Mac, FHA, and VA. FHA, VA, and conventional loans each have their own specific rules, but all use the same underwriting process. Top production agents also have the tendency to work with only the best loan officers who are knowledgeable, creative, and have a good understanding of what the underwriter requires and will accept.

Automated Underwriting System AUS The Automated Underwriting System was created to save time and cut costs in the loan approval process. This computerized program, recently released by Freddie Mac, uses the “point system” which has been used for over 30 years as a basis for loan approval or denial decisions. This software can access the three major credit reporting bureaus. These are Equifax Mortgage information Service, TRW Redi Property Data, and Trans Union Corporation. These reports can be merged to give a more accurate credit history of the applicant. The computerized program can also access credit card information of the applicant which shows credit balances, payment history and credit limits. A number of points are added or subtracted for factors such as years of employment, credit, savings accounts, assets and many other factors. Then these points would be totaled and if they added up to a certain threshold, the loan would be approved. If the number of points were too low the loan would be denied. If the number were ‘borderline”, loan approval may be reviewed for other factors or circumstances. This borderline application may fall into the category of “refer”. This means that the application is sent to the underwriter with reasons for the referral status, and then depending on these reasons it may be processed as normal. If the points are low, the application receives a “caution” status. Caution status applications are also sent to underwriting, but they have lees of a chance of being approved. With the AUS, the loan approval may be given in just minutes. Let’s say that the number of points were high. This loan application would be “accepted” subject to some further processing, such as the appraisal of the proposed secured property.

Collateral Assessment Collateral assessment is the appraisal underwriting evaluation. If the applicant has excellent credit, and the subject property fits generally accepted standards such as a tax assessed value, the lender may request an “expedited” evaluation. If this is the case an approval may be given in just a few hours. This is usually the case in applications where the property has little or no and has a high market value. This is an example of a high “loan to value ratio” or LTV. If the application is not in this category, the lender normally requests a “non-expedited” evaluation. This means that an appraisal will require a full appraisal. However, in most cases an answer can be given in two or three days.

Letter of Explanation A lender may accept less than perfect credit if there were extenuating circumstances, or a sudden, unexpected, or temporary situation that caused the problems but has since been corrected. The lender will be looking for five things: 1. A description of each credit problem. They cannot be grouped together. Example: My credit was bad between 4/20/92 and 6/15/94 because of a car wreck. Each spot on the report must be explained separately. Example: The late payment to Household Furniture dated 8/14/93 was due to, etc. The slow pay to Dr. White, dated 4/15/95 was due to, etc. 2. A detail of what happened. Example: I was injured in a car wreck and had to spend 6 months in the hospital. 3. Why did this cause credit problems? Example: I was unable to work during this time and I did not have disability insurance to cover debts while I was recovering. 4. What was done to correct the problem? Since then I have returned to work and made arrangements to pay off all debts. All are now paid or current and have been for 18 months. 5. What I have learned from this and why will this never happen again? Example: I realize now that things like this can happen so I took out a life and disability insurance policy. If I am ever disabled again, my bills will be paid. Or: I have set aside a reserve in case anything sudden should ever happen again. Making timely payments is important to me, so I have a special account that I pay into each month just to make sure that I am never caught in this situation again. It is always a mistake to blame someone else when explaining bad credit. For instance the lender will most likely not look favorably on a letter that says something like “My spouse told me I had to file bankruptcy or he/she would leave me”, or “my spouse ran up bills and I didn’t know about it”. Or “Household Furniture sent us incorrect bills”. Or, “Household Furniture sold us shoddy goods and we reused to pay”. The lender may feel that these are the excuses of a person who does not pay bills willingly or does not take their credit rating seriously. Although the may not write the explanation letter for the client, it is good practice to give advice on what the lender is looking for and to seek out and work with lenders who understand the importance of a well written explanation.

Review Amortization is a method of repaying the principle and interest of a loan through periodic payments. An amortized loan makes it possible for the borrower to pay interest and principle in level payments. Each payment is the same amount each month, bi-weekly or annually, with the first part of the payment applied to the interest and the second part applied to the principle. Negative amortization occurs in an amortized loan when the monthly (or periodic) loan payment amount is not large enough to pay the cost of accrued interest since the previous payment. A straight loan is the payment of the interest only on a weekly, monthly or yearly basis. At the end of the term, the full principal amount of the loan becomes due and must be paid in full. The date of the end of the term is called the maturity date. Balloon loans of today originated from the term loan. A construction loan is a short-term interim loan made to provide money to construct a house, building or other project. ARM is an abbreviation for an adjustable rate mortgage. Loan-to-value ratio (LVR) is the amount of the loan in relationship to the property's appraised value or sale price, whichever amount is less. An equity loan is a real estate loan based on the equity value of a property. When a buyer needs the type of payment plan that an amortized loan offers, but the seller cannot (or will not) accept payment over many years, they may agree to a partially amortized loan. This loan has level payments that would pay off the loan in a certain number of years, but instead of making the payments until the loan is paid in full, the entire balance is payable on a certain date as a balloon payment.

The “Term” loan or “Interest Only” loan is also referred to as a “straight loan”. It denotes the payment of interest only on a weekly, monthly or yearly basis. At the end of the term, the full principle amount of the loan becomes due and must be paid in full. The only difference between the interest only and the partially amortized loan is that no part of the monthly payment is applied to the principle. Negative amortization occurs when the level payments are not sufficient to cover the interest due, and the shortage is added to the remaining principle. The seller can provide the financing for a purchase using a security instrument called the land contract. The buyer normally pays a down payment in cash and asks the seller to "carry," or “carry back” a contract or note and deed of trust for the entire purchase price or a portion of the purchase price. It is sometimes called an installment contract.

The biggest advantage for the buyer is that an installment contract is an easy way to get financing. The seller has the advantage of holding the title until the final installment has been paid. There are potential problems if the seller “carries back a second”, to help a buyer. If the seller is carrying a “second” mortgage or deed of trust, the seller risks a loss of the balance owing and the property. “Equity skimming” is a well-known scheme that takes advantage of seller financing. This happens when the buyer offers to purchase the property at an inflated price and (most likely) does not have a strong credit history or verifiable income. Often the buyer will ask for additional money, supposedly to make improvements to the home and property. The buyer may convince the seller that the improvements will give the seller more security because it will become more valuable. However, the buyer now has much of the equity from the sale. Sometimes the buyer will resell the property, but will not apply any of the proceeds to the second contract being held by the seller. If this is actually an “equity skimming” scheme, the buyer does not make any payments on the new loan. And should this transpire, the loan will be foreclosed.

A “purchase money mortgage” could mean any loan to purchase property that gives the lender a mortgage on the property as security. A blanket mortgage is one mortgage that covers two or more parcels of real estate as security at the same time. This is often used when a buyer invests in several lots in a subdivision for the purpose of development. Rather than separate loans on each parcel the builder can secure the loan on the lots as a group. Lot releases require a payment of more than 100% of the value of the released parcel. To provide the lender with security, it is common to require at least 125 % of the actual value to be paid before release. A Wrap-Around mortgage is often used when a buyer cannot qualify for a new loan, and by lenders that hold loans on property. The buyer will make monthly payments to the seller, plus an additional payment which covers the balance of the buyer’s purchase price for the home.

A Growing Equity Mortgage (GEM) is a mortgage that combines a fixed interest rate with annually increasing monthly payments that allows the borrower to pay off the principle in much less time than a regular amortized loan. A Graduated Payment Mortgage (GPM) is a mortgage with low initial monthly payments which gradually increase over a specified time frame. The rate of interest on an adjustable rate mortgage (ARM) is determined by changes in a floating index, and the rate is adjusted at specific periods according to those changes. When the rates increase rapidly negative amortization can result because the payments start out low.

The personal line of credit is a revolving credit loan that is secured by the borrower’s home, credit cards, or other security. Borrowers can use the money for any purpose desired at relatively low interest rates. The open-end mortgage is much like a line of credit at a bank that is available to be continuously used and repaid up to a maximum limit. This allows the borrower a pre-approved arrangement to use a certain amount of the lender’s money. Construction loans are intended to finance the cost of building a home or the development of a subdivision or other project. Like the open end mortgage, the lender and borrower establish the total amount of money that will be made available on the line of credit as well as how much money can be drawn against the credit line for each phase of building.

The reverse mortgage can be beneficial to people over 62 years of age with mortgages that are nearly paid off. The lender basically gives back the money that the borrower has paid in equal installments to reduce the principal. Instead of reducing the balance it now increases while providing the borrower with additional income to use as desired. There are three basic types of loans available in the residential real estate market --- FHA, VA, and Conventional. FHA and VA loans provide government protection for the lender against a major loss if the borrower defaults. Conventional loans are loans that are not federally insured or guaranteed. Discount points are fees charged by most lenders to increase their financial yield or profit, on a loan. The loan origination fee, service fee, or loan fee is the amount paid for originating the loan, administration and processing of the loan. This fee is typically 1 % of the loan amount and is usually paid for by the borrower. The computerized Automated Underwriting System (AUS) was recently released by Freddie Mac and uses the “point system” which has been used for over 30 years as a basis for loan approval or denial decisions. Collateral assessment is the appraisal underwriting evaluation. A lender may accept less than perfect credit if presented with a letter of explanation. This explains (to the lender) what caused past credit issues such as extenuating circumstances, or a sudden, unexpected, or temporary situation that caused the problems but has since been corrected.

Chapter 3 The Government’s Role in Finance

The factors that affect supply and demand are constantly changing. To keep the economy functioning, supply and demand need to remain in reasonable balance. The United States Treasury and the Federal Reserve System manage the national debt and influence and control real estate financing through the supply, demand, and cost of money.

Treasury funds, which come from the personal and business income taxes we all pay, are by far the largest source of available funds. If the government spends more money than it brings in, it creates a federal deficit. The Treasury borrows money to cover the deficit by issuing interest-bearing securities called Treasury Certificates, Treasury Bills, or Treasury Notes.

These securities are backed by the government and because they are “low risk”, private investors often invest in these. In theory, this leads to a slowdown in the economy because the U.S. government is competing with private enterprise for the same dollars.

The larger the federal deficit, the more the government competes with the private industry, leading to a negative effect on the economy. If the federal deficit is reduced, there is a greater supply of money for private industry investment.

Supply and Demand

The factors that affect supply and demand are constantly changing. To keep the economy functioning, supply and demand need to remain in reasonable balance.

The United States Treasury and the Federal Reserve System manage the national debt and influence and control real estate financing through the supply, demand and cost of money. Treasury funds, which come from the personal and business income taxes we all pay, are by far the largest source of available funds.

If the government spends more money than it brings it creates a federal deficit. The Treasury borrows money to cover the deficit by issuing interest-bearing securities called Treasury Certificates, Treasury Bills, or Treasury Notes. These securities are backed by the government and because they are “low risk”, private investors often invest in these.

In theory, this leads to a slowdown in the economy because the U.S. government is competing with private enterprise for the same dollars. The larger the federal deficit, the more the government competes with the private industry, leading to a negative effect on the economy. If the federal deficit is reduced, there is a greater supply of money for private industry investment.

The Federal Reserve System

In 1913 The Federal Reserve System was established as the nation's central banking system under the Federal Reserve Act. A seven member Board of Governors in Washington, D.C. are appointed by the President of the United States and approved by the Senate regulate the system.

The system has twelve Federal Reserve districts that regulate the flow of money and interest rates through more than 5,000 member banks by controlling their reserve requirements, discount rates and open market operations.

The “Fed”, as it is often referred to, also supervises Ginnie Mae, Freddie Mac, and Fannie Mae and enforces the Truth in Lending Act. The goal of the monetary policy is to stimulate a high employment and economic growth rate, and stabilize interest rates, prices, and foreign exchange markets. Discount Rate When member banks borrow money from the Federal Reserve Banks, the rate of interest charged for the loan is called the “discount rate”. If the Fed raises the discount rate, the banks pass this on to their customers by charging higher interest rates on their loans, including home loans. Of course, if the Fed lowers the discount rate, the banks lower the interest rates they charge as well. The “prime rate”, is the rate of interest charged by commercial banks to their largest and strongest customers, which will influence the” street rate” of interest available to the consumer.

Reserve Requirements The FED determines the reserve requirements. Each member bank is required to keep a certain percentage of its assets on deposit at the Federal Reserve Bank as reserve funds that cannot be used for loans or other purposes. This requirement is intended to assure the depositors that their money is secure and available and to prevent any financial panics. Reserve requirements also give the Fed some control over the growth of credit, by increasing or decreasing the reserve requirement. If the reserve requirement is raised, available loan funds decrease and interest rates would have to rise. If there is more demand than supply for money, the cost of borrowing money or “interest” will increase.

“HUD” Department of Housing and Urban Development HUD is a federal cabinet level agency that has responsibilities in all areas of national housing policies. HUD provides grants and subsidy programs for various public housing urban renewal and rehabilitation projects, FHA insured loans and many, many other programs. It is also responsible for enforcement of the Federal Fair Housing Act.

“FHA” Farmer's Home Administration The FHA should not be confused with the Federal Housing Administration. FHA is an agency of the U.S. Department of Agriculture, which was originally created to provide for farm financing. Today, FHA provides loans to borrowers in "qualified" rural communities. The FHA, The Farmer's Home Administration is a direct lender that originates and services loans for rural residents, ranchers and farmers. In 1992, the government began a guarantee program that helped borrowers obtain loans through private lenders, rather than directly from FHA. These loans require no MIP, and can be for 100 % of the purchase price or appraised value, whichever is less. The interest rate cannot be higher than VA or Fannie Mae rates. No discount points may be charged on FHA loans. FHA loans can be used to buy, build, or rehabilitate farm homes and other farm buildings, or develop rural housing for the elderly in qualified communities. Qualified communities are rural towns with less than a 10,000 population, or cities lying outside of the standard metropolitan areas with populations between 10,000 and 20,000 that can show a lack of available home loan funding.

Federal Deposit Insurance Corporation (FDIC) A federal agency created to insure savers' deposits held in those commercial banks that are members of the Federal Reserve System (FRS). In the event a member bank is liquidated, FDIC will pay off depositors up to the maximum amount of coverage, presently set at $ 100,000 per named individual.

Federal Home Loan Bank (FHLB) A series of 12 regional Federal Home Loan banks providing a pool of reserve funds for loans to member savings and loan institutions.

Federal Housing and Federal Reserve System (FRS) A federal agency created to assist in the management of the nation's economy. The "Fed” operates through 12 federal reserve district banks that provide a pool of reserve funds for loans to member commercial banks.

FIRREA In 1986, Congress passed the Tax Reform Act, which eliminated the income tax shelters for investment real estate. Almost overnight, investment properties became devalued and the real estate market collapsed. When these borrowers defaulted, the properties were sold at foreclosure but the proceeds were far below the loan balance. The lenders suffered enormous losses and many became insolvent. In 1989, Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act “FIRREA”. The act created the “OTS”, (Office of Thrift Supervision) and SAIF, (Savings Association Insurance Fund) to close the insolvent savings and loan associations and manage the remaining thrift industry, and the “RTC” Resolution Trust Corporation to dispose of insolvent savings and loan associations and the repossessed assets they held. Today, saving and loan associations require much greater documentation before making a loan and they are required to maintain deposit insurance on their customer’s savings. Deposit insurance can be provided by SAIF, the Savings Association Insurance Fund or by private insurance companies. SAIF is a government agency which insures savings deposits in savings and loans that are members of the FHLB. If the savings and loan association became insolvent, SAIF would pay the depositor up to the maximum amount of coverage, which is presently set at $ 100,000. Since the enactment of FIRREA, the operations of savings and loan associations and banks have become quite similar. Because of the 1989 real estate collapse, there is far fewer saving and loan associations but commercial banks and mortgage bankers have significantly increased their market share.

The Primary Market The primary market is actually various lending institutions where homebuyers go to borrow money to finance the purchase of a home. Even though there are some other types of lenders that make home loans, the practices of the major lenders have the greatest impact on real estate transactions. There are several major sources of loans in the primary market, but most home loans are made by one of these types of lenders: • Savings and loans • Commercial banks • Savings banks • Mortgage companies

Savings & Loan Associations The savings of people and businesses in the community are the original source of funds in the primary market, and community savings and loan associations, also known as thrift institutions, are the most common lender in the primary market. These savings are used to make real estate loans to people in local areas. The condition of the local economy will affect the amount of available funds the local lender has to loan. When local employment is high, there is usually more motivation to borrow money to buy homes, furniture, cars, vacations, or expand businesses. However, if lenders increase the number of loans to meet consumer demand, while fewer people tend to deposit savings, the decrease in money supply would deplete the available funds for loans. Local lenders may decide to sell its mortgages on the secondary market to help meet the demand, or their funds would be depleted and the local economy would deeply suffer. This is a national market where real estate mortgages are bought and sold throughout the United States. When savings are low, there is less money to lend and the lender’s primary source of income is affected. It is also true that when savings are high and the lender is paying interest to its depositors, the savings must be quickly reinvested or the lender will lose money. Saving and loan associations can usually provide a variety of both government-backed and conventional real estate. They are chartered by the federal government or state governments and are regulated as to maximum loan amounts, loan-to-value ratios, and ratio of home loans to other types of loans.

Commercial Banks Since the savings and loan disaster in 1989, commercial banks became major competitors for home loans and . Prior to this, commercial banks were active in making loans for business ventures and short-term construction activities. Residential mortgages were not a large part of commercial banks' business. The reason for this was that most commercial bank deposits were made to checking accounts, rather than savings. The government limited the amount of long-term investments the banks could make, and checking accounts are “demand deposits”, or “short term” funds. At the same time, federal regulations allowed commercial banks to offer a wide range of other types of loans, so the commercial banks had no reason to specialize in residential mortgages. However, significant changes have been made since as far back as the 1970s. Commercial banks accepted an increasing amount of long term deposits, meaning that the short term “demand deposits” began to represent a much smaller percentage of the banks' total funds. Even though they are still very active making commercial loans, commercial banks have substantially increased the number of personal loans and residential mortgages. Today, the commercial bank’s share of the residential mortgage market is as large as the savings and loan associations. National Commercial Banks are chartered by the federal government, and the Federal Deposit Insurance Corporation (FDIC) must protect their deposits. State Commercial Banks are chartered by state government, but may still become members of FDIC to provide their depositors with federally insured deposits. They are the largest source of investment funds in the United States.

Savings Banks Savings banks can offer the same basic services as commercial banks and savings and loan associations, such as checking, credit cards, commercial loans, as well as residential mortgages. However, in the past there was little difference between savings banks and the savings and loan. They focused on their local community, serving mainly individuals rather than businesses, and their deposits were mostly long-term savings deposits. Savings and loan associations concentrated on home loans and although the savings banks did include home loans, they were also active in many other types of lending. Most savings banks were established in 16 of the Northeast states and were originally chartered and regulated by the state, but not by the federal government. Until the 1950’s the savings banks held many more assets than savings and loans, but they did not expand as the savings and loans did after World War II. In 1982, savings banks were given the option of a federal charter so that their depositors were protected with insurance against insolvency under the FDIC. Federal savings banks can be either mutual companies or stock organizations. State chartered savings banks can become members of the FDIC.

Mortgage Companies What is the difference between mortgage bankers and mortgage brokers? There are two basic categories of mortgage companies. The first type is the mortgage broker; the second is the mortgage banker. The difference between the mortgage banker and the mortgage broker depends on the source funds to lend, and the servicing of the loans. A mortgage broker simply acts as a broker. This means that he or she brings together a potential borrower and a lender and negotiates a loan. The mortgage broker receives a commission for this service, but does not loan his or her own funds, and does not service the loan. The mortgage broker’s job is finished as soon as the two are brought together. The mortgage broker's income comes from the loan origination and loan discount fees. Mortgage companies are sometimes referred to as mortgage bankers. Mortgage bankers sometimes use their own funds as a source to make loans, but more often they originate loans on behalf of their investors. The mortgage banker also services the loan and charges a fee. Mortgage companies can sometimes act as mortgage brokers, but mortgage companies are much more often mortgage bankers. Since bankers loan their own money, their income comes from not only loan origination and loan discount fees, but by packaging these loans and reselling them. • Brokers bring parties together as the middleman. • Bankers actually loan their own money, or they loan money on behalf of an investor. • Banks have money and service. Mortgage companies may also borrow money from banks to originate mortgages. These are packaged and immediately sold to investors or the on the secondary market. Many times mortgage companies make loans on behalf of large investors such as life insurance companies and pension funds. Since these types of funds are not associated with sudden large withdrawals, they are excellent sources for long-term lending. National scale investors seldom handle day-to-day management of these loans. Instead, they usually use the specialization of mortgage bankers.

REIT - Real Estate Investment Trusts A REIT is somewhat like a mutual fund. A mutual fund’s method of obtaining money to invest is accomplished by selling stock. A REIT obtains money by selling shares, or certificates of ownership, in the trust to give the individual investors the funds to purchase real estate investments. A REIT must use at least 75 % of its assets to invest in real estate to obtain certain federal income tax exemptions. This current tax requirement results in a very large amount of investments being made. Because of this, Real Estate Investment Trusts often buy and sell through the secondary market rather than by direct loans.

Life Insurance Companies Insurance companies are a huge source of funds for large projects. They not only invest the policyholders' insurance premium dollars, but they frequently participate in the investments with their own money and as part- owners. These investments are typically in large commercial projects such as shopping centers, and multi- family complexes and office buildings, although they can also be involved in residential loans.

Credit Unions Unlike a mortgage company, credit unions are depository institutions, more like savings and loan associations and banks. However, credit unions typically limit their lending services to their group members. Credit unions were first established to make small, personal loans to members of a certain group, such as teachers, metal workers, government employees, etc. Credit Unions have recently become involved in making residential home loans and loans on their borrower’s existing home equity.

Private Lenders Although private lenders are apt to charge a higher rate of interest than the street rates, they are often easier to deal with than an institutional lender. These private lenders are investors, who make real estate loans secured with a note and deed of trust, which is a higher yield than investing the same money into a “certificate of deposit and certainly higher than putting the money into a savings account. Private sources of money are always available and usually will negotiate face-to-face meetings with potential borrowers. Private investors could be anyone such as friends, relatives, or employers. They can also be referred by attorneys, financial advisors, accountants and other business contacts.

The Secondary Market The secondary market is made up of private investors and government agencies that buy and sell real estate mortgage loans. Two thirds of all residential loans made in the United States are government-related loans that are sold to the secondary market. The three major government agencies are: • FNMA or "Fannie Mae" - Federal National Mortgage Association • GNMA or "Ginnie Mae” - Government National Mortgage Association • FHLMC or "Freddie Mac” - Federal Home Loan Mortgage Corporation Real estate loans made by primary lenders are “investments” that are expected to produce a return in the form of interest payments and other fees. Like other investments, real estate loans can be bought or sold. The value of the loan depends on the rate of return and the risk of default. The conditions of the local economy affect the amount of available money the lenders have to lend. Sometimes they will have a shortage of money, OR they may have an excess of money to lend. The secondary market creates a balance in the market by moving available funds from areas with excess funds to areas with a shortage of funds. When a lender has a shortage of funds, selling some real estate loans on the secondary market can raise money. However, unless the loans conform to the secondary market's underwriting standards, the secondary market will not purchase them. Most lenders adhere to the uniform standards because of the stabilizing effect it has on the local mortgage market. These underwriting standards are a set of criteria that the loan applicant and the property must meet. The applicant must meet acceptable “debt- to-income” ratios and comply with a precise set of terms. The borrower’s “debt to income ratio”, credit, “loan to value ratio” and other standard underwriting requirements are used to evaluate the strength of the loan applicant as well as the property being used as security to determine if the loan is a low or high risk. Lenders are more willing to accept the risk of making long term real estate loans even when there is a shortage of funds, because they can raise more funds by selling their “uniform standards” loans on the secondary market. Each year in January, Fannie Mae and Freddie Mac determine the maximum loan amount for conforming residential loans. “Conforming” loans are “regular” real estate loans for single family, and up to four unit multi-family home loans. A formula prepared by the Housing and Community Development Act of 1980, is used to set the limit, based on the national average price increase according to the Federal Housing Finance Board.

Federal National Mortgage Association "Fannie Mae," originated in 1938 as a federal agency to provide a secondary market for FHA- insured and VA guaranteed loans. However, in 1968, FNMA became a private corporation, which offers common stock to the public, and also buys conventional loans. In the same year “Ginnie Mae” was created to take over Fannie Mae's governmental capacity.

Ginnie Mae - Government National Mortgage Association Ginnie Mae is a federal agency that provides federally regulated secondary mortgage market for FHA, VA and FHA loans. The agency also purchases high-risk subsidized HUD guaranteed loans that provide “social benefits” such as urban renewal projects and housing for the elderly.

Freddie Mac - Federal Home Loan Mortgage Corporation Freddie Mac is a federally chartered and regulated government agency that can buy FHA, VA, and conventional loans from any type of lender. The loans that are bought by Freddie Mac are packaged into mortgage based securities that are sold to investors all over the world. The Emergency Home Finance Act of 1970 created Freddie Mac to purchase conventional loans from savings and loan associations as a means to help them recover from the 1969 recession.

Uniform Residential Loan Application In January of 1992, the Uniform Residential Loan Application form became mandatory for all loan applications to purchase residential single family and up to four unit multi-family housing. The four-page form requires the applicant for any government-related loan, to undergo a thorough examination. The reason for this “tightening” was to prevent a repeat of the numerous foreclosures of the 1980’s and 90’s. These requirements may not be applicable if the loan is not government related and will not be sold to the federal secondary market. However, only a very small amount of loans fall into a non-government related category. The Uniform Residential Loan Application form requires the applicant to provide all names used to obtain credit, such as a maiden name, married name, previous married name(s), aliases, information and addresses of all past and present residences during the past seven years, employment verifications, among many other requirements. The new form includes all of the home mortgage disclosure laws and a provision that the buyer is aware that if the loan is sold, the buyer can require t the borrower to re-verify information. The requirements for refinancing a home are usually the same as the application for a new home loan purchase. During the low interest rates of 1991 and 1992, borrowers flocked to lenders to refinance their home loans. While some were successful, many found that for a period of time since their purchase, real property had depreciated in value. It is common for lenders to require a minimum of an 80% Loan to Value ratio in order to make a refinance loan. This means that in order to refinance a house, the loan amount can be no more than 80% of the home's value. In many other respects, a refinance loan is much like a new home loan. However, unlike new home loans, the points paid when refinancing a home are not tax deductible.

The Truth in Lending Act The Truth in Lending Act, which is implemented by Regulation Z, was enacted in 1969 to protect consumers by requiring the lenders to disclose the complete cost of credit to their applicants and by regulating the advertisement of consumer loans. Anyone who grants credit to customers in the ordinary course of their business must comply with the requirements of the Truth in Lending Act and Regulation Z, if the type of loans they made is consumer loans. If a lender makes a loan to a borrower for a personal, family, or household use, the loan is a consumer loan. • The Truth in Lending Act covers all consumer loans if: • They are to be paid back in four or more payments • The borrower pays finance charges for the loan of up to $25,000 • The loan is any size and it is being secured by real property This means that a to purchase a home or an equity loan for college tuition or remodeling the borrower’s home would be considered “consumer” loans. But if a corporation refinances real property for a business purpose, it is NOT a consumer loan and is not covered by the Truth in Lending Act. Truth in Lending legislation requires all lenders of FHA, VA, or conventional loans, or any loans that will be sold on the secondary market, to provide the applicant with a Good Faith Estimate describing all costs of the loan. This same law also requires that a seller, who is providing financing (as in a land contract), that contains a “balloon payment”, must advise the buyer of the total balloon payment amount, at the time of acceptance of the contract.

Disclosure Requirements The purpose of disclosure is to inform the applicant of the total cost of the loan, so that there are no surprises at the closing table. Although there is no particular form, the disclosure statement must be clear and understandable and include all the disclosures required by Regulation Z. The primary disclosures that the Truth in Lending Act requires a lender to make to the loan applicant are the: 1. Total Finance Charge This includes the interest on the loan, origination fee, funding fee, discount points, document preparation fee, warehousing fee, escrow fee, title policy charges, etc. In real estate loan transactions, the appraisal fees, credit report charges, and points paid by the seller are not included in the total finance charge. 2. APR- Annual Percentage Rate The annual percentage rate is the total of the finance charges in relationship to the amount of the loan, shown as an annual percentage (%). The lender must give an accurate computation of the APR within one eighth of one percent of the exact calculation. In addition to the total finance charge and annual percentage rate, the form must disclose the following information: • Total amount financed • Payment schedule • Total number of payments • Total amount that will be paid • Balloon payments, late fees, or prepayment charges • And if the loan can be assumed without (or with) the lender’s approval Lenders usually give the applicant a disclosure statement, or “Good Faith Estimate”, at the time of their application. The Truth in Lending Act requires the lender to provide this disclosure to the applicant within three days of receiving the written application. Estimated figures may change over the course of the transaction, and the lender must make these changes in new disclosures to the borrower prior to closing. The Truth in Lending Act has special rules for the refinancing of homes. When the security property is the borrower's existing principal residence, the act gives the borrower a right of rescission. The home equity borrower has a three-day “right of rescission”. This means that the borrower can back out of the refinance loan anytime during three days after: 1. Signing the agreement 2. Receiving the disclosure statement 3. Or receiving notice of the right of rescission

WHICHEVER COMES LAST However, if the borrower is not given the statement or the notice, the right of rescission does not expire for three years. These rights apply only to home equity or refinance loans. There is no right of rescission for a borrower to purchase or build a home.

Loans Exempt from TILA The Truth in Lending Act does not apply to loans made for business, commercial, or agricultural purposes, loans made to corporations, trusts or other “artificial” persons, or to loans in excess of $25,000, unless the loan is secured by real property. Almost all loans made by a seller, such as a land contract or installment contract, are exempt, unless the seller’s ordinary course of business is extending credit.

Advertising under TILA The Truth in Lending Act applies to everyone who advertises consumer credit, so real estate brokers and agents must become completely familiar with Regulation Z's limitations on the advertising of any finance terms. If even one detail of financing information is mentioned in an advertisement, it may trigger “Reg” Z, making it necessary to give a full disclosure in order to comply with the law. If a real estate broker advertises “$1,000 down”, this would be a violation of the Truth in Lending Law unless the ad fully discloses the APR, the monthly and down payment, and complete terms and costs of repayment. It is not a violation to state the price of a home, or to give a general statement such as "small down payment," "easy terms," or "low interest”. Regulation Z also applies to lenders that make loans for the purchase of personal property, such as cars, furniture, etc. The security agreement, also called a chattel mortgage or conditional sales contract, must include a full disclosure of all costs, and the annual percentage of the loan.

Equal Credit Opportunity Act The EQUAL CREDIT OPPORTUNITY ACT was enacted to ensure that anyone who is capable of repaying a loan must be considered for the loan. The Equal Credit Opportunity Act does not entitle any person to credit if the person does not have the ability to repay. The Equal Credit Opportunity Act originally prohibited discrimination because of gender or marital status, but it now also includes the prohibition of discrimination because of race, color, religion, national origin, age, reliance on income from public assistance, or because of the exercise of rights under the consumer protection laws. Applicants may be asked questions regarding credit, but only when asked for specific reasons to determine credit worthiness. They may also be asked their age to determine if the person is of legal age to enter into contract. The lender could ask about age to determine how many years the person might be employed or to determine a level of income, but the lender may not use the applicants age as a decision to refuse to lend to the applicant. The creditor may ask to what degree the applicant's income is affected by alimony, child support or maintenance payments, whether paying them or receiving the payments. If the applicant is receiving any of these payments, the creditor must first inform the applicant that this information does not have to be revealed unless the payments will be used to repay the loan. Creditors may not ask applicants about birth control choices, practices, intentions or pregnancy nor any discrimination based on a perception or assumption that a woman’s employment would in any way be affected or that the woman would stop working to have a child. The creditor has a maximum of 30 days after the completion of the application to notify the applicant of approval. If approval is denied, the applicant has a right to request the reason for denial and the creditor must reveal the reason within 60 days of the request. Creditors are defined as any person or any organization that regularly participates in credit decisions or whose regular business ordinarily allows customers the right to extend credit by deferring payment for goods or services purchased. Accepting credit cards issued by other companies, firms or banks does not make a merchant a creditor. The Equal Credit Opportunity Act may be obtained from: Department of Consumer Affairs Federal Reserve Bank of Philadelphia P.O. Box 66 Philadelphia, Pennsylvania 19105

Review When title is transferred without any right to possession, and only as collateral, it is called legal title, or naked title. The right of possession to the property is called the equitable right or title. Financing real estate is known as “leverage”. Leverage is a benefit that comes from using as little cash of one’s own as possible, while using someone else's cash. This frees up more of the purchaser’s cash to invest in more purchases to make more money. Finance is the lending and borrowing of money and is considered to be the core of the real estate

business. Amortization is a method of repaying the principle and interest of a loan through periodic payments. An amortized loan makes it possible for the borrower to pay interest and principle in level payments. Each payment is the same amount each month, bi-weekly or annually, with the first part of the payment applied to the interest and the second part applied to the principle. Negative amortization occurs in an amortized loan when the monthly (or periodic) loan payment amount is not large enough to pay the cost of accrued interest since the previous payment. A straight loan is the payment of the interest only on a weekly, monthly or yearly basis. At the end of the term, the full principal amount of the loan becomes due and must be paid in full. The date of the end of the term is called the maturity date. Balloon loans of today originated from the term loan. A construction loan is a short-term interim loan made to provide money to construct a house, building or other project. An equity loan is a real estate loan based on the equity value of a property. Loan-to-value ratio (LVR) is the amount of the loan in relationship to the property's appraised value or sale price, whichever amount is less. The first to record has the highest priority. Because property can be used as security for more than one loan, from different lenders, the priority of the lien is established by the date of recording. There is an exception if a subordination agreement appears in the records. Subordination clauses state that a certain lien will have lower priority than another lien that will be recorded in the future. This can be used to give a higher priority position or “first” mortgage position to a lien even though it will be a “junior lien”, recorded after the first lien. The seller can provide the financing for a purchase using a security instrument called the land contract. This is also called an installment contract, real estate contract, contract for deed, or contract of sale. The borrower is called the mortgagor and the lender is called the mortgagee. The lending institutions will explain these different loan services to the customer, but the agent must be able to advise the borrower of the choices that are most advantageous for their situation. The United States Treasury and the Federal Reserve System have the authority to manage the national debt and the power to exercise influence and control real estate financing through the supply, demand and cost of money. The factors that affect supply and demand are constantly changing and cycling. To keep the economy functioning, supply and demand need to remain in reasonable balance. The federal government’s role has been to regulate and limit adverse effects of the economy on real estate markets by shaping a national secondary market. The primary market is actually various lending institutions where homebuyers go to borrow money to finance the purchase of a home. The secondary market is made up of private investors and government agencies that buy and sell real estate mortgage loans. Two thirds of all residential loans made in the United States are government-related loans that are sold to the secondary market. PMI is private mortgage insurance that insures the lender in case of default of a non-FHA or any other governmental agency mortgage loan. Points are the fees that most mortgage lender’s charge to increase the financial yield on a loan. Equity is the cash value difference between the property's present market value minus all liens, mortgages and other encumbrances. Lenders compute the interest rate on an adjustable rate loan based on an index. The prime rate is the rate of interest a lender charges its largest and strongest customers. Arbitrage results from the difference between two interest rates. For example, if a person borrows money at 8% and loans it to someone else at 12%, the income that results between the two interest rates is called arbitrage. Caps are the maximum limits of increase or decrease in interest, payments, and time periods. Junior liens are any liens in subordinate positions of priority to another lien on the same property. The margin is an amount that is added to the current index value on the rate adjustment date to establish a new interest rate on an adjustable rate loan. A Loan Origination Fee is the one-time charge made by the lender, to make and process a loan application. An Impound Account is a trust account used by the lender to hold a portion of the borrower's payment to be used to pay insurance premiums, real estate taxes, etc. as protection for the lender.

The Equal Credit Opportunity Act was enacted to ensure that anyone who is capable of repaying a loan must be considered for the loan and does not entitle any person to credit if the person does not have the ability to repay. According to the Equal Credit Opportunity Act, a creditor is defined as a person (or organization) that regularly participates in credit decisions or whose regular business ordinarily allows customers the right to extend credit by deferring payment for goods or services purchased.

Chapter 4 Buyers and Pre-Qualification

Introduction As we mentioned in the beginning of the course, everyone has his or her own thoughts, ideas, and memories regarding home ownership. Some people feel that it may be too much of a commitment where maintenance, payments, and liquidity of the asset are concerned. Others enjoy the advantages that home ownership provides, such as security, pride, and the freedom to do what one wants with the property. One of the most important benefits is the pride that owning a home can bring. Ownership allows the privacy and freedom that cannot be found in or leasing from a landlord. Homeowners can make changes to their property, choosing house colors, planting trees and planning landscaping, having pets, and remodeling without having to get permission.

In this chapter, we are going to discuss a variety of topics concerning the home buyer. What are the advantages to owning a home? What are the disadvantages? What are the types of buyers that you as a licensee will encounter? What are some of the best ways to find these buyers? What are some of the best ways to track these prospects and stay in touch?

Advantages of Home Ownership Obviously, a person decides that they want to own their own home because of having so many advantages over renting and leasing. Listed below are the main advantages that most people find for owning their own home. • Pride of ownership • Freedom to change or alter the property • A reflection of the owner’s self-image • Control of premises –landlord cannot make you move out • Can dramatically strengthen credit ratings • Equity to borrow against or resulting in profit when selling • A practical investment of increasing in value by appreciation • Civic contribution through property taxes that support local concerns • Tax advantages by deducting property taxes and interest for mortgage

Naturally, where there are advantages, there are also some perceived disadvantages such as the following: • Down payment and closing costs can amount to a large amount of cash • Down payment could drain cash that could be used to earn other income • Time consuming to negotiate and close sale • May leave owner low on cash to make other payments. Real estate investment is “frozen”, rather than liquid investment • If forced to sell quickly a loss may result • Monthly mortgage payments could be variable and payments could increase • Ownership has the responsibility of ongoing costs and obligations • Owner responsible for own repairs and maintenance • No built in recreational activities (such as with pools) • Increases in property taxes and the additions of special assessments • Expense of homeowner's insurance

As a licensed professional, you will find that there are all kinds of buyers in every market. However, for the most part, buyers are classified into four primary groups as follows: • First-time home buyers • Buyers moving to larger home • Buyers moving to smaller home • Recreation home buyer and retirees

In order to understand these different types of buyers, a description of each category would be in order, so let’s dig in and learn more about them.

First Time Home Buyers It can be extremely satisfying to work the first-time homebuyer. They are often very excited about buying a home, but they can also be a serious challenge. First time buyers may have a limited amount of cash and have some difficulties coming up with a down payment. Since this is their first large purchase, they also may not have built up enough established credit to get a home loan. The first time buyer can also be uninformed about important matters concerning a home purchase, and can tend to turn to the advice of friends and family, rather than letting you assist them and educate them in the process. This can cause some frustration if the first time buyer is relying on information given from a person who has little or no knowledge of real estate. There are several ways to overcome these challenges. Agents who work with first time buyers should provide plenty of information, and use patience to build a rapport and trust. When handled properly, the process can be very rewarding.

Buyers That Are “Moving Up” Homebuyers who are moving up to a larger or more expensive home usually have more knowledge of how a works. Because this is not their first real estate purchase, they most likely have a clear picture of the home they want to buy, and more funds (usually from their current home’s equity) for the purchase of the new home. These buyers often appreciate the knowledge and expertise that their real estate agent has to offer them, and will oftentimes insist on working with the best. It is wise for the agent working with this type of buyer to be prepared with an organized method to find the right home and expertise in listing and marketing the buyer’s current home.

Buyers Moving To Smaller/Lower Maintenance Homes These are buyers that no longer want or need the financial or maintenance demands of a large family home. Maybe their children have grown up and moved into their own homes, or maybe they just don’t want to have to take care of a big house or a large yard. Or maybe the buyer has retired and is now living on a fixed income and wants (or needs) to make smaller monthly payments. Like the buyers who are moving up, these buyers have also have a clear picture of the home they want, and also have more funds resulting from their current homes built up equity. This may also be an opportunity for the real estate agents to not only sell the buyer a new home, but to list and market the buyer’s current home. For this reason, this often equates to a win-win situation where this type of buyer is concerned.

Recreation Home Buyers and Retirees Recreational or second homebuyers are usually looking for a home that offers not only a house, but recreation and entertainment as well. Often these buyers have retired and now want a different lifestyle. Or, as in the case of the buyer that is “moving up”, they are now in a financial position to buy a vacation home or a waterfront property as examples. This buyer might also be interested in condominiums or planned unit developments that offer recreational facilities. These buyers are typically well informed and well qualified financially.

So now that we have gotten to know a little about the types of different buyers, how do you go about finding them? What are some of the best methods for “prospecting” as it’s called? Successful agents will prospect for buyers, just like listing agents who prospect for listings. Listed below are 20 of the best methods you can use for prospecting for home buyers.

1. Make ad calls from your listings 2. Call friends or relatives and specifically ask who might be buying soon 3. Ask people in your area, either face to face or by phone 4. Check the Internet for buyers 5. Advertise as a Buyer’s Agent. 6. Hold Open House at your own listing, or get permission to open another agent’s listing 7. Mail out, or hang on doors, 100 invitations in the surrounding neighborhood of the open House in order to attract viewers to the home 8. Ask past clients, open house guests, and everyone for possible buyers 9. Send information with clippings from birth announcements, various promotions, marriage announcements, etc 10. Design a Buyer’s Agent presentation for you to use with potential buyers 11. Attend Home Buyer’s Seminars 12. Contact your local Chamber of Commerce 13. Contact personnel managers about transfers and relocations of employees 14. Attach a buyer referral form to each of your listing agreements 15. Pass out your business cards no matter where you are 16. Ask for business 17. Cold call any "for sale by owners" that you happen to see when you are out on business. They also have to buy another house! 18. Wear your name badge everywhere. People will talk to you about real estate! 19. Practice good phone skills for maximum floor time advantage. 20. Make it a habit to even call expired listings. This is a good way to find listings, but remember that they also are moving somewhere!

The following form is an example of a “Buyer Information Worksheet”. These are very easy to design and create on Excel and will help you to not only keep track of your clients, but will make it easy for you to perform follow-up calls with your clients.

Personal Information Name Address ______Phone: Home Work Cell ______Desired Style No. Bedrooms ______No. Baths _____ Family room _____Dining room _____ Fireplace _____Sq. ft ______Age ______Heat _____ Garage _____ Lot size _____ Location ______Preferred School district ______Price range: $______

Financing Information Mr. Income $ ______Employer ______Position ______How long ______Ms. Income $ ______Employer ______Position ______How long ______Other income $ ______Closing funds $ ______Available by ______Maximum mortgage payment $______Conventional / FHA / VA

Monthly Obligations Total Payment Balances Total Payments Remaining Housing Auto(s) Credit cards Revolving accounts Other

As you can see, this is a very basic form, however it is a very effective tool. Tracking Your Prospects Using this information, the agent can determine the buyer’s income-to-debt ratio to determine the buyer’s loan qualification. This is only a preliminary determination. The buyer should still qualify through a loan officer and even then, the loan may be subject to a good credit rating and other criteria. The agent can also be helpful in suggesting some ways for the buyer to come up with a down payment. Many times a buyer will have good credit and a good income, but has not saved for a down payment. If the buyer inquires about ways to appropriate a down payment, here are some of the suggestions that you can offer them: • Credit cards (not always advisable as it does create further debt) • • Personal loan (credit union -lending institution) • Relatives (borrow from Mom, Dad, brother, sister, cousin, good ol’ Uncle Joe) • Gift letter • Borrow against a car, truck, or other vehicle • Borrow against the tools of the trade • Cash out or borrow against an insurance policy • Draw from an investment portfolio (such as stocks, bonds, or CD’s) • Draw from a retirement plan • See if you can arrange to receive cash instead of vacation time from your employer • Draw from a 401-K plan • Draw or borrow against a savings account • Borrow against jewelry, art, or antiques • Refinance other owned property • Have a huge garage sale • Sell contracts that are payable to you • Take on a second job • See if your landlord will refund all of your deposits early • Borrow from employer as a future draw • Trade in something in lieu of down payment (such as land, car, bike, etc.)

Using the Prospect Sheets Before the agent begins the search for the buyer’s home, they must first know the answer to two critical questions: 1. What does the buyer want and need? 2. What can the buyer afford to pay? It does no good to begin a search for a home that the buyer wants and needs, if the buyer cannot qualify for a loan or other method of financing for that home. If the buyer were to find the “perfect house”, and then find out that they qualify for a much smaller loan amount, the buyer will be disappointed, and ALL other homes will seem inferior. Chances are, you may be fighting an uphill battle from that point on. “Pre-qualifying” the buyer can prevent this. In order to determine what the buyer can afford and qualify for, the agent must determine the amount of the buyer’s income, the buyer's debts, and the buyer’s available cash or savings. It is also important to know how much the buyer is willing to pay for monthly payments. Sometimes, a buyer will qualify for a loan amount much higher than they are willing to pay. Pre-qualifying can also help your buyers to prioritize their “needs” with their “wants”. There may be times when the buyer’s expectations exceed their ability to purchase. This can usually be overcome by the buyer prioritizing and by the agent exercising some creativity.

Here’s an example: The McKenzies tell their agent, Joe, that they have three young children and they take care of Mr. McKenzie’s mother in the home. They tell Joe that they need a 5 bedroom, 2.5 baths with an eat-in kitchen, family room, large deck, a garage with a shop, fenced yard, and a pool. They would also like to have a full basement and prefer a two-story. Joe has pre-qualified the McKenzies, and knows from recent previewing that a home with ALL of these features will not be in their price range. Joe actively listens to the McKenzies and begins to write down the most important features that they truly need. Joe says that he feels he can find a home in their price range with the most important features, such as enough bedrooms for the family and “Mom”, at least 2 baths, a large kitchen and a fenced yard for the kids. ”If we find a home with a couple of the other desired features, that would be nice, too. What do you think”? The McKenzies agree, and begin the search using the most important features.

Review The factors that influence home ownership are extremely diversified. One of the most important benefits is the pride that owning a home can bring. Ownership allows the privacy and freedom that cannot be found in renting or leasing the landlord’s house or .

Advantages of owning a home include: • Pride of ownership • Freedom to change or alter the property • A reflection of the owner’s self-image • Control of premises –landlord cannot make you move out • Can dramatically strengthen credit ratings • Equity to borrow against or resulting in profit when selling • A practical investment of increasing in value by appreciation • Civic contribution through property taxes that support local concerns • Tax advantages by deducting property taxes and interest for mortgage

Disadvantages to owning a home include: • Down payment and closing costs can amount to a large amount of cash • Down payment could drain cash that could be used to earn other income • Time consuming to negotiate and close sale • May leave owner low on cash to make other payments. Real estate investment is “frozen”, rather than liquid investment • If forced to sell quickly a loss may result • Monthly mortgage payments could be variable and payments could increase • Ownership has the responsibility of ongoing costs and obligations • Owner responsible for own repairs and maintenance • No built in recreational activities (such as apartments with pools) • Increases in property taxes and the additions of special assessments • Expense of homeowner's insurance There are four main types of buyers: • First-time homebuyers • Buyers moving to larger home • Buyers moving to smaller home • Recreation homebuyer and retirees It can be extremely satisfying to work with first-time homebuyers, but they can also be a challenge. First time buyers may have a limited amount of cash for a down payment and they may not have built up enough established credit to get a home loan. Homebuyers who are moving to a larger or more expensive home usually have more knowledge of how a real estate transaction works. Because this is not their first real estate purchase, they most likely have a clear picture of the home they want to buy, and more funds (usually from their current home’s equity) for the purchase of the new home. Buyers moving to a smaller home may no longer want or need the financial or maintenance demands of a large family home. Recreational or second homebuyers are usually looking for a home that offers not only a house, but recreation and entertainment as well. Often these buyers have retired and now want a different lifestyle. Pre-qualifying can also help your buyers to prioritize their “needs” with their “wants”. There may be times when the buyers' expectations exceed his/her ability to purchase. This can usually be overcome by prioritizing the buyer and creativity on behalf of the agent. By practicing “active listening”, the real estate agent can gain a better understanding of features that are most important to the buyer.

Chapter 5 Real Estate Investment and Taxation

Glossary

Appreciation The increase of value of the asset due to inflation or supply and demand Capital gain Profit realized from an investment that is subject to taxation Capital loss Loss realized from an investment that may be tax deductible Cash flow Spendable income left after all expenses have been paid, such as operating costs, debt payments, taxes, etc Equity The total amount of the difference between a property’s current value and the amount of encumbrances against it Gross income Unless it is specifically excluded by the IRS, Gross Income includes all forms of income, including passive, active, and portfolio income Investment Purchasing assets in the expectation of generating a return OR profit Leverage Using other people’s money (OPM) to purchase assets for investments Liquidity The assets ability to quickly and easily convert to cash Portfolio Collection of different investments held by a person OR a company Real Estate Investment Trust R.E.I.T. These are trusts that invest only in real estate and real estate mortgages

Real estate A group that is formed to purchase and develop real estate as an investment Taxable income Income on which tax is paid Tax-deferred exchange Also called the 1031 tax-free exchange, a non-taxable exchange, subject to established rules

Introduction The ultimate goal of the investor is to make a profit. Investments are assets that are acquired for the purpose of generating a profit. These properties are bought and sold as investments for the sole purpose of producing an income. Homeowners often become investors of real estate after selling their own home. They see how much it appreciated and realize that the value usually increases over time. Real estate appreciates because of inflation and demand. When property in a high demand area becomes scarce, the remaining properties will normally increase in price.

MOST IMPORTANT OF ALL --- Common sense mandates that real estate licensees should never represent themselves as financial advisors or investment counselors. Nor should they offer advice in these areas. Although agents should have knowledge of these subjects, they should always refer their investment clients to an investment specialist or accountant for advice.

Choices of Real Estate Investment Investors can hold many different types of investments. This collection of investments is called a “portfolio”. REIT or Real Estate Investment Trust is an investment group formed as a trust. REIT’s have some special tax benefits for investors, but complex IRS requirements must be met to qualify for these advantages. Mortgage-backed securities are issued from the secondary market, such as Fannie Mae OR Freddie Mac. Individuals or groups can purchase them. Real Estate are formed for the purpose of investing in a particular real estate project. These syndicates can be corporations, partnerships, or an LLC (Limited Liability Company). Investment Property Types There are many different types of real estate for investors to choose from such as: • Single family • Multi-family units • Manufactured home parks • Condominiums • Raw land • Retail and office buildings • Shopping malls, etc. Some types generate a return from rental income, and some are meant to produce a capital

gain when sold. Rental homes are one of the most common real estate investments, and are generally the easiest to manage for the owner. Duplexes and small apartment houses can also be a benefit to the investor who lives in one of the units. Being on the premises to manage can cut costs and prevent potential problems and damage. Preferred Qualities An investment property has a better chance to increase in value if it is kept in good condition and is well located. The property should fit an average renter and be somewhat conforming and functional in design. A good structural condition, sound foundations, safe heating, safe electrical wiring, and a good roof are features to look for. The investor will look for properties that have the “right things wrong.” These are cosmetic defects that require little work and money, such as paint, carpet, and cleaning and small repairs. Capitalization Rates The “capitalization” rate is the desired percentage rate of return that an investor wants to make on his/her investment. Determining value, by dividing net income by the investor's desired , is the most commonly used method when investors make offers to purchase income-producing property. After operating expenses are deducted from , the remainder is called net income. Some examples of operating expenses would be items such as maintenance, management fees, utilities, repairs, etc. Personal income taxes, reserves for the property’s depreciation, and mortgage payments made on the investment property are not classified as operating expenses. The net income is converted into a capitalization rate, or cap rate, to determine the property's value. The formula for determining the property’s value is: Annual Net Income divided by the (desired) Capitalization Rate = Value Advantages of Investing In Real Estate The home buyer decides to purchase based on the perceived advantages over leasing or renting. This is also the case with investing in real estate as there are advantages involved there, also. The following is a list of advantages that real estate investors perceive: • Increasing value due to appreciation • Leverage - buying real estate with OPM (Other People’s Money) • Real estate and mortgage tax benefits • Ability to rent OR as income • Pride of ownership • Freedom to do as one wishes with the property – no landlord “Buy low - Sell high” is the real key to the advantages of investing in real estate. Leverage is a term for using borrowed money at interest rates less than the rate of return earned by property that you already have or will acquire. Real estate investors are wise to use OPM (Other People’s Money) in order to take advantage of leverage. Leverage allows the investor to make big investments with little or no cash of their own. The investor keeps his/her cash to continue buying property, while the previously purchased properties continue to appreciate increasing the rate of return on the investment. Appreciation increases the equity, which is the difference between the property’s value and the existing encumbrances. The declining loan balance also increases the equity by reducing the principal balance, although very slowly.

Real estate is generally referred to as a “frozen asset”, as opposed to a “liquid asset,” because liquid assets can be quickly converted to cash. Cash in a bank account is a liquid asset. The disadvantage of liquid investments is that they don’t pay high returns, because there is little or no risk involved. However, liquid assets are the safest investments for the same reason. Even though real estate is not liquid, it can offer a very high rate of return and can increase the investor’s net worth. Disadvantages of Investing in Real Estate Just as there are advantages to investing in real estate, there are also disadvantages. The following are some of the ones to be aware if you are contemplating any type of real estate investment: • Responsibility of maintaining the property • Frozen asset – some risk • Subject to value changes due to economy & other factors • Real estate involves the maintenance of the property, such as painting, yard work, and general upkeep. • Real estate investments are not liquid and do not typically result in quick returns. • They are long-term investments, which may be a disadvantage for some investors. • Finding the right property can take a lot of time and work. • There is also risk that the property's value could decrease because of other factors outside the control of the investor that could result in a loss of capital and income.

Here is an example of how investing in real estate can result negatively: Lloyd has been watching the national economic trends and the economy looks healthy. He purchases a mobile home park in Wallace which happens to be a mining town. Most of the miners live in the park and it has been generating a high income for years. Six months after Lloyd has made his purchase, the mines suddenly and unexpectedly close down, ceasing all operations. As a result, the miners are forced to move to another state to find employment. Wallace’s economy is ruined and local businesses begin closing down. Although the economy has NOT changed on a national basis, Lloyd’s mobile home park has now become obsolete.

Federal Income Tax Classification of Property There are several different classifications of property and the IRS treats each differently for tax purposes. The following is a list of how the IRS classifies the different properties. Dealer Property Dealer property is usually a short-term investment of real estate intended to resell quickly. Building lots are an example of dealer classified property. A dealer status allows deductions for ALL operating expenses and mortgage interest. The dealer does not hold property as a capital asset, so gains and losses are not capital gains or capital losses, and because the properties are not capital assets there are no deductions for depreciation. Gains are taxed as ordinary income and losses can be deducted as business expenses. Income Property

All income received from property held for the production of income is taxable as passive income for the year the income was received, even it is due and payable in a later year. Operating expenses, mortgage interest and depreciation of the income property is all classified as deductible. The gains from the sale of the property are considered to be capital gains and capital losses. Unimproved Investment Property Vacant land held for investment purposes is classified as unimproved investment property. This unimproved land produces no income but may appreciate and produce a future profit. Property Business OR Trade Use This use includes land and structures owned and used for a business. A real estate broker could own an office building or a manufacturer could own a factory. These buildings would be considered property used for a business or trade. Again, all operating expenses, mortgage interest and depreciation is deductible. Gains from the sale or transfer are classified as capital gains, and any losses are fully deductible as ordinary losses. Principal Residence Principal residence refers to the homeowner’s primary home. The homeowner is allowed to have only one primary residence. Homeowners that fall into this classification can deduct property taxes and uninsured casualty losses. They can deduct debts secured with the principal or the second residence. In addition to this, the can deduct all interest on money borrowed to buy, build, or improve the home for $1,000,000 or less, as well as any and all interest on home equity loans up to $100,000 or for any purpose.

IMPORTANT NOTE: TAX LAW CHANGES TO REAL ESTATE FOR 1997 For sale of a principal residence after 5/7/97, the rules are as follows: 1. No more rollover to new home purchased in a 2 year period or once-in a-lifetime tax exclusion for persons over 55. 2. If the residence at the time of sale was used as a principal residence (i.e., not a vacation OR second home) for 2 of the last 5 years prior to sale, a single return filer can exclude $250,000 of gain, and joint filers can exclude $500,000 of gain. Exclusion can be taken an unlimited number of times but not more than once every two years. 3. Gain in excess of the $500,000 OR $250,000 limits is taxed at capital gains rates. Personal Use Property This refers to property owned by the taxpayer for a personal use, but is not used as the principal residence. Ski condos, lake cabins, or vacation homes are some examples of this type of property. Taxable Income The Internal Revenue Service collects income taxes for the United States from all individuals and businesses. Federal income tax rates are “progressive.” This means the higher the income level, the higher the tax rate. The progressive tax rates are grouped into “brackets,” or levels of incomes. Tax brackets for individuals are 15%, 28%, 31%, 36% and 39.6%. They are not equal, and each dollar is taxed on the “bracket” it is counted in. The income above each bracket is taxed at the next bracket, but the higher bracket does not affect the part of the income that was already taxed at the lower bracket. The IRS considers all income, from all sources, as taxable income unless it is specifically excluded. This includes all income resulting from salaries and wages, as well as rental income, investment income and all other income received in the year even if it was paid in advance. Tax Credits and Deductions When real estate is sold or transferred, the seller or investor almost always has a profit or a loss. A profit is referred to as a capital gain, and a loss is referred to as a capital loss. Tax deductions are taken from the income which reduces the taxable amount. A loss may be a deduction, which can lower the taxable income. Tax credits were initially created to revitalize the economy and they are important to real estate investors because they are deducted directly from the amount of income tax due. A good example of a tax credit is the homeowner’s deduction of mortgage interest from income tax due. One of the main benefits to real property ownership is the numerous deductions available for property owners. A deduction is subtracted from the gross income before it is counted into a tax bracket, thus reducing the amount of taxable income. Deductions include depreciation, property taxes, and interest on mortgages, as well as passive losses. Deducting depreciation allows the taxpayer to recover the cost of an income-producing asset over its estimated useful life. Remember that land does not depreciate because it is always considered to be useful. However, buildings and equipment have an estimated useful life that will eventually run out. Depreciation must be taken over the number of years of the property’s useful life. It can never be taken all at once. Depreciation is subject to legislation and does not actually mean the property’s useful life has really ended when the time period runs out. Congress has modified the time periods of useful life many times, and the periods are subject to change. Property taxes, such as real estate taxes and assessments are generally deductible as well. Interest payments made on personal residences are the only allowable interest deduction and are deductible in the year they were paid. The taxpayer may deduct interest paid on a mortgage up to $1,000,000 on a primary or second home. Deductions affect property owners by reducing the taxpayer’s adjusted basis if the deduction is allowable. The reduction in the adjusted basis will reduce the eventual gain or loss. Capital expenses are those that add value to the property, and repairs are not capital expenses. However, property owners may deduct the cost of repairs only in the year they were paid. It is up to the property owner to keep track of all expenses and keep receipts. Passive income is the income generated from the property, such as a rental house. Passive losses result if the losses are higher then the income from the property. Passive losses can only be offset by passive income, but if the owner doesn’t have enough passive income that year, the passive losses can be carried forward to be used in a year when a passive income is generated. Exceptions are always made for investors of rental properties that have a taxable income of no more than $100,000. In this case, the owner can use up to $25,000 of the passive loss to offset income from any other source. The maximum deduction is a reduction of 50 cents for every dollar of taxable income over $100,000.

Taxpayers involved in real property trades or businesses may deduct all losses from rental real estate to their non-passive income if they are in the real property business. A good example real property business example here would be a Realtor. They are required to perform more than 750 hours of work and over 50% of their personal services in the business. All passive losses that were not deducted in the first year can be carried forward to future years.

Property Value after Profit or Loss Formula If the investor made no profit, but also had no loss, the property value would remain the same. The percentage of the profit or loss is the comparison of the property “value before” the profit or loss, to the property “value after” the profit or loss is taken. The value of the property before the profit or loss was taken is 100% of its value. This 100% figure is called the “value before.” If the investor realizes a profit, the property is valued at 100% of its “value before”, plus the percentage of profit. Of course, if the investor shows a loss, the property is valued at 100% of its value before, minus the percentage of profit. Value Before and Value after Formula The percentage of the profit or loss is multiplied by the Value of the property before the profit or loss, plus 100% (of the Value BEFORE), equals the Value after the profit or loss. Or to write this as a true formula: VB + 100% (of VB) x % = VA (The Value after divided by the Value before plus 100% of the Value before equals the percentage of profit or loss)

Here are a couple of examples to illustrate the formula: 1) Joe bought a house seven years ago for $169,000. He sold it to Troy for 40% more than he paid. What is the "value after" of this property? Remembering that the % x VB = VA, .40 x $169,000 = $67,600. Therefore, Joe’s profit is $67,600. He can now add the profit to 100% of “value before,” which was $169,000 for a total of $236,600 “value after”.

2) If Wanda sold her rental for $174,300, which was 27% more than she paid for it 1 year ago, how much did Wanda originally pay for it? She knows the “value after” is $174,300 and that the percentage of profit is 27%. Once again, applying the formula above, VA divided by % + 100% of VB =V B Since 100% + 27% is 1.27%, $174,300 divided by 1.27 = equals $137,244, therefore Wanda originally paid $137,244 for her rental property.

Capital Gains Profits are considered income and are subject to taxation. The rules for capital gains tax have been changed as follows: • For sales or exchanges after 7/28/97, the holding period to qualify for long-term gains is increased from 12 months to 18 months. • For sales after 5/7/97, the capital gains tax rate has been reduced from 28% to 20% for long- term gains. • For those in the 15% tax bracket, the rate is reduced to 10%. • For sales after 12/31/2000, the tax rate will be reduced to 18% (or to 8% for those in the 15% tax bracket) for assets held at least 5 years. • For sales after 5/7/97, depreciation recapture will be at a tax rate of 25%. If a taxpayer takes depreciation on a principal home (e.g. if it was used as rental property) after 5/7/97, that depreciation must be recognized and recaptured on sale. Basis To figure capitol gains and/or losses, first the basis of the investment must be determined. The initial basis is usually what the taxpayer has invested in it, including the purchase price plus specific closing costs including attorney fees, title insurance, etc. When an asset is sold or transferred the taxpayer’s basis is the amount that can be received without realizing a capital gain. This means that if Drew bought a home for $108,000 and paid closing costs of $4,500, for a total of $112,500, he could sell the house for $112,500, and without owing Federal tax, because he did not realize a gain. The taxpayer’s initial basis can be adjusted by considering capital expenditure, depreciation, and cost recovery deductions. After these costs are figured into the initial basis, it becomes the adjusted basis. Capital expenditures are capital improvements that add to the value of the property or extend the property’s useful life. This could be assessment for streets, or improvements such as adding bathrooms or remodeling the kitchen. Normal maintenance and repairs do not add value or extend the useful life and cannot be added to the basis. Here’s an example showing how the basis is calculated: Charles pays $165,900 for his house, plus $ 6,400 in closing costs. Three years later he adds a second bath for $3,200. He totals the original $165,900, plus the $6,400 in closing costs, plus the $3,200 for capital improvements for an adjusted basis of $175,500.00. Realization Capital gains are not taxable until the property has sold or transferred and the gain has been realized. If the property has appreciated in value, the gain would not be realized (taxed) until the property was sold or exchanged. When the property is sold or exchanged, the gain would then be figured and become taxable.

Here’s an example to illustrate how realization is figured: For the past three years, Charles’ house has been appreciating in value. His house now has a market value of $250,000. Charles paid $165,900 for the house, $6,400 in closing costs and added $3,200 in improvements for an adjusted basis of $175,500.00. His house is now worth $74,500 more than he has invested. Charles will not have to pay tax on the $74,500 gain until it is realized when he sells OR transfers it. Net Sale Price A gain or a loss is the net sale price (that is realized) minus the adjusted basis. The “net sale price” is the amount realized. This is a total of all money paid, plus the value of other property or exchange received, plus any debt relief (assumed or paid off), minus the selling costs. Money paid (including cash, notes, and mortgages) plus the Value of exchange or other property plus the debt relief (mortgages paid or assumed by buyer) minus the selling costs (commissions, legal & loan fees, points) equals the amount realized (or the net sale price).

Investment Exchanges and Investment Sales A “tax free exchange”, also called non-taxable exchange or 1031 exchange, is actually a tax- deferred exchange. Section 1031 of the IRC establishes the rules for all tax-free or “tax deferred” exchanges. These tax free (deferred) exchanges help to make it possible to purchase property with tax deferred proceeds from the first sale. The tax-free exchange is used in the exchange of investment properties. These exchanges must be of tangible “like-kind” properties. Like - kind property is exchanged and the recognition of realized gain is deferred. Like-kind means that both properties are properties held for investment or is capable of producing income. Personal use homes, principal residences, and dealer owned properties are not like-kind and are not eligible for the tax-free exchange. A Laundromat in exchange for a manufactured home park would be like-kind. Any money or other property other than like-kind is called “boot”. Boot, such as personal property, cash, etc., cannot be deferred.

Here’s an example to help illustrate the above: Stan exchanges his tavern for Skip’s café. Stan owes $100,000 on his loan balance and Skip owes $60,000 on his mortgage. By making this exchange, Skip is giving Stan $40,000 as boot as a result of debt relief. This is because Stan now has a balance of $40,000 less than he did before with his $100,000 loan on the tavern that Skip now owns. As a result, Stan will have to pay tax on the $40,000 in the year he received it, as though it were income. Installment Sales All sales automatically qualify for tax deferral if the seller does not receive the full purchase price of the property in the year of the sale. It should be noted that almost all seller-financed transactions are installment sales that allow the seller to defer recognition of part of the gain. The seller is only required to pay taxes on the profit amount received in each year. The gain recognized in any year is based on the ratio of gross profit. The gross profit is the difference between the sales price and the adjusted.

The following example will illustrate what this means: SALES PRICE $289,500 SELLER’S BASIS $210,000.00 + COMMISSION (10%) $28,950.00 + SELLING COSTS $1,737.00 ADJUSTED BASIS $240,687.00

SALES PRICE $289,500.00 ADJUSTED BASIS - $240,687.00 GROSS PROFIT $48,813.00 Gross profit divided by the contract (sales) price equals the gross profit ratio. In other words, $48,813.00 ÷ $289,500.00 =.17 OR 17% Now the Gross Profit Ratio is applied to the payments made to the seller in any given year to figure the amount of principal that is taxable gain. Gross Profit Ratio is not applied to interest. Interest payments are taxable the year in which they are received. Assuming that the seller above had received $28,950as a down payment, and $1,460 in installment payments, then the total principal payments would be $30,410. So to calculate the seller’s total taxable income, it would be as follows: $30,410 Payments x 17% Gross profit Ratio = $5,169.70 Total taxable Income When a seller allows the buyer to assume a loan that is bigger than the seller’s basis, the amount over the basis is treated as a payment received and is subject to taxation.

Review The ultimate goal of the investor is to make a profit. Investments are assets that are acquired for the purpose of generating a profit. For this reason, homeowners often become investors of real estate after selling their own home. They see how much it appreciated and realize that the value usually increases over time. Real estate appreciates because of inflation and demand. When property in a high demand area becomes scarce, the remaining properties will normally increase in price. Mortgage-backed securities are issued from the secondary market, such as Fannie Mae or Freddie Mac. Individuals or groups can purchase them. Real Estate Syndicates are formed to invest in a particular real estate project. The Syndicates can be corporations, partnerships, trusts or an LLC (Limited Liability Company). Rental homes are one of the most common real estate investments and are generally the easiest to manage for the owner. An investment property has a better chance to increase in value if it is in good condition and is well located. The property should fit an average renter and be somewhat conforming and functional in design. The investor will look for properties that have the “right things wrong.” These are cosmetic defects that require little work and money, such as paint, carpet, cleaning and small repairs. Appreciation increases the equity, which is the difference between the property’s value and the existing encumbrances. Real estate investments are not liquid and do not typically result in quick returns. They are long- term investments, which may be a disadvantage for some investors. Dealer property is usually a short-term investment of real estate intended to resell quickly. Building lots are an example of dealer classified property. Principal residence refers to the homeowner’s primary home. The homeowner can have only one primary residence. The IRS considers all income, from all sources, as taxable income unless it is specifically excluded. This means that all income from salaries and wages, as well rental income, investment income and all other income received in the year, even if it was paid in advance. When real estate is sold or transferred, the seller or investor almost always has a profit or a loss. A profit is called a capital gain, and a loss is called a capital loss. Deductions affect property owners by reducing the taxpayer’s adjusted basis if the deduction is allowable. The reduction in the adjusted basis will reduce the eventual gain or loss. Capital expenses are those that add value to the property, and repairs are not capital expenses. However, property owners may deduct the cost of repairs in the year they were paid. It is up to the property owner to keep track of ALL expenses and keep receipts. The percentage of the profit or loss is the comparison of the property “value before” the profit or loss, to the property “value after” the profit or loss is taken. There are several ways that tax on gains may be deferred. A “tax free exchange”, also called a non-taxable exchange or 1031 exchange, is actually a tax-deferred exchange. Section 1031 of the IRS establishes the rules for all tax-free or “tax deferred” exchanges. All sales will automatically qualify for tax deferral if the seller does not receive the full purchase price of the property in the year of the sale. Almost all seller-financed transactions are installment sales that allow the seller to defer part of the gain.

Chapter 6 Short Sales, Loss Mitigation, and Foreclosure

Glossary

Acceleration Clause A clause that accelerates the payments so the full amount of principal and interest becomes due all at once

Alienation Clause The same as a “due on sale” clause. This means the loan is not assumable without lender's approval

Foreclosure the equitable proceeding in which a bank or other secured creditor sells or repossesses a parcel of real property (immovable property) after the owner has failed to comply with an agreement between the lender and borrower called a "mortgage" or "deed of trust".

Lis Pendens Latin for "suit pending."

Loss Mitigation a process in which lenders help borrowers that are in danger of default, avoid foreclosure.

NOD Notice of Default - a notification given to a borrower stating that he or she has not made their payments by the predetermined deadline.

Post Foreclosure The last stage of foreclosure wherein the lender has already taken control of the property. The home is then in the possession of the lender's REO () department, or in the hands of a new owner or investor who purchased the property at auction.

Pre-foreclosure The first stage of foreclosure. Further damage to the home owner's credit rating can be forestalled and the home may be transferred at a mutually-agreed-upon price before it is necessary to get the lender involved.

REO Real Estate Owned - a class of property owned by a lender, typically a bank, after an unsuccessful sale at a foreclosure auction.

Short Sale When a bank or mortgage lender agrees to discount a loan balance due to an economic hardship on the part of the mortgagor.

Strict Foreclosure Under strict foreclosure, when a mortgagor defaults, a court orders the mortgagor to pay the mortgage within a certain period of time. If the mortgagor fails, the mortgage holder automatically gains title, with no obligation to sell the property. Strict foreclosure was the original method of foreclosure.

Introduction

It’s a sad fact about life, but oftentimes homeowners and their families encounter financial hardships that force them into making decisions that create very emotional situations for them. The one single possession that they endeavored to purchase and then maintain for years to come was the roof over their heads. It is without a doubt the most difficult decision that a homeowner will ever have to make in his/her life, giving up their home.

With the state of the economy in constant flux, things have become very difficult for a lot of homeowners to maintain the standard of living that they had originally gotten used to despite having lived within their means. As a result, people are forced to walk away from their homes without getting a dime out of it in return for all the years they spent watching their equity and investment grow.

One of the options that a homeowner has available, though it is obviously not that desirable of an option, is to go to their lender to seek assistance in the matter and ask the lender to discount the balance that remains on their loan obligation. This enables the homeowner to sell the mortgaged property for less than the outstanding balance of the loan. When the property is sold, the homeowner then turns over the proceeds of the sale in order to satisfy the debt obligation to the lender.

This concept has become known as a Short Sale, and has become a way for homeowners to avoid foreclosure proceedings. The decision to approve a short sale ultimately rests in the hands of the lender and is based on things such as the current real estate market climate or if they believe that this course of action will result in less financial loss than foreclosing. There are other circumstances that could prevent the lender from approving this course of action, however these two are the most prevalent reasons for approval or denial.

In definitive terms, “a short sale is nothing more than negotiating (with lien holders) a payoff for less than what they are owed, or rather a sale of a debt, generally on a piece of real estate, short of the full debt amount.” Characteristically, short sales are normally handled by a lender’s Mitigation Department which is responsible for the processing of potential short sale transactions.

In order for the lender to accept a short sale offer, a Notice to Default must be either issued or recorded in the locality where the property is located. Without this document, the short sale offer or request will not be accepted by the lender or the mitigation department.

Short sales are generally conducted in a “non-brokered” environment in the presence of either a facilitator or some form of specialist. Usually the lender does this in order to save on the margins. Facilitators will sometimes work with private lending agencies, such as a partner or syndicate, where the financing is concerned. In addition to this, the lender has to approve of any buyer’s or listing agent’s commissions should any result from the transaction.

Positives (?) and Negatives

The majority of lenders in the industry will have a pre-determined set of criteria that applies strictly to the short sale process. However, there are those lenders who do not allow it. This is due solely to the fact that they possess a varying tolerance for short sales and mitigated losses. Despite the fact that short sales are always subject to a mitigator’s approval, some lenders will allow any reasonable offer in order to clear the debt off the books, so to speak.

As is the case with HUD and REO (lender’s “real estate owned”) properties, “red tape” holds an all too common presence within the business of short sales. Oftentimes, there exists an abundant number of conditions as well as multiple levels of approval being required to complete the process. In some cases, it is necessary to receive approvals from the following:

• HELOC (Home Equity Line of Credit) • HOA (Homeowner’s Association) • Second mortgagees

In any event, the process is often arduous on the way to approving the sale of the property in this manner. The following two groups are usually the main objectors when it comes to the short sale approval process:

• Tax lien holders (income, estate or corporate franchise tax - as opposed to real property taxes, which have priority even unrecorded) • Mechanic’s lien holders

Additionally, the junior lienor can also keep a short sale from being completed. The bottom line is that the approval does not always equate to the proverbial “done deal”, and for the most part, the only positive feature that comes out of the process rests on the homeowner being relieved of his obligation.

It is not that uncommon or that infrequent of an occurrence for lenders to forgive the balance on the obligations in question. However, it is often unlikely that lien holders who are not mortgagees will often forgive any of their balance. Unfortunately for the homeowner, lenders have the tendency to omit the zero balance on the loan that should be on the books once the short sale is approved and completed. Most often, they refuse to do so stating that it is “due to their financial loss.”

It’s a good idea to try and learn how a lender thinks. There are things that the agent will need to take into consideration once that lender joins into the transaction. One of the first questions most people ask is why a lender would be willing to take a discount on this. There are a number of reasons, but there are basically two reasons that probably account for the majority of the short sales that are approved.

Remember first and foremost that lenders don’t want to be embarrassed because of “excess inventory” that is just sitting on their books. And yes, bad loans are considered inventory and when it’s excessive, it becomes a major embarrassment that no lender likes to endure. So when an opportunity presents itself wherein they can sell the suspect property without incurring a huge loss, they are apt to do it.

Secondly, if the property in question winds up going to auction that can equate to a huge loss for the lender. The discount involved with a short sale all too often proves to be the better option for the lender because with auctions come all the associated fees. This also adds to the lender’s losses, which in turn makes them look even worse. So if that opportunity is a better option than the embarrassment of stagnant inventory, your client could be the beneficiary of an inexpensive investment that could eventually turn a profit for them.

The occurrence of foreclosures 2006-08 hit an all-time high nationwide which presented more opportunities for the real estate (as well as the non-real estate) investor since it will often translate into more discounting on property on behalf of the lenders. Just remember that even though some lenders will refuse to discount and approve short sales, there are those who oftentimes will, given the right type of circumstances, if the numbers make sense to them to do it.

Although a short sale can be performed once it’s in the hands of the lender (i.e. foreclosed), this will obviously reduce profits that result from the transaction’s completion. So it is always a better idea to attempt negotiating the sale when it’s in the pre-foreclosure state. Be aware that there are two stages in the pre-foreclosure state of affairs which are relative to time frames. The first stage involves those homeowners that are behind on their payments. The second stage involves those that are behind on their payments with a notice of default.

For the client to be successful and for the short sale to function properly, the agent has to find those homeowners who are in the second stage of the pre-foreclosure process, or more than three months behind in their payments. Don’t forget that once the Notice of Default is recorded, that the lenders become motivated to move the inventory off their books. The client will benefit from this as a larger discount may result.

Up until this time, lenders are much more reluctant to discount a mortgage, and if the Notice of Default isn’t recorded yet, there is no point in attempting any negotiating anyway. Besides that, why would the lender want to do any discounting yet? There is still time for the homeowner to catch up on those back payments.

One final thing to remember is that it doesn’t matter as to what type of house it is or what kind of condition it’s in, all mortgages can be discounted. Typically, the best houses for a short sale are the ones that need some repair and work. That isn’t bad advice if you think about it. Usually, lenders will offer the tentative buyer larger discounts when the homes are in this sort of condition.

Another good candidate for a short sale is a home that has been overleveraged. Also, those properties that have a 2nd (or even a 3rd) mortgage on them are good deals as well in that the mortgages are wiped out in foreclosure auctions. Additionally, lenders who find themselves in a 2nd and 3rd mortgage position would rather get something instead of nothing. So the agent needs to keep these things in mind as investment options for a client.

If the term “short sale” sounds similar to the term “quick sale”, it’s because it could be construed as such. It basically means that the homeowner is attempting to sell the house for less than what is owed on it. The agent should remember to be compassionate in their thinking since most of the homeowners who engage in this are doing so out of desperation and not deceit. When approved and completed, the short sale proves to be a bargain for the buyer and a relief for the seller. So it could be called a win-win situation.

On the downside, the short sale provides no incentive for the lender to pursue this route rather than that of foreclosure. Lenders often think that they stand to gain more financially by foreclosing on a home and selling it themselves. Since this is what is referred to as a third-party approval scenario, the lender is a foreboding entity constantly hovering over the entire process.

Dealing with any third-party can be very cumbersome and tedious. Anytime the agent is engaged with a client where a short sale is one of their options for purchasing a home, by all means educate that client as to what a knock-down-drag-out process they could be up against. It’s ironic that they would coin the terminology “short” sale since they wind up being anything but in most cases.

According to the Baltimore Sun’s Jamie Smith Hopkins, a large majority of short sales fall into the hands of Wall Street investors as cheap financial opportunities. So in essence, things have become even more difficult. According to her, there are sometimes four parties now involved in the process:

• the buyer • the seller • the • the note holder

So the mix is getting pretty thick, and this just complicates and delays completion of the process that much more. An interesting note here is that lenders often offer bigger discounts on properties that are valued over $500,000, so the agent should keep that in mind.

Rules for Rookies

Having a better knowledge of how short sales work will enable the agent to offer another option for to the client. When first getting started, there are always the “do’s and don’ts” that an agent needs to be aware of so they can better serve that client.

According to Foreclosure University, the single most important step in the process is getting the deed from the homeowner. This is a vital step that a lot of investors overlook, and all too often, it proves to be a costly mistake. So why is this step in the process such an important one? Because homeowners in this situation are prone to changing their minds and backing out of agreements. They get scared, they want to re-negotiate, or good old “buyer’s remorse” sets in sometimes. One way or the other, if they still have possession of the deed, they can back out on the transaction whenever they get the urge to do so.

Once they have signed the deed over, the real work is just beginning. When the deed changes hands, so does the control of the property and the agent can start the process by calling the lender. When doing a short sale, be advised that there is actually a process to follow in the initial steps of contacting the lender. Here are a few rules to follow before getting started. It is advisable that they are done in the order that they are listed:

Rule #1 – check the public records. Finding out who is in title, if a foreclosure notice is on file, or how much is owed to the lender is crucial information. Common sense dictates this. It also helps gives the agent and investor an idea of how much to offer on the property. Additionally, you should also find out if there is a 2nd or 3rd on the property.

Should there be two loans on the property, the agent and client will have to deal with the lender that controls the 2nd mortgage. Unless the lender on the 2nd mortgage does not want to foreclose, the first lender’s position is usually protected by the second. As an example, let’s say that the seller owes the first lender $220,000 and the second lender $80,000. Offering $220,000 is not workable because it will wipe out that second lender.

Rule #2 –lenders are smarter than you think. Lenders know when a person is doing this for the first time, so in order to be effective where the client is concerned, it is a good idea for the agent to be educated in all aspects of the process. Just remember going into this that lenders will not agree to any short sale if the seller has no equity and cannot repay the difference between an existing loan and the sales price.

Rule #3 – Keep the client’s intentions confidential. This is the biggest and most common mistake made by the rookie investor and it usually results in the lender not accepting short sales. When first making contact with the person in charge, the agent should tell them that they are representing the homeowner. It’s amusing, but some lenders will ask the licensee if they are a real estate attorney. The licensee should reassure the lender that they are the rep for the homeowner and nothing more.

Rule #4 – ask for the “short sales packet” or the “workout packet”. A soon as the packet has been received, the agent and the client should start doing their homework. It will line out the steps that need to be taken in order to be successful at completing the short sale transaction.

Rule #5 – give the bank what they ask for ASAP! Chances are the first thing the lender is going to do is request a hardship letter stating the reasons why the homeowner has ceased making his monthly payments. They may also request items such as pay stubs, income statements, bank statements, etc. Additionally, the lender can ask for a HUD-1, as well as a real estate purchase and sales agreement.

Don’t waste any time. Just prepare for this and send them whatever they ask for, otherwise the negotiation will be dead in its tracks. It is not uncommon for the lender to take three or more weeks to respond, so the sooner that this is taken care of, the sooner the agent and client may get some sort of answer. Remember that if there is an auction approaching, time is of the essence. However, a person can ask for an extension and a delay of the auction. In most cases, if one can justify the reasoning behind such a request, they will grant an extension.

Here are a few more helpful suggestions to consider once contact has been made with the homeowner and the lender:

When starting out, it is a good idea to seek out the advice of someone that has experience dealing with short sales. There is no harm in learning from someone who is more knowledgeable. Missing important details along the way can be costly. Besides that, gaining necessary knowledge will help expedite the process and protect the client’s interests in the matter.

Remember when dealing with the homeowner that they already feel vulnerable enough, so do what you can to give them some peace of mind. Try not to be too strong in your approach and be compassionate. For most homeowners this is a heartbreaking experience.

The seller receives no money in a short sale for the obvious reason, so the lender controls the commissions. Since the lender is losing money on this, the money is shared with the listing broker, who then shares it with the licensee.

The most successful investors are not afraid to give the lender a deadline. For instance, he or she might make the offer contingent upon the lender’s acceptance, letting them know that they only have a certain amount of time to respond to the offer.

It is important to know to whom the offer should be submitted. Just because they have a short sale (or workout) department, that doesn’t mean the one who is responsible for approving the sale is in that office. It’s true that in some instances a short sale is submitted to a committee for approval. However, most primary decision-makers can give the agent or the client an answer within a few weeks, provided the documents have been submitted to the correct decision-maker. Hint – always try to get the name and phone number of the appropriate person as this will help avoid delays in the process.

A good strategy when investing in property is to reserve the right to conduct any necessary inspections on the property. The lender is not expected to pay for these things since it isn’t customary for them to assume the liabilities that the seller normally would. Remember that the property is purchased “as is”, in other words, warts and all. A home inspection is always a wise investment whether or not a person feels that the situation warrants it. Also, consider inspections for the chimney and fireplace, pests, the roof, and the septic tank or sewer. Better safe than sorry.

For your clients’ protection, recommend obtaining the advice of a competent real estate attorney and a good accountant to find out the tax ramifications of a short sale. Remember to cover all the bases wherever possible.

What it Takes to Qualify for a Short Sale

If all short sales transpired the way that everyone involved wants them to transpire the process would be pretty simple and go without a hitch. Ideally, the seller would sign a listing agreement, an agent would find a buyer, the seller would accept the buyer’s offer, the lender would accept the offer, the buyer would deliver the funds, the lender would release the lien, the seller would deliver the deed, and the transaction would close.

But what about the actual qualification part of the process (sound of screeching brakes in the background)? There are usually four criteria that a lender looks for when it comes to qualifying the sale of the property as a short sale.

• The mortgage is in default --- as long as the mortgage is current, the lender won’t even consider the possibility of a short sale. Usually, if the lender is receiving timely payments on the loan, they’re pretty much satisfied with things

• The market value of the home has dropped --- comparable sales in the area will often substantiate this to the lender. If the home is valued at less than what the balance remaining on the loan is, then it has fulfilled this requirement.

• The seller is experiencing financial hardship --- the lender requires a formal letter of hardship be submitted by the homeowner. The seller needs to state why they are unable to pay the difference between the true balance and the discounted balance, as well as why they have stopped making their monthly payments.

The following reasons do not constitute a financial hardship:

1. Bad purchasing decisions – obviously, frivolously blowing a paycheck on a 52” plasma television is an example of this, along with similar examples of spending behavior 2. Not liking your neighbors – they can be growing marijuana in every house on the block and this may not influence the lender’s decision to approve a short sale of the property 3. Purchasing another residence – if the homeowner decides that the current property is no longer suitable for their needs, the lender won’t care 4. Pregnancy – starting a family or increasing the size of it will not be considered a hardship by any lender 5. Downsizing – the decision to move into an apartment or is not a valid qualification for a short sale

On the other hand, lenders will perceive the following to be financial hardships:

1. bankruptcy 2. death 3. divorce 4. medical emergency / debilitating illness 5. unemployment

• The seller has no assets – one of the main reasons that a lender asks to see any financial statements (or tax returns) is to determine if the homeowner has the ability to pay the shorted difference between the proceeds of the short sale and the true balance outstanding on the loan.

Usually, if a lender sees all four of the above, they are more apt to approve the property as a short sale entity so that the buyer can dive into the process.

Notes on Negotiating the Short Sale

Bids on properties are going to get rejected, so it may be a good idea to reassure the client that this will happen and to not get discouraged. No lender in his or her right mind is going to get emotionally attached to any property, so the client should not anticipate that they are going to always get a fantastic bargain.

On a positive note where the lender is concerned, the short sale saves the lending institution on expenses compared to the foreclosure route. Attorney’s fees, the process, delays from borrower bankruptcy, damage to the property, and costs associated with resale are the more common expenses that are incurred during foreclosure. The lender gets the property back faster in the short sale scenario, enabling them to cut their losses that much quicker. As an agent representing a client, the lender has to be convinced that it is more feasible for them to accept a short sale bid offer and accept less money now.

The negotiation process can be tedious and oftentimes very frustrating. It’s also a fact that very few investors out there are skilled at negotiating a short sale, so it becomes even more important that the agent negotiate effectively for their client. Too many clients have the misconception that all there is to the process is submitting an offer and waiting for the lender’s response.

Obviously this is not the case. Every agent needs a good strategic plan of action, which means controlling the transaction and helping to make it go the client’s way. A strategic plan is always necessary with short sale negotiating. Here are a few tips to ensure success at it.

One of the most common mistakes that a fledgling investor makes is the assumption that any homeowner facing foreclosure is an excellent candidate for the short sale. One might as well say that they can fit a square peg into a round hole. It should be recommended that the client discuss the matter with a real estate attorney before making this decision.

It is important to analyze the transaction thoroughly, and move on to the next phase in the process when the time is right. Developing a strategic plan helps the agent and the client to master the art of the short sale.

Secondly, when it comes to negotiating with the lender, instead of taking NO for an answer ask:

• Why was my offer too low? • How does the lender determine the lowest offer? • What was the BPO amount? • Is there someone else I can speak with regarding this matter?

When asking questions it is always best to be professional, be very tactful and polite so that the lender does not feel challenged.

The more the agent resists a lender’s negativity and counters it with professional curiosity, the greater the chance that they will successfully negotiate the transaction to the client’s satisfaction.

Loss Mitigation

What is Loss Mitigation? In the simplest of definitions, it is an option (or a process) wherein a struggling homeowner can prevent foreclosure proceedings from happening. The process can be conducted by one of two individuals:

• An employee or representative of the lien holder • A third-party acting on behalf of the homeowner

The better choice of the two is the disinterested third-party since they are capable of working with lenders without any emotional attachments to the property. The loss mitigation concept was the result of a collaborative effort conducted between the federal government and the mortgage industry for the purpose of assisting homeowners who were facing the possibility of losing their homes.

Professional loss mitigation counselors work with the homeowner and the lender in the hopes of avoiding foreclosure proceedings. In the short sale process the loss mitigation department will be involved. How a person deals with that department is critical to the success of the sale.

All financial institutions have such a department; however they may call it by another name. If the CSR says they don’t have a department by that name, ask them for the foreclosure, short sale, or workout department. Regardless of the names, the function of the department is the same.

The main focus of a loss mitigation process is to keep the homeowner in their home. The job of the counselor is to arrange a loan modification or repayment plan that the homeowner and the lender can live with. The plan has to be realistic where the homeowner is concerned since the lender is looking for not only future payments on the loan, but for settlement on the arrears as well.

When loss mitigation fails to resolve the issue for the homeowner, then other options come into play. Short sales (as has been discussed) and deed-in-lieu of foreclosure (see section on foreclosure) become the next two options before foreclosure comes into the picture.

Negotiating a Short Sale with Loss Mitigation

For the real estate investor, there is a genuine opportunity to benefit from loss mitigation for a short sale. Keep in mind that the ultimate goal from an investment standpoint is that the client has a chance to walk away with a piece of property that now has equity, where there wasn’t any to begin with. Also, the homeowner is usually relieved since they can move on with their lives after having been through a traumatic experience. In essence, it becomes a win-win situation for all parties concerned --- even the lender.

When loss mitigation answers the phone, the agent might explain that they are calling on behalf of the homeowners, and that they have an “Authorization to Release Information” document that they need to fax over to them. Once the document has been faxed, the agent could stay on the phone with them and confirm they have received it and obtained the proper signature to authorize the document.

Ask other questions such as how long will it take to get a decision? Once the transaction has been accepted, ask how long will it take to close? Once the offer has been accepted, put it into writing.

Foreclosure

The following are two definitions of the word Foreclosure --- the first is the more technical one from Wikipedia (http://en.wikipedia.org/wiki/Foreclosure), and the second comes from the website “Foreclosure University” (http://www.foreclosureuniversity.com).

“Foreclosure is the equitable proceeding in which a bank or other secured creditor sells or repossesses a parcel of real property (immovable property) due to the owner's failure to comply with an agreement between the lender and borrower called a "mortgage" or "deed of trust". Commonly, the violation of the mortgage is a default in payment of a promissory note, secured by a lien on the property. When the process is complete, it is typically said that "the lender has foreclosed its mortgage or lien".

Pretty technical isn’t it? Foreclosure University’s is a little easier to swallow:

“Foreclosure is to shut out, to bar, to extinguish a mortgagor's right of redeeming a mortgaged estate. It is a termination of all rights of the homeowner covered by a mortgage. Foreclosure is a process in which the estate becomes the absolute property of the lending institution.”

Foreclosure basically translates as a method that is enforced by a court’s action wherein a lender takes and sells an estate for the purpose of enforcing the payment of a debt that has been secured by a mortgage. A challenge ensues from these proceedings in that the lender and the borrower are seeking a compromise that permits a win-win situation for both parties involved. The borrower wants to keep their home (or business, or both) and the lender wants to keep receiving their monthly payments.

The bottom line is that the homeowner may no longer have a roof over their heads because they failed (for a variety of reasons) to maintain payments on their mortgage. Sadly, the amount of foreclosures in the United States grows annually. According to Foreclosure University (2007), there were 120,000,000 or so homes in the U.S. and roughly 4% (or 4.8 million) of them were facing foreclosure proceedings.

The Two Main Types of Foreclosures

Once a homeowner has defaulted on their mortgage, the lender can initiate foreclosure proceedings. With the exception of only a few states, there are basically only two types of foreclosures that are used. Foreclosure by judicial sale is the most important form used. Not only is this form available in every state, but it is the required method in most. The court supervises the sale of the property with this method. The proceeds go to the lender first to satisfy the mortgage, then to satisfy other lien holders (if they exist), and then the mortgagor. Since this constitutes a legal action, they require the lender to file a lawsuit against the borrower. The lawsuit must be filed in the county where the secured property exists. Lien holders with lower priority will be notified so they can attempt to protect their interests. There will be pleadings and then a judicial decision. The lawsuit will state the default under any of the terms of the mortgage agreement, and the lender can demand repayment of the entire debt at once. If the debt is not repaid, the lender can begin foreclosure proceedings, but the mortgagor has a redemption period, or a certain amount of time to redeem the property after the sale. The judge can then order the sale by auction called a sheriff's sale. Any time prior to the sheriff’s sale, the borrower is entitled to the period of equitable redemption. This means that the borrower may redeem the property by paying off the mortgage and all of the costs incurred. Once the property goes to the sheriff’s sale, if the sale does not bring enough cash to cover the balance owing, the mortgagee has the statutory right to lien any other real or personal property that belongs to the mortgagor to make up the deficit. If the proceeds are sufficient the debt is paid off. In either case, the new buyer is given a certificate of sale. The new owner with the certificate of sale has the right to possession of the property throughout the statutory redemption period unless the property was the debtor's homestead. If the property was the borrowers homestead, the borrower could actually live in the home without making any payments during the entire redemption period. The reason many lenders prefer the deed of trust, is because the mortgage also allows a period of time AFTER the sale in which the borrower is given an additional period to redeem the property. This is called the statutory redemption period. If the property is not redeemed, the holder of the certificate of sale is given a sheriff's deed and the debtor no longer has any claim to the property. The lender usually bids only the loan balance amount, so the lower priority liens are usually not be paid. If people other than the lender are bidding, and the sale exceeds the amount to pay off all valid liens against the property, the surplus must be paid to the borrower.

The second method is known as foreclosure by power of sale. In this method, the lender or mortgage holder sells the property without the involvement of the courts. There is no lawsuit or court action required to authorize the trustee to sell the property if the Trustor defaults. This is called a non-judicial foreclosure. The trustee can simply hold an auction called a trustee's sale and the sale proceeds will be used to pay off the loan and all costs. The majority of the states allow this method of foreclosure, and it is the more expedient method of the two. Once again, the proceeds from the sale are dispersed in the same order as the judicial form.

The procedures of the non-judicial foreclosure are prescribed by statute and are designed to give the borrower a period of time to cure the default and reinstate the loan. The trustee must give the borrower a thirty-day notice of default. After thirty days, the trustee will give notice of sale to the borrower and record the notice in the county where the property exists. The sale can be held no sooner than 90 days from the notice of sale. The borrower still has up to eleven days before the sale to pay the delinquent amount plus late charges and costs incurred to cure the default. If this is done, the foreclosure is terminated and the loan is reinstated. This is an important feature of the deed of trust. Under a mortgage the borrower would have to pay off the entire mortgage amount rather than just the amount that was delinquent, plus all costs incurred. Preventing a non-judicial foreclosure means the borrower can pay the delinquent amount even though the lender may demand immediate payment of the entire loan balance. Another important feature is that the trustee's sale is final and there is no statutory redemption period to wait out. The deed of trust instead, allows a waiting period before the property is sold. If the Trustor can pay the amount owing and become reinstated the sale will not take place. If the Trustor fails to pay the amount owing and reinstate during the waiting period, the sale goes forward and the Trustor loses the property. The buyer is delivered a trustee's deed, which gives legal title to the new owner. When the proceeds of the trustee's sale are less than the amount of the debt, the lender takes the loss and the lender may not sue the borrower for any deficiency. There is an exception that if the mortgagor commits waste. Like the sheriff's sale, if there is a surplus of proceeds the excess amount must be given to the borrower.

Other Foreclosure Methods

There are other methods of foreclosure, but they are limited as to the places that they can be used and are therefore considered to be minor ones. The most prominent minor form of foreclosure is called strict foreclosure. Under this method, when the mortgagor defaults, the court orders the mortgage to be paid off in a specified period of time. Should the mortgagor fail to comply, the title is automatically granted to the mortgage holder with no obligation to sell the property. Interestingly enough, this was the original method of foreclosure that was used.

A Trustor facing foreclosure can prevent a forced sale and avoid the publicity of the foreclosure by giving the beneficiary a deed in lieu of foreclosure. If the beneficiary gives consent, the Trustor can transfer the property back to the beneficiary. If the property is worth substantially more than the outstanding balance owing, the Trustor could sue the beneficiary for the difference.

The mortgage or deed of trust will usually contain the following:

• Date • Amount of the loan • Terms of repayment • Interest rate • Payment amount • Payment due date • Name of lender • Borrower’s signature • Property Description • Taxes and Insurance • Property Maintenance • Provision requiring borrower to protect lenders security by paying real estate taxes, assessments, and hazard insurance premiums when due and adequately maintain the property.

7 Helpful Tips for the Investor

There are actually three stages of the foreclosure process, but before we dive into those, here are 7 helpful tips offered by Robert Lam. Robert is a successful real estate agent who assists his clients in foreclosure investing. The following is what he recommends that agents should do when helping their clients locate foreclosure properties to invest in:

Tip #1: Use the internet This will save the agent and the client a lot of driving, legwork, phone calls, and time in general. Search the County Recorder’s website for the most recent NOD’s (Notices of Default). Also, look at actual foreclosure listing sites for properties that will soon go to auctions or trustee sales.

Tip #2: Work quickly The agent needs to work quickly once the home is in the pre-foreclosure stage (see below). Bear in mind that the homeowner must sell the property by a certain date before it moves into the actual foreclosure stage (see below) and goes to auction.

Tip #3: Get your financing in place Make sure that the client has been approved for the amount of the loan that they will need. Take into consideration that the loan approval process could take anywhere from 1 to 3 weeks. Having the financial aspects in order ensures the ability to settle on a price for the property, and to avoid delays or the potential of the transaction falling through.

Tip #4: Get a qualified valuation Advise the client to consider hiring a qualified person for the valuation of the home, especially if they are not an expert at it. Make sure this person is well versed about the homes in the surrounding neighborhood and is familiar with the area in general.

Tip #5: Inspect the property It goes without saying that any property should be inspected before placing a bid on it. This is especially true when it comes to buying properties that are in one of the three stages of the foreclosure process. This becomes even more of a critical action if the property is to be purchased at auction (since it is sold “as is”) or is a real estate owned (REO) property that is in the hands of a bank. If it is about to be auctioned or is already REO, negotiate that the purchase price be subject to inspection of the property.

Tip #6: Ascertain any liens, taxes, or other liabilities Never take the homeowner’s word on anything. Do title searches (or any other searches) if they are warranted and in order to identify these issues as well as avoid them. You don’t want your client to get stuck with a foreclosure that has “skeletons in the closet” so to speak, because they will be liable for all of them.

Tip #7: Have a game-plan When it comes to monetizing the client’s investment, a game plan is critical. The client should have answers to the following questions:

--- Will the property be flipped or kept as a rental? --- Is the property in need of major renovation or repairs? --- What if the market takes a dive after purchasing the house? --- Has a Plan B or even a Plan C been developed?

Making and following a good plan is always best.

The Three Stages of Buying Foreclosures

When do foreclosure proceedings typically get started? Proceedings normally start with the Notice of Default (NOD), which is a letter that the lender issues to the homeowner as a formal demand for payment. Depending on the state of residence, these are usually issued when the homeowner becomes 90 days (three months) or more delinquent on their mortgage payments. The notice is basically a “legal threat” to do three things:

• sell the homeowner’s property • terminate all the homeowner’s rights to the property • evict the homeowner from the premises

There are normally three stages of the foreclosure process, and each of them provides opportunities for the investor. Buying or selling a home in any of the stages is never a happy scenario. It is the opposite of the American Dream, the anti-thesis of home ownership, and a nightmare in general. But for a motivated investor and a traumatized homeowner it can prove to be a mutually beneficial experience.

Despite the “mutually beneficial” experience, there is both the upside and the downside of foreclosure. The upside of course is the terrific opportunity that the agent can present to the real estate investor and the relief experienced by the distressed homeowner. The downside is that investing in foreclosures still continues to be a gamble in a lot of ways.

Based on where the property is in the foreclosure process, there are three stages of foreclosure in which it can be acquired. The three foreclosure stages are:

• pre-foreclosure • foreclosure • post-foreclosure

1) It is likely that the benefits for the investor and the homeowner are at their greatest in the pre- foreclosure stage. First of all, if the transferring of ownership can occur in this stage, there is usually less damage inflicted on the homeowner’s credit rating and one can usually avoid any intervention by the lender. Most of the time, the best leads for locating properties in this stage are provided by accountants, attorneys, a business associate, friends, or other real estate agents.

2) When a property has moved into the foreclosure stage, it is most easily identified as an investment property through a County Clerk’s Office. The agent can determine the best way to sort through the index and discover pending foreclosure sales once they find out where the NOD’s are filed. If the agent is allowed to place their name, address, and an e-mail address on an advanced contact list, they should take advantage of that. They can also get assistance from most title insurance offices because they can provide recorded information as well, especially if they feel that the agent will bring some future business their way in exchange for that valuable information.

The variance in the foreclosure process from state to state is based on whether it is a “title state” or a “lien state.” This determines whether a judicial or non-judicial form of foreclosure is required. Since judicial forms of foreclosure pertain to mortgages, the process often takes longer than those forms involving deeds of trusts.

With a non-judicial form of foreclosure pertaining to a deed of trust, there is third-party, or the involvement of a trustee. Trustees normally handle the entire process in roughly 60-120 days after the homeowner has defaulted and stopped making their payments on the mortgage. After the property has passed through either of these phases of the foreclosure process, it is then prepared for auction and ultimately sold to the highest bidder.

3) Once the property has moved to the post-foreclosure stage, it means that it is either in the hands of the lender’s Real Estate Owned (REO) department, a new owner, or an investor that purchased the property at a foreclosure auction. In order to determine who the lender is and the balance on the mortgage, the agent will need to refer to the foreclosure notice. Since an REO on the books is an indication that the lender made a bad decision, they typically become very willing sellers.

Be aware that an REO involves both overhead and losses. This is reflected in the added reserves that a lender must maintain as well as any fees that they may incur in the process. As a result, the lender may be willing to negotiate for that property.

If on the other hand, the property has fallen into the hands of the investor, the transaction may not be as tempting. However, the investor may still be willing to negotiate for the property despite the fact that the price will not be rock bottom, so one needs to act accordingly.

The investor will need to make the critical decision as to where they should enter the foreclosure process. It is also critical that the agent is able to identify where in the above stages that the property is in as well as becoming thoroughly knowledgeable in each of the stages. This will go a long way in helping the agent develop long-term relationships with client investors in the area of distressed properties.

Guidelines for Buying in the Pre-foreclosure Stage

The goal of purchasing property in the pre-foreclosure stage is to develop a win-win situation. For the most part, the only people involved in this stage are the homeowner, the buyer/investor and the agent, but occasionally, there is a lender in the mix as well. Once the homeowner is in this stage of the foreclosure process, they are willing to entertain an investor’s offer. Even though the agent and the client won’t encounter much competition in this stage, they won’t be the only investors interested in the property.

Guidelines to buy pre-foreclosures:

• locate loans in default, • evaluate each property by comparing and contrasting location, price, and property condition • narrow the selections down to a few • inspect the properties • determine the property owner's needs, his motivation and flexibility • determine the market value of the property, fix-up costs, potential sales price and profits • arrange default work out by negotiating with the owner and the lender • close on the property

Recommendations for Buying Foreclosures at Auction

The biggest positive about buying properties at an auction is that the investor is able to purchase them below the current market value. However, even though it can be a rewarding experience in that they purchased the property in a short period of time, it can also be devastating if they have placed a bid without having proper financing in place. Bear in mind that most property auctions will require at least a small down payment immediately at the point of purchase, and then the remaining balance is due within 1 to 30 days.

If the investor does not have a deposit ready before bidding and their financing is not in order, they will be wasting their time and the auctioneering team’s time as well. If they are unable to get financing in the allotted time frame, even though they have placed a deposit on the property, they will lose their deposit as well as the property. Additionally, buying property at an auction is also the riskiest way of purchasing a foreclosure. The investor is buying this property “as is”, so they need to be careful and do their homework before deciding to bid on any property at an auction.

Here is a small list of recommendations on bidding on properties at an auction:

• visit a local auction so your client a) has a feel for how the bidding procedure works, b) finds out what will be required as a down payment, and c) knows when the balance will be due so they have their financing prepared • get proper financing in order • research the properties that will be for sale, doing the necessary homework prior to the auction date, and make a list of which properties they plan to bid on • calculate the potential profits from the properties they have decided to bid on • if property values have been determined, determine the top dollar they are willing to bid for each property

Buying Foreclosures that are REO’s

REO means Real Estate Owned (by a lender). An REO means that the lender has reclaimed the property and has re-established their control over it. This is also the easiest way for an investor to pick up distressed properties. Most lenders list properties immediately that return from an auction since having excess inventory is an embarrassment. It is very easy for them to find these types of properties since they are in the lending business.

Because there always seems to be an abundance of REO properties, lenders usually hire a broker or real estate agent to handle them. If there is a large number of REO’s, it’s a safe bet that the lender will be motivated to get them sold since they are considered to be a huge expense that needs to be eliminated.

The big disadvantage with buying REO’s is that the investor will pay close to market value on these properties since the lender has paid off any outstanding taxes, liens, or other expenses that are associated with that property. The benefit is getting a good price on a property with a clear title.

Finding Foreclosures

Up to this point, we have covered the definition of foreclosure, the two main types (and the prominent minor type) of foreclosures, and the three stages of the foreclosure process. We’ve also covered tips, recommendations, and guidelines for buying foreclosures in each of those three stages as well as discussing seven helpful investment tips where foreclosure buying is concerned. The next step is to know the best ways to find these distressed properties.

Non-judicial basically means that the foreclosures are conducted without the courts being involved in the process. Lenders issue the borrower/homeowner the NOD, which is then filed with the county recorder wherein the property is located. Fortunately, a lot of these county recorders have established websites where the agent can find properties for their clients.

The scenario is a bit different in the judicial states. Rather than the NOD, the initial document that gets issued is called a “Lis Pendens” which translates from Latin as “Suit Pending.” There is the possibility that since this is a court originated document, that all the foreclosure documentation is filed in the court rather than a county office. This also creates another dilemma in that one may have to dig through countless other Lis Pendens to find the one they’re looking for as this is not strictly a loan default notice. It is notice of a pending legal action, so the search for the proper document may be tedious and extremely time consuming.

Searching through a county recorder’s database at their site can be simplified if the agent can search by “document type.” This enables the agent to not only see all the notices of default, but allows them to see the relevant owner’s names and the document numbers as well. However, it is not always a certainty that an agent can find all the details regarding the loans and properties in these notices. This means that they will have to make a note of names and document numbers and take that information with them when they head for the county recorder’s office to search the appropriate documents (i.e. Lis Pendens or NOD’s) to find the loan details and addresses of the properties in question.

Once a thorough search of all the paperwork has been done, one can start perusing the different properties that have been targeted. The initial search can rule out some properties and begin narrowing their list. It will also be possible to determine which are worthy of a phone call to arrange a meeting with the homeowner.

Though the process of finding foreclosure properties appears to be a simple one, don’t be misled. Despite having access to the information, there is also required some serious legwork. On a positive note, they may find that there isn’t as much competition from other property investors. .

The following list is 5 of the best tips for locating foreclosure property for the investor. The list was put together by Gwen Lopez, owner and operator of the FreeForeclosureBlog.com, which is loaded with tips on buying all types of properties in the market.

1. Concentrate on homes that have no photos – as amusing as this sounds, it’s a very good piece of advice in that homes online that do not have any photos rarely get visited. Home shoppers today are so spoiled with “virtual tours” provided by so many of the real estate companies out there that they won’t bother with looking at homes that they can’t see first. The benefit to the client is that the agent can find some really lucrative investment properties for them. 2. Don’t get discouraged – there will always be those say that the foreclosure websites are a rip off, they don’t give a person enough information, the houses listed are all trashed and require way too much work, etc. The biggest reason is that most of these people are only trying the FREE trial versions. I usually respond by saying “What do you expect for nothing?” If it was too easy to find foreclosure properties, we’d all be living in one. Don’t get discouraged; if you stay vigilant, you will find your client a viable property to invest in. 3. Make sure the property is still available –if the agent wastes valuable time chasing after property that is no longer available, the better investment opportunities get snatched up in a hurry. One of the negatives about using foreclosure websites is that they leave older listings and even defunct properties online in order to beef up their stats. The agent is going to have to do some due diligence on this. They should make a list of maybe half a dozen homes on the site and do a drive by. In this way, the agent can check and see if there are any “for sale” signs up or if the property is in total disrepair. 4. Search county tax resources online – today it’s easier than ever to find additional information on distressed properties because most counties in all states have their own websites. The agent has the ability to find out the number of bedrooms or baths, the square footage, and so on. In addition to this, they can find even more critical details, such as taxes that have been paid and last sale dates. 5. Search in the local area – the agent is the most familiar with their local and surrounding areas so why venture out? It doesn’t make any sense to do that. The local papers normally publish when areas are getting refurbished and revitalized. Also, the agent should know what areas to avoid. This is the key to finding a good real estate investment for the client.

Financing Foreclosures – 10 Quick, Creative Tips

When it comes to buying foreclosures for investment reasons, the one thing in the business that worries clients the most are the financing aspects that come into play. Too many people assume that it takes money to do this and therefore they walk away from investing. The truth is, they don’t have to have money to begin investing. Granted, everyone’s financial situation is different so some of these techniques listed here won’t be for everybody. The agent needs to find one that their client is going to be comfortable with.

The 10 different techniques are listed below without any details for now. Several of them will be discussed in the next chapter on Creative Financing Techniques, while the others are self- explanatory. Financing methods that can be suggested to the client include:

1. assuming the seller’s obligations 2. borrowing against a life insurance policy 3. finding a partner 4. borrowing from hard money lenders 5. acquiring home equity loans 6. acquiring home improvement loans 7. taking over “subject to” existing financing 8. using banks and other lending institutions 9. using small amounts of money from different banks 10. acquiring VA loans

These are just a few of the ways in which the client can come up with financing for foreclosures. There are countless others and some will be discussed in the next chapter as was stated above.

New Rules Regarding Foreclosures

From late 2003 into 2005, we experienced a market where, despite the economic realities of the day, just about anyone could get into the investment game or purchase a home without the need to protect oneself from that “worst case scenario.” Markets with high profitability factors got flooded with competition and people found themselves swept up by either low “teaser” interest rates, refinancing, or buying at above market values.

Fingers pointed out the blame at financial pools and investors, homeowners, real estate brokers, underwriters, and of course, Wall Street to name a handful of alleged culprits. Then the problem got compounded even more when all the builders went through a period of both unprecedented and unrestricted growth. The increase in new home construction was NOT followed up by an increase in jobs or demand.

So what followed this? They started advertising “teaser” interest rates or were telling people to “sell the loan.” What resulted was that a lot of unqualified people wound up buying a loan and not a house. As a result of what was referred to as the “perfect real estate storm” by Christopher Litchfield in his article “5 New Rules of Foreclosure”, the wake of the event will most assuredly reset the credit and commercial paper industries.

Resulting from all this is a new set of rules, mandated by the federal government that we will all have to live with for some time to come. And many of these rules are going to affect the average homeowner that is already facing tough times. Five main rules that are emerging are as follows:

1) Banks will begin to choose who they work with (but only to a certain extent for now) – banks, in so many words, are starting to wake up with “lending hangovers” in that they are admitting to a major problem with lending practices that have been used in the industry. These practices were the wheels on a fast moving vehicle, and guess what? The wheels are falling off the bus. Banks currently have the option of either restructuring loans or letting the deeds pass into the hands of a loss mitigation department. Enter the snowball (actually avalanche) effect.

Since there will be an overflow of work, licensees will start to see mitigators coming to the table with discounts already in hand. Next, the banks and investors will take the worst hit from the foreclosure market, and consequently, will reset the market price for housing that they currently have in their inventory. The end result is that this will affect the homeowner’s because there is now a more receptive audience where their plight is concerned. But they will have to really convince the lender of their hardship.

2) Lending will become tighter, so debt consolidation will become more widely available – the best way for any homeowner to protect their credit and their home is to prevent foreclosure from occurring. The industry is already creating experts in the areas of forbearance, loan consolidation, and other forms of loan modification. If the homeowner implements a good plan of action, they will now be able to reduce their debt quicker and easier than before. When it’s all said and done, they’ll be able to breathe a sigh of relief because they will have saved their homes and kept those nasty “black marks” off their credit.

3) Banks will need to see some form of history – there is a good possibility that within the next year or so, banks will try to work with only those people who have maintained steady employment and a good rental history. Concerted efforts to thwart foreclosures, getting good referrals from prior , and solid rental histories will become critically important to someone desiring to become a homeowner. 4) Eventually, Uncle Sam will stick his fingers in the pie – Research is showing that foreclosure help is available, especially for those homeowners who had experienced only a brief hardship and were only a few months behind (Congress was working on some bills to restructure the industry at the time that this content was published). The MBA stated that as of the second quarter of 2007 that 5.12% of outstanding loans were in default, which equated to a 17% increase over the prior year.

5) The homeowner’s credit rating will be more critical than ever – for homeowner’s, this is really the BIGGIE where the pending new rules are concerned. And if they are smart, they will figure out their current credit rating ASAP! It can literally cost or save a buyer thousands of dollars in interest payments. Everything is based on credit today, so now more than ever, the homeowner needs to secure their credit and protect themselves from identity theft.

Drawbacks Encountered When Buying Foreclosures

Investors and home buyers alike are lured to the thought of realizing a profit on a foreclosed property. Since auctions are an excellent venue for price, it bears some discussion where the drawbacks to investing in foreclosures are concerned. The possibility of property inspections is omitted with an auction. How smart is it to purchase a home if it isn’t inspected first? If the price is dirt cheap, that’s about the only way that there could be any justification for not inspecting the property. What’s important to consider are the drawbacks and repercussions that buying a home with no prior inspection can have.

Is someone currently living at the property? This is a very valid question. The successful bidder has the responsibility of removing occupants from the house. They may not be the original homeowners or tenants either. Sometimes, if the home has been vacant for a while, it could be beset with squatters or vagrants. The bottom line is that the client may have to evict them, and that often becomes an unpleasant experience if they retaliate against the legal action. If the client is unfamiliar with , it is highly recommended that they let an attorney handle it for them.

Is it a non-owner occupied home? The easiest way to convey the potential direness of this scenario is to quote a story written by Elizabeth Weintraub (a Sacramento real estate broker) for About.com - --

“One such home in Yolo County, California, was rented to a dubious couple: a former convict recently released on parole and his partner with sketchy credit, who flinched at loud noises like a domestic abuse victim.

“The seller, unaware that his deed of trust contained an ‘assignment of rents’ -- meaning the lender had a right to collect the rent if the owner did not make his payments -- stopped paying on his piggyback loans and didn't much care who he rented to as long as they paid him. Fully intending to pocket the rents and forget about his mortgage loans, the seller listed the rental for sale. His agent made an initial attempt to gain access to the home. The ex-con, a neo-Nazi with a shaved head, massive tattoos and holding back a barking pit bull, peeked through the door and then slammed it in the agent's face.

As “soon as the For Sale sign was planted in the lawn, the tenants stopped paying rent. Neither the lender nor the seller could collect any money from the tenants. The agent could not show the property. This was an ugly situation. The lender filed for foreclosure and vowed to file a deficiency judgment against the seller, which lenders can do in California if the loans were not purchase money.” As one can see, this was not only an unpleasant situation, but a potentially dangerous one as well. So advise your client to be aware.

What is the condition of the home really like? Since these types of homes are purchased “as is”, there is no telling what kind of condition an agent or their client will find it in upon first inspection. There is the occasional stroke of luck wherein the potential buyer is allowed an inspection, but in other cases, it could be the same situation as in the above story where access was refused. There is also the very real possibility that the seller may quit caring about the condition of the home as a result of losing it to foreclosure proceedings. Here are some things that have been known to happen when this was the case:

• When something gets broken or quits working properly, they don’t repair it • Because some homeowners have turned angry or even desperate, they have destroyed the home. In some cases, the owners have plugged the drains, turned on all the faucets, and let the house flood. In other circumstances, they have knocked holes in the walls and ripped out copper pipes and wiring to sell as scrap metal. • Owners have been known to take and sell the appliances and cabinets • Some horrible-excuses-for-human beings have even left animals behind locked up inside without food or water

To quote Elizabeth Weintraub again, “buying foreclosures is not for the faint of heart. It's best handled by the pros and is not recommended for first-time home buyers” (or rookie investors).

Review

With the amount of foreclosures reaching all-time highs nationwide, homeowners have turned to the concept of Short Sales to avoid foreclosure proceedings. A short sale occurs when a property is sold and the lender agrees to accept a discounted payoff. This means that the lender will release the lien to the property upon receipt of less money than is actually owed. Short Sales are normally handled by the lender’s Mitigation Department.

Seeing as how the threat of foreclosure is a stressful situation for the homeowner, short sales have proven to be a win-win situation in that:

• the buyer gets an excellent price on a home (or the investor does) • the homeowner has been relieved of stress over the situation • the lender gets “inventory” off their books

Short Sales checklist:

1. Check the public records - find out who is in title, if a foreclosure notice is on file, or how much is owed to the lender. 2. Remember that lenders are smarter than you think - lenders know when a person is doing this for the first time. 3. Keep the client’s intentions confidential - when first making contact with the person in charge, the agent should tell them that they are representing the homeowner. 4. Ask for the “short sales packet” or the “workout packet” - as soon as the packet has been received, the agent and the client should start doing their homework 5. Give the lender all the documents they request ASAP – usually, it will be a hardship letter stating the reasons why the homeowner has ceased making his monthly payment, pay stubs, income statements, bank statements, and possibly a HUD-1, as well as a real estate purchase and sales agreement.

There are usually four criteria that a lender looks for when it comes to qualifying the sale of the property as a short sale and they are the following:

• The mortgage is in default • The market value of the home has dropped • The seller is experiencing financial hardship • The seller has no assets

Loss Mitigation is defined as an option (or a process) wherein a struggling homeowner can prevent foreclosure proceedings from happening. The process can be conducted by one of two individuals:

• An employee or representative of the lien holder • A third-party acting on behalf of the homeowner

The main focus of a loss mitigation process is to keep the homeowner in their home. The job of the counselor is to arrange a loan modification or repayment plan that the homeowner and the lender can live with. The plan has to be realistic where the homeowner is concerned since the lender is looking for not only future payments on the loan, but for settlement on the arrears as well.

Foreclosure is defined as the shutting out or barring a mortgagor's right of redeeming a mortgaged estate. It is a termination of all rights of the homeowner covered by a mortgage. Foreclosure is a process in which the estate becomes the absolute property of the lending institution.

The two main types of foreclosure are foreclosure by judicial sale and foreclosure by power of sale. Judicial sale involves a court action and proceeding. With a power or sale, the courts are not involved. The three foreclosure stages are:

• pre-foreclosure • foreclosure • post-foreclosure

REO means Real Estate Owned (by a lender). An REO means that the lender has reclaimed the property and has re-established their control over it.

Buying foreclosed homes can come with drawbacks. The following questions allude to some of those possible pitfalls involved in purchasing a foreclosed property:

• Is someone currently living at the property? • Is it a non-owner occupied home? • What is the condition of the home really like?

On a final note, the following is a “Foreclosure Flowchart” displayed on it courtesy of http://www.foreclosureuniversity.com, showing the process for both judicial and non-judicial foreclosures.

Foreclosure Flowchart

Mortgage Judicial Foreclosure Trust Deed Non-Judicial Foreclosure

Borrower Defaults Borrower Defaults

File Complaint (Initiate Law Suit) Beneficiary authorizes Trustee to proceed with Foreclosure

Record Lis Pendens Record Notice of Default

Court Hearing Date set for Sale Period of Equitable Redemption-Trustor can reinstate

Advertise the Sale Advertise the Sale

Sell to highest bidder - Buyer pays cash at sale Sell to highest bidder - Buyer pays cash at sale

Buyer receives Certificate of Sale Trustee conveys Trustee's Deed to Buyer

Period of Statutory Redemption Deficiency Judgment Unlikely

Sheriff's Deed Conveyed to Buyer - Evict Mortgagor

Possible Deficiency Judgment

Chapter 7 Creative Financing

Glossary

Acceleration Clause A mortgage acceleration clause is a common provision of a mortgage or note providing the holder with the right to demand that the full outstanding balance is immediately due in the event of default. This is a legal right that is bestowed on the mortgage or loan if the borrower fails to live up to his or her obligations

Alienation Clause Important clause, since the lender can call the entire balance due when the borrower sells the property. It can make the debt non-assumable and eliminate the possibility of a new buyer taking over an existing loan without the lender’s approval. If there is no alienation clause, the loan can be assumed without the lender’s approval

Creative Financing Refers to the non-traditional types of financing, or those less common financing techniques that are used

Due on Sale Clause An agreement in the loan contract that demands the loan be paid off when the property is sold

Hard Money Loans A specific type of asset-based loan financing in which a borrower receives funds based on the value of a parcel of real estate

Land Contract An agreement for the purchase of property where the buyer is allowed to take possession of the land while making payments but the seller holds the title until the last payment is completed.

Land Trust An agreement wherein one party, called the trustee, agrees to hold ownership over a piece of real property for the benefit of another party called a beneficiary

Lease-Option The right to buy (or not buy) the property for a designated price at the end of the original lease period

Lease-Purchase Mortgage An option for a potential homebuyer which will allow you to lease a property with the option to buy. The mortgage is often constructed so that the monthly payment will cover the owner's rent and a little extra which is put into an account and can be used for a down payment at the end of the lease

Low Documentation Loan A loan designed for persons' that are self employed, recent immigrants, or entrepreneurs that may not want to reveal information of their incomes. These loans require exceptional credit history, a substantial down payment, and incur a higher interest rate

No Documentation Loan When a borrower supplies a minimum amount of information and the lender makes their decision based on credit history and the size of the down payment. These loans typically have a higher interest rate

NINA No income/no asset verification – a form of no-doc loan - these loans require the least amount of documentation

No Ratio Loan Sometimes nicknamed a “don’t ask, don’t tell” type of loan. Normally, the borrower does not reveal income when applying

Private Mortgage This type of financing always involves a private lender and is a mortgage that is secured by real estate

Simultaneous Closing Seller technique wherein the mortgage created by the seller is simultaneously sold to a note buyer at the time of closing

Stated-Income Mortgage Tends to be for people who work but don't draw regular wages or salary from an employer; that includes self-employed people or those who make a living off commissions or tips

Straight Contract A form of wrap-around contract but contains no override of interest payments

“Subject To” A creative finance technique where a buyer is able to take title to property without procuring a note of their own

“Sweat Equity” A process wherein the future homeowner actually contributes to the construction/home improvements of his home and thus accrues equity on his home

Vendee Another word for buyer

Vendor Another word for seller

Wrap-Around Mortgage A consolidation of balances on all mortgages into one loan

Introduction to Creative Financing

Widely used amongst real estate investors, Creative Financing refers to the non-traditional types of financing, or those less common financing techniques that are used. The financing of (or purchasing of) property is the reason for using these forms of financing, with the buyer or investor using as little of their own money as is possible. It’s often referred to as “leveraging”, or using Other People’s Money (OPM). The use of this type of financing enables the buyer or investor to purchase multiple properties, using little (and sometimes none) of their money.

The following content in this chapter describes the more common types of creative financing that investors often use. Additionally, the pros and cons of each method will be discussed as well and certain other issues regarding the subject matter. Some of these have been used in conjunction with one another, or as a temporary solution while a more permanent form of financing is being arranged.

Do all of these really work? Yes they do. At some point in time, each one of these has probably worked somewhere for somebody at least once or twice. However, it isn’t just a matter of one or more of the methods working; it’s more a matter of if it makes sense and if it is ethical. The basic purpose of this content is definitive in nature and in no way does it condone or recommend the use of the types of financing listed.

The different types of creative financing do not come without flaws. It’s the nature of the beast that creative financing methods have advantages and disadvantages. There are beneficial types of creative financing and there are detrimental types from both sides of the buy/sell coin. Licensees should be aware of those that will have a negative impact to either buyer or seller and be completely ethical in nature.

Hard Money Loans (HML)

These types of loans are categorized as asset-based loan financing because the borrower receives funds based on an asset --- in this case a parcel of property. Two things are certain with this form of loan --- it is rarely issued by banks or other lending agencies and it comes with a much higher rate of interest.

Hard money loans (HML) are sometimes compared to “bridge loans” or “swing loans” in that they are done for very short periods of time (sometimes as little as briefly as 1-3 weeks) while more long- term financing is being arranged. The main difference is that the latter types of loans usually apply to commercial properties and investments (only) that are in transition and haven’t yet qualified for traditional financing.

HML can also be indicative of money that gets borrowed for the purpose of easing a distressed financial situation like a bankruptcy or arrears on a mortgage as well as a foreclosure proceeding. The other unique characteristic of a hard money mortgage is that it typically is made by a private investor on a local format. The credit score of the borrower is rarely taken into consideration and the loan is generally taken out against the collateral of the property.

The maximum loan-to-value (LTV) is usually 65-70%, so if the property is worth $200,000 you can borrow $130,000 to $140,000 against it. The lower LTV covers the lender should the borrower default and they have to initiate a foreclosure on the property. This is a form of real estate lending that is collateralized against the quick-sale value of the property that the loan was borrowed against.

When it comes to determining the LTV, the word “value” has the same meaning as “today’s purchase price.” It is the amount that the lender can expect to recoup from the sale of the property that would result if the borrower defaults and the lender is forced to sell it within 30-120 days. The value factor of a HML differs from a regular one in that the seller is acting under duress in most instances.

The following is an example of how a commercial real estate purchase might be structured by a hard money lender:

65% Hard money (Conforming loan) 20% Borrower equity (cash or additional collateralized real estate) 15% Seller carryback loan or other subordinated (mezzanine) loan

Where legal and regulatory concepts in lending are concerned, HML’s have been “formally unregulated” by federal and state laws. However, there are “usury laws”, or restrictions on interest rates still in effect in certain states. The interest rate on hard money is normally determined by the real estate market and the availability of hard money rather than the actual bank rate. For the past decade, through 2007, the interest rate on HML’s has varied between 15 and 25%. Default rates can go as high as 29%.

The points on a HML are 1-3 points higher than the traditional average which amounts to 3-6 points on the average HML. It is not uncommon for the points on commercial HML’s to be upwards of 4 points to as high as 10 points. Avoiding foreclosures and quick sales of property prove to be the two main reasons that a borrower would agree to pay this high of an interest rate on a loan.

Finally, when it comes to HML’s, it is always advisable that the borrower seek professional counsel to assure that the property is protected from being given away due to a late payment or other forms of default.

Positive aspects of a HML: • quick solution to distressed finances • involves private lenders, not banks • credit score of borrower is insignificant • easier to appropriate, fewer denials

Negative aspects of a HML: • Lower LTV • Higher rate of interest and points • Must be repaid quickly • Defaulting results in immediate loss of property

Private Mortgages

This type of financing always involves a private lender and is a mortgage that is secured by real estate. In this case, the lender can be the seller, a private individual, or an investor. Unfortunately, anyone can offer a private mortgage. Home sellers can offer this type of mortgage which is often called a “land contract”. For the seller that is having a hard time selling a home while trying to avoid foreclosure, this is an option to look at.

This type of financing was very popular in the late 1970’s and early 1980’s, but when loan requirements eased up and the interest rates fell below 8%, this type of financing began to disappear as a financing option. They began appearing again in 2006. and usually offered more attractive finance rates (at that time) over the higher rates and the rigid qualification requirements of conventional financing.

It’s also another way for a buyer to get financing when he or she normally wouldn’t qualify. But the buyer needs to remember that the seller keeps control of the title until it is paid in full. For the seller, this equates to lower risk because if the buyer defaults, the seller regains the house and keeps all the money that the buyer has paid to that point in time. The private mortgage is a viable option for the seller who is anxious to sell, and when the buyer has not been given enough time to arrange other financing.

Private mortgages are often called “land contracts” or “contract for sale.” It is just another way to state that the seller lets you make the payments to them with no involvement by an tradtional lender. Another way to describe this concept is to state that it is used for short-term seller financing. Characteristically, the last payment on this type of mortgage is referred to as a “balloon payment” in that it is so large compared to those during the course of the loan. The borrower could seek conventional financing to make this final payment.

Third-party investors might offer this type of financing as an investment vehicle at times because they can charge an interest rate that proves to be significantly higher than the prime rate. This is especially true when it comes to buyers who have poor credit and cannot qualify for conventional forms of financing.

For this reason alone, the private mortgage is an excellent option for some home buyers. It also provides the buyer with a way to build equity in the property and establish a positive payment record in the process. Usually, within a few years, the buyer is able to finally be approved for conventional financing once they have proven that they are a good risk.

Despite the fact that investors and sellers choose this instrument, it is still a mortgage that can be bought and sold. If at a future point in time, the investor decides that they want to receive a single large payment rather than monthly ones, they can always sell the mortgage to another investor and be done with it.

As is the case with HML, interest rates with private mortgages can be much higher than with the conventional types of finance. They are usually in the neighborhood of 12-18%, which is less than that of the HML. At times, points are required as well. And just like with the HML, the LTV equates to 65-70%, which in turn helps preserve equity in the property should the borrower default on the loan. The term of these loans usually falls between 6 months and 3 years although at times this may vary.

Other variations of the private mortgage include lease options and “rent-to-buy” options which will be discussed later in the chapter. Since this type of finance contract is mutually composed between buyer and seller, it is not uncommon to see quite a variety of repayment plans. Also, the legal status of these types of contracts will vary from region to region.

Land Contracts

A Land Contract (also called “contracts for deed”) is basically a security agreement between a seller (vendor) and a buyer (vendee). The vendor agrees to sell the property to the vendee by financing the purchase themselves. It should be noted that the even though the vendor retains the legal title, the vendee receives what is called equitable title.

The financing can also include either an existing mortgage balance (see “Wrap-Around Contract” below) or be owned totally free and clear. Once the obligation has been paid in full, the vendor will present the vendee with the deed to the property and the transfer of ownership has been completed.

A question that often comes up when contemplating land contracts for the sale of property is “How do I sell my property using a land contract?” The seller holds the deed until the agreement is paid in full, but there are other things that need to be done in order to protect the seller.

The following is a list of things that the seller should consider when engaging a buyer in a land contract.

Obtain a credit report on the buyer – this should be done first before going any further in the process. If the tentative buyer has been consistently late on payments, filed a bankruptcy or worse yet, has no significant credit history, the agent and seller should already be seeing red, as in RED FLAGS! Regardless of what the risk factor may or may not be when doing a land contract, there’s no point in increasing that risk.

Demand a Title Insurance policy – this is a useful tool as well in that if there have been any judgments or liens, they will show up in the title search. There is a good possibility that the title company will ask for satisfaction of the encumbrances before they even consider insuring the land contract. Ask to see a copy of the preliminary title report or the commitment for title insurance to see if a search has uncovered any negatives.

Insist on a large down payment – this mayl give the seller some peace of mind because there is less likelihood of the buyer defaulting if they have put a large sum of money down on the property up front.

Make it a short-term contract – even though the seller can amortize the payments over a 30 year period, they might ask for a balloon payment after 5 or 10 years. The result will be that the buyer gets their own financing and pays the seller off in proper fashion or that they sell the property to pay the loan.

Verify the buyer’s employment – Is the buyer is employed? A minimum of two years,may be reasonable.

Get personal references – investigate the buyer’s references, including current past landlords.

Homeowner’s Insurance policy –the seller may run the risk of legal action because they are still liable and responsible for the home and the property. Reaffirm to the seller that they be named as an additional insured on the policy and get a copy of the policy.

Establish a disbursement account with the bank – banks and financial institutions often offer a service that will collect payments from the buyer and either mail them directly to the seller or deposit them into their account.

Collect all the applicable taxes from the vendee – this may be a service that can be arranged with the bank or disbursement company. Have the vendee send the tax payments to them and the disbursement company (if the arrangements are set up as such) will send the seller’s tax payments to the assessor. This way, the seller knows that their property taxes are paid on time.

Make sure to put in a late payment clause – if the seller is paying on an underlying mortgage, they would want to avoid any late fees, so they should make sure that the buyer/vendee always gets the payments to them (or the bank) in a timely manner. The seller can charge a fee for late payments.

Ensure that the property is maintained and properly cared for – this is a good reason to think about including an “acceleration clause” in the mortgage/contract. This enables the seller to ask the vendee to refinance the property if they allow the condition of it to deteriorate to such a condition as to become a risk to the seller’s financial investment. The following is a quote from Wikipedia showing the wording of such a clause:

“In the event of default in the payment of any of the said installments or said interest when due as herein provided, time being of the essence hereof, the holder of this note may, without notice or demand, declare the entire principal sum then unpaid immediately due and payable.”

Prevent the vendee from assigning the contract – performing due diligence of approving the buyer, prevents giving the right to assign the contract to an unknown entity.

Discuss everything with an attorney – obtaining legal advice is a good idea and may result in solutions to in addition to this list of suggestions.

Here are a few more important notes regarding private mortgages/land contracts taken from “How a Land Contract Works” by Elizabeth Weintraub of About.com:

Vendee's Bundle of Rights

For all practical purposes, the Vendee owns the property and has the right of:

• Possession. • Quiet enjoyment and use of the property. • Exclusion, forcing others to leave the premises. • Resale.

Benefits to the Vendee

• No qualifying, although the Vendor could ask for a copy of the buyer's credit report. • Down payment flexibility. The amount is negotiable. • Length of land contract term, interest rate and payments are negotiable. • Low closing costs. There are no lender fees to pay. • Fast closing. Transactions can close in 7 days or less.

Benefits to the Vendor

• Typically higher sales price and no appraisal. Although buyers are advised to obtain an appraisal. • If taxable, possibly can qualify for deferred gain. • Monthly income. • Often a better rate of return than money market accounts. • If property is non-conforming, it's an easy way to sell. • Fast closing.

Buyer Tips

• Get an appraisal. • Obtain title insurance. • Engage the services of a holding company to retain possession of an executed deed and the original documents. • Talk to a real estate lawyer.

Seller Tips

• Pull the buyer's credit report. • Include both Vendor and Vendee names on the existing insurance policy. • Hire a disbursement company to handle contract collection. • Talk to a real estate lawyer.

Positive aspects of a private mortgage: • buyer with poor credit is approved more frequently • excellent investment vehicle for investors • allows anxious sellers to sell property faster • seller controls mortgage

Negative aspects of a private mortgage: • lower LTV • higher rate of interest and points • final payment is a balloon payment • buyer does not receive title until loan is paid in full

Wrap-Around Contracts

This is another way to finance a property purchase without the necessity of a traditional lender being involved in the process. With a Wrap-Around contract, the buyer will make monthly payments to the seller, plus an additional payment which covers the balance of the buyer’s purchase price for the home.

Not all lenders will allow wrap-around type contracts, so it is wise to keep that in mind. Also, only an assumable loan is wrappable. In a simultaneous closing, wrap-around loans can also be created and then sold to a note buyer at closing of the transaction. This allows for the underlying mortgage to be paid off.

The use of a wrap around loan could allow the person to circumvent restrictions that result from assuming older loans, so a wrap around must not be used in this fashion. The home seller who does this is violating the contract they have with their lender.

Some states require that escrow companies (by law) make a lender aware of any loan that is being wrapped.

It’s a safe assumption that if the interest rates begin rising, so too will an interest in wrapping assumable loans. It becomes a significant temptation to sellers primarily because they might be able to sell their houses for a better price.

There are basically two ways to set up this type of arrangement. The first is to create what is called an All-Inclusive Wrap-Around Land Contract wherein there is an override of the interest that accompanies the regular loan payment. The second method is the Straight Contract. The best way to demonstrate the difference in the two is to take a quote from Elizabeth Weintraub from her article “How a Land Contract Works” found at About.com, where she displays an example of how each works. According to her ---

“This is how it (the all-inclusive wrap-around land contract) works:

1. Say the sales price is $100,000. 2. The Vendee puts down $10,000. 3. The Vendee agrees to make payments on $90,000, bearing interest at 6.5%, payable $567. 4. The existing underlying loan is $50,000, payable at 5% interest with a payment of $268. 5. The Vendor earns 6.5% interest on $40,000 of equity, PLUS 1.5% interest on the existing mortgage of $50,000 and pockets $299 a month.”

Here is an example of the Straight Contract, which contains no override of interest payments, appears as follows:

“Let's look at the previous example on a straight contract:

1. Sales price of $100,000. 2. Vendee puts down $10,000. 3. Vendee makes one payment of $268 on the existing loan balance of $50,000, bearing interest at 5%. 4. Vendee makes a second payment to Vendor on $40,000 owner-carried financing, bearing interest at 6.5% and payable at $253 per month. 5. Total of both payments is $521, which saves the Vendee $46 per month over the wrap- around.”

All loans issued today contain acceleration and alienation clauses. An acceleration clause is specific terminology “that fully matures the performance due from a party upon a breach of a contract.” A sample acceleration clause would read like this:

“In the event of default in the payment of any of the said installments or said interest when due as herein provided, time being of the essence hereof, the holder of this note may, without notice or demand, declare the entire principal sum then unpaid immediately due and payable.” An alienation clause “allows a lender to call a loan immediately due and payable in the event the owner sells the property or transfers title to the property.” Almost every loan today contains an alienation clause, which means the title cannot be transferred and a buyer cannot purchase “subject to” an existing loan without triggering a due on sale clause.

The wrap-around contract is an extremely risky arrangement for the seller due primarily to all the liability factors involved. Until a lender lets the seller know that the payments are late, he has no way of knowing if that’s the case or not. The impact of course is that his good credit can deteriorate as a result.

Simultaneous Closing

This type of financing is a real estate seller technique wherein the mortgage created by the seller is simultaneously sold to a note buyer at the time of closing. Normally, the seller and buyer agree on the terms with some input from the note buyer. Two transactions take place on closing day - literally simultaneously, hence the name. There is the real estate transaction and a note purchase transaction.

Occasionally the note transaction won’t happen until between a few days to a few weeks later, however this usually depends on when the note buyer gets involved in the process. It also depends on whether or not there are any closing issues during the process. The main reason that a seller chooses this type of financing is that he can receive all of the money from the property purchase at the time of closing or shortly thereafter. And just like with the above forms of financing, the buyer attempts to be financed in this manner due to a poor credit history or inabilities to qualify for standard forms of financing.

The note buyer’s motivation is the cash flow that the note will produce. He must limit his participation in the process so as not to appear like a lender, which in most cases, he is not to begin with. A note of caution here is that not all title companies are familiar with this type of financing and may decide to involve one of their attorneys for the purposes of reviewing everything before the title is approved.

Not all states allow simultaneous closings. Not all title companies allow it. In fact, some title companies will go so far as to tell you that it can’t be done. Don’t get discouraged. The first thing to remember is that every state has different rules when it comes to simultaneous closings (also referred to as “Double” or “Back-to-Back Closings”). And the rules are always changing. What was allowable 5 years ago could be taboo now.

It is a good idea to find a title company that will allow this as well as what all the state’s rules and regulations are pertaining to simultaneous closing.

Simultaneous closings can be performed in a number of ways, but the use of it appears most commonly in foreclosure properties that are in default. The first step that is always advised is to take over control of the homeowner’s property. This is usually done by virtue of a “land trust”, and it will prevent other judgments from going on title before the agent can get the transaction closed. This will also prevent any chain-of-title or due-on-sale issues from occurring.

A land trust is an agreement wherein one party, called the trustee, agrees to hold ownership over a piece of real property for the benefit of another party called a beneficiary. It can be used by non- profit or regular corporations, investment groups, or by individuals primarily to keep real property ownership private and to avoid probate situations.

Other advantages of a land trust:

• Sales price of the property can be kept off the public records • Property taxes are lower if the purchase price is kept private • Judgments or liens (such as IRS liens) against an individual's name are not a lien against their land trust property • Partners can more easily continue a project if one dies or is divorced • Interests can be transferred quickly without recording a deed • Managing a rental property is easier when the trustee can be blamed • Negotiating a purchase or sale can be easier when the trustee can be blamed • Liability on financing can be limited to the assets of the trust

The homeowner signs over beneficial interest in the property to another company, but remember that that company can be either beneficiary or trustee, but not both. This is seen as a conflict of interests and no title company will tolerate this. Once the agent or seller has negotiated the debt with the lender, either the seller or their company then purchases the home from the owner for the agreed upon price. At this point in time, the title company will prepare the HUD for the transaction.

The end buyer will then be obligated to provide the funds necessary in escrow at the title company. When the buyer runs the title report, it still shows the homeowner’s last name in the form of a trust on the title.

The seller (or their company) can sell the property to the end buyer which is performed simultaneously by your title company. At this time, the title company will wire the debt amount to the foreclosing lender which needs to be the identical to the first HUD-1. The seller gets to keep the difference between the bank’s payoff amount and the end buyer’s purchase price, less any closing costs of course.

(PLEASE READ --- VERY IMPORTANT Disclaimer: Every state is different and laws continue to change. This information is presented with the understanding that the publisher, author, nor staff is engaged in rendering accounting, legal, and financial or other professional services. If legal advice or other expert assistance is needed, the services of a competent professional person should be secured. Considerable efforts are made to provide the reader with timely and accurate information; however there are no guarantees.)

“Why don’t all property sellers offer seller financing?” The main reason is that the seller has to be in a position to or be willing to accept payments on a monthly basis. If the seller is looking to gain a monthly cash flow, then of course this becomes a viable option. However, if they already happen to be in foreclosure proceedings, then this option makes no sense.

Another key reason is that the seller is worried about the buyer defaulting should he/she keep carrying the loan. If the buyer quits making payments, the cash flow ends and they have to go after them legally with the foreclosure process. This of course proves to be very costly and time consuming. The thought of evictions, attorney’s fees, etc. is a bigger headache than it could ever be worth.

The benefit of simultaneous closing is that monthly payments and the worry over defaulting goes away, affording the seller peace of mind. If the buyer defaults, it is no longer the seller’s problem.

Finally, sometimes there just isn’t enough equity built up in the property for the seller to offer this type of financing. Others are not aware that even if they don’t own the property and are still making payments on it that they can still offer seller-type financing. So there are some downsides to be considered before jumping into this kind of transaction.

“Who benefits the most from a Simultaneous Closing?” is another frequently asked question. Generally speaking the investor or the rehabber tends to benefit the most from simultaneous closings. Usually it’s because of a time schedule wherein they need to proceed to another project as quickly as possible. The investor is already accustomed to dealing with attorneys, buyers, title agencies and the like, so they have the time to deal with these issues. For this reason, these are the people who stand to benefit the most from a simultaneous closing.

The homeowner has a marked ability to benefit as well. However, they cannot be a “hands-off” type of homeowner. The homeowner that is involved will have numerous responsibilities such as the screening of potential buyers, negotiating and setting the sale price and mortgage terms, dealing with the note buyer and title company, etc. They will have to have ample amounts of time to deal with these issues so in a sense, they will be a hands-on type of homeowner.

Another group of individuals that can benefit from simultaneous closings are loan originators. If they experience problems getting their buyers approved due to miscellaneous credit issues or time constraints, then they are also prime candidates for this type of financing option.

Basically, any other parties that are representing a seller who need to sell the property quickly and are having problems locating a buyer can benefit from this financing method. Accountants, attorneys, title agencies and so on, would be among those “other” parties being referred to in this instant. Where these people are concerned, they would appear to be offering a valuable service to their clients.

“Subject to” Financing

When someone takes over property in this method, they are taking it over “subject to” an existing loan. Buyers and sellers who decide on this method of financing should become thoroughly familiar with the concept, how to explain it, and what steps to take to prevent the loan from being called.

The note on the property says that mortgagee owes X amount of dollars while the Deed of Trust or mortgage says "here is how the lender proceeds to take over the collateral or sell it if the mortgagee doesn't pay the note as agreed upon." Generally, the borrower is the one who is personally liable for repayment of the loan. What this means is that if the collateral that is backing the note, once it is sold, is an insufficient amount and cannot cover what is owed, the borrower is obligated by the contract to come up with the difference.

Characteristically, if the buyer does not take out a loan when buying a piece of property, they take over ownership and “assume and agree to pay the loan as was agreed upon." Be aware that most lenders today have a “due on sale” clause in the agreement or contract. The due on sale clause allows the lien holder to demand full payment of the loan immediately rather than continuing to accept payments. This is normally done to protect them against the homeowner selling or transfering any interest in the property.

In the earlier years of the due on sale clause, the interest rates were much higher than those on older loans so lenders had a good reason to enforce the clause should it be violated. But since interest rates have reached all time lows and have pretty much stayed down, lenders have not been filing due on sale legal cases at all.

Usually, when a buyer takes property “subject to” an existing mortgage, they are getting the deed but they are not assuming the loan. They are now controlling the property and making the payments on the loan, but the loan stays in the original homeowner’s name. If they quit making the payments, they will lose the property and any equity that has built up in it. However, on a positive not, if they lose the property and equity due to defaulting on the loan, their personal liability ends with the loss of the property.

The most motivated type of seller generally falls into one of these three categories. They have fallen behind on their payments, they are already in foreclosure, or they have no equity built up in the property.

The seller’s biggest benefit is that the buyer will be making their payments and will be making them on time. This of course will help improve their credit. They can always discuss including a clause wherein they agree to pay off their loans in a prescribed period of time.

Another way to make the transaction more secure is to offer setting up the payment arrangement handled by an intermediate wherein the intermediate collects and disburses the payments. This could be either a loan servicing company or a trust company. Opening a savings account at a Savings and Loan who happens to be carrying the loan might be a good idea. The buyer would then make payments into the account and also have it set up where the loan is automatically paid on out of that account.

This way, the seller has the ability to monitor the account and see that the payments are being made each month. The Savings and Loan also has an advantage in that they are seeing the payments come from whoever they were accustomed to seeing it come from.

Insurance poses the biggest problem and it is required --- both the seller and the buyer have to have insurance. Once the transfer is complete, the homeowner’s policy is good for only 30 days. The first thing the buyer needs to do is call the insurance company and have them add them to the policy. In two weeks, they will want to follow this up by changing the policy to a “renter’s” policy. Another option is to open a new homeowner’s policy in both the buyer and the seller’s names. Finally, the seller could just go get a second policy without doing anything to or with the original, but then that means they would have two insurance payments.

Something else that the seller can do when dealing with the insurance issue of a “subject to” transaction is to use a “land trust.” Normally used for estate planning and tax purposes, the land trust holds title to real property. The buyer (or sometimes a third-party) becomes the trustee and the homeowner becomes the beneficiary. The trustee is responsible for carrying out all orders and controlling the property.

The next step would be for the buyer to send a letter to the lender in which the buyer makes them aware of the change of a trustee, and that all future correspondence be directed to the trustee. Beneficial interest should then be assigned to the buyer and in turn, this will protect their interest in the property.

The following is a quote from http://www.foreclosureuniversity.com as relates to the “subject to” issue:

“There is a chance, as interest rates climb in future years, that lenders will be more interested in who is making the payments. But the sure way to catch their attention is to get behind on payments. So those of you who are using ‘subject to’ as a tool, make sure you do everything else by the book and on time.”

Lease Option / Lease-to-Purchase / Rent-to-Buy

Another terminology that often is mentioned where Lease Option and Lease-to-Purchase are concerned is Rent-to-Buy. Lease Option and Lease-to-Purchase are not identical but are synonymous with Rent-to-Buy. Owner financing is common to both leasing methods, so as a buyer, you wouldn’t have to approach a lender for the financial aspects during the term of the agreement.

The term “option” is often under utilized, but it is treated as a separate function from both of the leasing methods. No confusion intended here. Lease options, lease purchases, and options are nothing new. In fact, they have been in use for decades, and were especially popular methods in the late 1970’s and early 1980’s.

According to Wikipedia ---

“A lease option (or lease purchase) is the abbreviated form of the appropriate term lease with option to purchase. It is a type of contract used in residential real estate. The contract is typically between two parties: the tenant (also called the lessee), who will occupy a house or apartment, and the landlord (), who owns the property.”

“During the term of the lease option, the tenant pays rent to the landlord, and in exchange is permitted to occupy the property. At the end of the contract, the tenant has the option to purchase the property outright; the tenant would typically obtain the money to do this using a mortgage. In exchange for this option, the tenant pays extra money to the landlord, in excess of usual market rent. “Excess rent may also be applied towards the eventual purchase of the property, or towards the down payment for a mortgage. In that case, the lease option works as an automatic savings plan for the tenant.”

It’s a good method where a buyer with a poor credit history is concerned. It also involves less risk for a landlord/owner versus a lender. Should the tenants default, they can be removed with the eviction process which is less costly than foreclosure. The lease requires less money up front, whereas the down payment on a mortgage can be quite a sizeable amount. So just like with all the other creative methods discussed thus far, it has its advantages as well as disadvantages.

The biggest negative falls on the tenant in that, at the end of the lease agreement, should they decide against purchasing the property, all the money paid to date has gone to waste. Usually, there are two reasons that this happens. Either the tenant has decided that they don’t want to purchase the property (various reasons involved), or more importantly, they cannot obtain financing.

The concept was created to avoid alienation clauses that were always an integral part of a mortgage. The proponents argued that the sale wasn’t really a sale. However, the courts saw otherwise. Today, lease options, lease purchases, and options to purchase are treated as three different types of financing documents. We see the differences based on variance in state laws, so it becomes more of a semantics and terminology issue since laws between states are never identical. Many tentative buyers who pursue this route often do so after seeking out the advice of an attorney.

Basics of each of the three methods.

Basics of a Lease Option

• Buyer pays the seller option money for the right to later purchase the property. The lease option money may be substantial. • Buyer and seller may agree to a purchase price now or the buyer may agree to pay market value at the time the option is exercised. It is negotiable. However, most buyers want to lock in the future purchase price upon inception of the lease option. • During the term of the lease option, the buyer agrees to lease the property from the seller for a predetermined rental amount. • The term of the lease option agreement is negotiable, but the common length is generally from one year to three years. • The option money generally does not apply toward the down payment. • A portion of the monthly rental payment typically applies toward the purchase price. • Option money is rarely refundable. • Nobody else can buy the property during the lease option period. • The buyer generally cannot assign the lease option without seller approval. • If the buyer does not exercise the lease option and purchase the property at the end of the lease option, the option expires. • The buyer is not obligated to buy the property.

Basics of a Lease Purchase

• Buyer pays the seller option money for the right to later purchase the property. This option money may be substantial. • Buyer and seller agree on a purchase price, and often it is at or slightly higher than market value. • During the term of the option, the buyer agrees to lease the property from the seller for a predetermined rental amount. • The term of the lease purchase agreement is negotiable, but the common length is generally from one year to three years, at which time the buyer applies for bank financing and pays the seller in full. • The option money generally does not apply toward the down payment. • A portion of the monthly lease payment typically applies toward the purchase price. • Option money is nonrefundable. • Nobody else can buy the property unless the buyer defaults. • The buyer typically cannot assign the lease purchase agreement without seller approval. • Buyers are often responsible for maintaining the property and paying all expenses associated with its upkeep, including taxes and insurance. • The buyer is obligated to buy the property.

Basics of an Option

• Buyer pays the seller option money for the right to later purchase the property. This option money may be substantial or as little as $1. • Buyer and seller may agree to a purchase price now or the buyer may agree to pay market value at the time the option is exercised. It is negotiable. However, most buyers want to lock in the future purchase price upon inception of the option. • The term of the option agreement is negotiable, but the common length is generally from one year to three years. • Option money is rarely refundable. • Nobody else can buy the property during the option period. • The buyer can sell the option to somebody else. • If the buyer does not exercise the option and purchase the property at the end of the option, the option expires. • The buyer is not obligated to buy the property.

Notice that in these agreement’s descriptions that no single stipulation is common to all. For instance, in both the lease option and the option, “the buyer is not obligated to buy the property,” but in the lease purchase, they are. Also, in those same two again, the “option money is rarely refundable,” (keyword being rarely) whereas in the lease purchase, the option money is non-refundable. One can see that each one of these is a nit-pickingly unique type of agreement.

It is always a smart decision for the buyer and the seller to involve their attorneys in that they can inform them of their rights, inclusive of default and possession consequences. There is always that possibility, once the buyer investigates, that the property might be encumbered by underlying loans that contain alienation clauses, giving the lender the right to accelerate the loans upon sale. So due diligence and thoroughness are paramount in the process.

There are pros and cons for using these three methods of buying or selling a home. But some pertinent information follows. Should the lease purchase method be the agreement of choice, the buyer should again perform their due diligence which includes obtaining all the disclosures that a person normally would obtain with a regular sale of property. The five key ingredients here are:

1. Getting a home inspection. 2. Examining the title policy. 3. Obtaining an appraisal. 4. Reading all seller disclosures. 5. Consideration of obtaining pest inspections, a roof certification, plan and hiring other qualified inspectors.

With a lease purchase agreement, there are a few benefits for the buyer and the seller alike. This type of agreement usually is the agreement of choice where difficult-to-sell-properties are concerned. If the property was easy to sell, why wouldn’t the seller pursue a conventional buyer who would pay cash for the transaction?

Five more points to ponder where this method is concerned:

1. Sellers generally get market value at today's prices and relief from paying a mortgage on a vacant property. 2. Although the lease payments may exceed market rent, the buyer is building a down payment and banking that the property will appreciate beyond the agreed upon purchase price. 3. Buyers generally make a small down payment, with little or no qualifying, making a lease purchase an attractive way to ease into the benefits of home ownership. 4. Buyers also receive a forced savings plan since part of the lease payment is credited toward the purchase price at the end of the lease option agreement. 5. If the buyer defaults, sellers do not refund any portion of the lease payments nor the option money and may retain the right to sue for specific performance.

The following will explain both sides where using the lease option type of agreement is taken into consideration --- how to buy and how to sell a house using a lease option agreement. Some of this may be more targeted towards the non-real estate individual, however there are still tidbits throughout the content that may be useful and could be taken into consideration.

The lease option agreement from the buyer/investor standpoint

The first factor is “affordability”. In other words, are the buyer’s finances going to be an issue when it comes to the option fees? This question is more applicable to the regular buyer, but in some cases, those who want to invest run the risk of biting off more than they can chew. These fees are a requirement if the contract is going to be a valid document. Sometimes, the fees equate to one or two month’s rent. Other times, they turn out to be anywhere from 3-5% of the purchase price.

Should the tenant decide to buy the property when the agreement is fulfilled, then they should make sure that there is a clause in the contract that states that every penny of the fees goes towards a down payment on the property. Otherwise, that money will have been wasted. This is common sense, but not always with the regular buyer. Unlike security deposits in rental agreements, this money is usually non-refundable should the buyer decide not to purchase the property or is unable to.

Is relocation a possibility, or will they remain in that locality? This should probably indicate to the buyer that the lease option is not the agreement of choice if they plan on moving out of the area and won’t be buying the house. Should they be purchasing as an investor (i.e. as rental property), then this is not a critical factor. If they should relocate far enough away, then the expense of a property management company may come into play.

Is financing going to be an issue for the buyer? There are always occasions when the seller will carry the financing, but for the most part, it will be up to the buyer. It is true that a lease option affords the buyer a more favorable loan, but it is never a guarantee. This question is not normally applicable to the real estate investor unless carrying the financing for them becomes an option.

Are the monthly payments affordable? Usually, a lease option’s monthly payments include the fair market plus option money that will go towards the purchase once the agreement is satisfied. So monthly lease payments are normally more costly than typical rent payments. Again, this question is more targeted towards the buyer.

Once the home has been purchased, will monthly payments and the obligations that come with homeownership become an issue? All too often, a buyer will lease outside their future means and wind up losing the property. The financial obligations of home ownership exceed simple rental responsibilities, and sadly, a lot of buyers will overlook this. In addition to the mortgage payments, there are also property taxes, insurance, and maintenance costs --- this isn’t incurred with renting.

The buyer or an investor should make sure that they find the house they really want to buy. The buyer needs to consider liking the house and being able to afford it. As an investor, whether they like the house is insignificant. What is critical is the affordability of it should repair and refurbishing be necessitated. One has to consider profit and loss since this is equates to being a business and not standard homeownership.

Get the home and property inspected. This is a must whether buying or investing. If the problems are serious enough, it could hinder the availability of financing. This will also give the client some ammunition which will help them to decide whether or not it’s a wise investment. It also becomes a great bargaining chip for either lowering the initial down payment or the overall price of the property.

Whether buying the property or investing in it, negotiating skills need to be fine-tuned. Since any lease agreement is a step closer to regular home buying from renting, certain ingredients of the financial equation become negotiable. The amount of the down payment, the amount of the monthly payments, the purchase price, and the terms of the agreement are all negotiable.

Should the buyer pay an option fee? In some cases, depending on location, it may be required in order for the agreement to be legal and binding. The tenant/buyer needs to remember that down the road, this lease agreement could become an addendum to the actual sale contract.

What about insurance needs? These will obviously be different as the investor. Refer to the lengthy paragraph under the “Subject To” section prior to this one for advice on insurance. One way or the other, it does equate to standard protection against law suits and other liabilities that can arise and the buyer should be aware of this.

The buyer is obligated to make their monthly payments due to the consequences, but as an investor, they better make those payments on time so it doesn’t affect the seller’s credit. Also, the buyer needs to remember that the monthly payments will be larger than those of most rental agreements on the market.

Should the buyer make improvements on the home? It’s probably a good idea, especially if the buyer is an investor. In that case, it could be necessary and the question doesn’t make any sense. Buyer’s who make improvements create what is called “sweat equity” in the property. From an ordinary buyer’s standpoint, the benefit is that it will improve their chances of getting the home financed when the agreement is finished. If they’re the investor, making improvements will prove to be in their best interest as it will improve the value of the home and help them make a profit on the sale of it down the road.

Applying for a loan comes into play for the buyer as the end of the agreement approaches, and hopefully, they don’t procrastinate on this issue, especially if they are buying the home from your client. It’s a good idea to start seeking financing 45 days to two months in advance, so offer that advice to the tenant if they have decided that it’s time to reap the rewards of their investment. The investor should have the ability to carry the financing for the buyer if seeking out a lender fails to be a viable option and the investor steps into the third-party role.

The lease option agreement from the investor/seller standpoint

At times, a lease option is a great choice for a seller to pursue. Whether or not they’re involved in real estate as an investor, there are many benefits of selling a home in this fashion. Depending on the length of the agreement, they could be giving their monthly cash flow an added boost.

In some instances, the lease option is also a way to ensure that the seller gets top dollar for the home. Selling a home this way also broadens the market of prospective buyers in that the seller has made a sale possible to someone who may have less than lender approvable credit. The following 10 key steps/suggestions apply to any seller who is selling a home this way by virtue of the lease option agreement.

1) Before getting involved in a lease option, the seller should decide if it is the best option for them to pursue. This selling method isn’t always a viable option for everybody. One needs to decide whether they want all the money up front, or if they would rather have a temporary addition to their monthly cash flow. If they want all the money up front, then they need to consider the straight sale and forget about the lease option.

Take into consideration all the responsibilities and variables that exist where this type of option is concerned. In a lot of instances, if the majority of the lease options aren’t exercised, then the seller may find themselves in a position where they are marketing the house again. This won’t be very positive if they have shifted their focus from the monthly cash flow scenario to taking the money and walking away from the property.

They might also consider rethinking the idea should they decide that they don’t want to keep up with the responsibilities. Don’t forget the less pleasant option where they can no longer physically (or possible, mentally) keep up with those responsibilities. Even with a lease option scenario, the seller is still responsible for homeowner’s insurance, major repairs, and property taxes. These can become financially as well as mentally and physically draining.

2) Once the seller decides that the lease option is the route to pursue, they should place an ad in the paper or other advertising mediums where it will get a lot of attention from potential home buyers. They should also use the internet as one of the advertising mediums as well. Ads for lease options typically get better response than standard “for sale” ads, so the seller should make sure that they target that larger audience by putting the ad in the applicable section of the publication.

3) Recommend performing a background check on every applicant. Consider the fact that even though it is a lease purchase option, until the agreement is satisfied and there is a sale that changes their status, they should still be considered as tenants and not owners. So as far as this bit of advice is concerned, why would a seller consider leasing to someone that they wouldn’t rent to? They should look for an applicant that can meet all of the following four criteria (and the order is not as important as if they can meet all four criteria listed):

• they have given good references - especially those that are related to their past rental payment and credit history • they have a steady source of income - beware of the commission-only earner as they have the tendency to go through periods of both feast and famine, and are not always good at budgeting for the tough times • they have the ability to pay the rent (regardless of financial situations that arise) – also that they have always paid on time • they have the ability to pay the additional monthly option fees despite not having done so in the past

As far as the past credit history goes, the seller doesn’t want someone who has always had issues, but they do need to be more lenient than the typical lender. After all, they are trying to obtain a dwelling for themselves and their families, and the traditional lending scenario is not a viable option.

4) Suggest that the seller pre-qualify the lessee. Don’t overlook this step as it will shed some light on the buyer being able to get financed when the agreement is fulfilled. The seller should investigate the buyer’s potential for obtaining a loan with a loan officer or mortgage broker and eliminate any uncertainties about this as soon as possible. This step is beneficial to the buyer as well in that they will also know if they are going to be able to buy the house.

5) The seller needs to provides the buyer with a seller’s disclosure form. This lets the buyer know if there are any problems with the house so that the agent, buyer, and seller can come to an equitable solution. The seller is attesting to the condition of the house to the best of their knowledge, so they don’t need any surprises either. Although this is a standard form for other home purchasing options, it is oftentimes omitted from the lease purchase option. The buyer should be allowed to make an informed decision about the house, and while the seller is at it, they should allow the buyer to pay for a home inspection should they desire to do so.

6) Where negotiating a contract and collecting the option money the lease agreement can be added as an addendum to the standard sales contract once the agreement has been fulfilled and the tenant opts for buying the property.

Important issues between buyer and seller need to be covered, such as who is responsible for what types of repairs, and other issues.

Agree on the purchase price of the home

The price should be no less than fair market value. Splitting the cost of an appraisal is recommended in that the actual lender will only loan against that appraised value.

Determine how much option money to collect

In general, the initial option fee (or option money) can be almost any amount. But be aware of the fact that certain municipal and state governments do have laws specifying maximum amounts where these fees are concerned. The seller needs to find out what the amount is in their area and stay within legal limits on this.

As was mentioned earlier in the chapter, it could equal to one or two months rental fees or be between 3-5% of the purchase price. (NOTE: This money is the seller’s to keep.. Should the lessee decide to buy the home, this money will be applied toward the down payment or the purchase price. If they decide against purchasing, they forfeit the money to the seller. The buyer probably chose the lease option to help them come up with a down payment towards an eventual purchase, so the seller shouldn’t expect to charge a large sum up front.

Decide how much of the lesse’s monthly payment to apply towards the option

Technically, the seller can credit anywhere from 0% up to 100% of the monthly rental fees towards the option. Also, once again, that amount may be regulated by certain local and state laws. The seller should calculate the monthly payment at fair rental market value and add a separate amount that will go towards the purchase price. As with the option money, should the lessee decide against purchasing or be unable to, then that money is forfeited to the seller.

Finally, the buyer and seller want to decide on the terms of the lease. The typical lease option to purchase can run anywhere from 6-24 months. An agreement for less than 6 months won’t make any sense to the buyer, and over 2 years (sometimes over 1 year) may create undue legal or tax complications.

There is a better possibility of the agreement converting to a sale if the terms are shorter, but the term needs to be long enough so that the lessee can get their financing arranged. If the price of housing appreciates too quickly, then the purchase price that was agreed upon won’t be as beneficial to the buyer. If housing prices decline, then the seller stands to gain more. Keep in mind also that if the prices drop too much, the lessee will more than likely walk away without purchasing. Regardless, they still forfeit those option fees.

7) The buyer and the seller need to protect themselves and get the proper insurance coverage. The homeowner’s insurance policy will need to be converted or updated to a “dwelling policy” since the seller will no longer be classified as owner-occupant. Consult an insurance agent to determine the best policy and the necessary coverage warranted by the change. The tenant will also be required to get insurance coverage as well. Also, depending on the state of residence, additional insurance may be required due to any gaps that result from the lease option.

8) The seller (or the leasing agent) collects the monthly payments and keeps track of them. The tracking is necessary since there will be a need for that record when the time comes for the lessee to exercise their purchase option. It’s also a good idea for the seller to have this should they have to pursue legal action to settle any disputes with the buyer.

9) At the end of the lease agreement, sell the house. The lessee is entitled to exercise the option to buy the house for the price specified on or before the date specified. The down payment is now comprised of:

• the total option money paid which including the initial option money • any credit from the monthly payments

The seller needs to be aware that when a buyer and they are engaged in a lease option purchase agreement, that there are certain truths that exist with this type of arrangement that are not common with other financing methods. Where the seller is concerned, it is common for them to charge the buyer a higher-than-market rental fee.

The seller has the option to charge just the fair rental fee, if they so desire, so that only the initial option money (or down payment) get credited towards the purchase of the property. The seller also has another option wherein they can charge the fair rental fee and credit a portion of this towards the option. This proves to be beneficial to the buyer initially, but it can lead to complications when they attempt to get qualified for financing at the end of the agreement. In most cases, the seller can still deduct mortgage interest payments on their personal income tax during the term of the option. Normally, taxes are not paid during the term of the option on the option money, but they are due once the agreement has become satisfied, in other words once the lease option has ended. Depending on whether or not the tenant gets financing arranged for the purchase of the property, this will determine whether the seller either files capital gains or reports rental income.

There is also the possibility wherein the seller opts to carry the financing (be the lender) on the property themselves. Should this be the case, it needs to be spelled out in the contract. Also, there is a law on the books in some states (states not listed) that makes foreclosure the eviction vehicle if the option money exceeds 5% and the tenant and the tenant is making their rental payments. This is a huge impact to a seller’s budget should things progress in this manner. As a result, sellers in these locations usually keep the amount of the option payment below 5%.

An often asked question is “who is responsible for making repairs?” As mentioned earlier in the text, the owner/seller is normally responsible for all major repairs. However, the tenant can be assigned the responsibility of minor repairs in the contract. It just has to be written into the agreement, and should be done when the contract is initially drawn up. The seller and the buyer/tenant can agree to these terms prior to drawing up the final contract. Depending on local and state laws, if the house is classified as a “fixer upper”, the seller may or may not be able to rent it under a lease option agreement.

Should the tenant make improvements and repairs on the home during the lease term, the home’s market value could improve, therefore increasing the tenant’s “sweat equity” in the home. This may also afford the tenant a better opportunity when it comes to getting a more favorable loan for the property.

It is advisable that the seller get two deposits from the buyer/tenant. The seller needs to make sure that the down payment is listed as a non-refundable down payment in the terms of the lease. It is also recommended that the seller put a cleaning deposit clause in the contract as well, should the tenant decide not to purchase once the agreement has been satisfied and they have been relegated to the classification of renter.

Along with the benefits to both buyer and seller in a lease option come the drawbacks, and there are four that come to mind immediately:

1) There is a greater tendency for a tenant that is bound by a lease option agreement to take better care of the property versus the standard renter. But there is still a possibility that the seller will encounter a bad tenant even with a lease option. Any tenant is capable of damaging the property, defaulting on the payments, or deciding not to purchase at the end of the agreement.

2) If the value of the property has increased substantially since it was bought, then the tax implications of the capital gain need to be considered. An individual can deduct up to $250k ($500k if married and filing jointly) from their federal return if they have owned and lived in the property for at least 2 of the past 5 years. If a person has leased the property for 4 years and then sells it, they can not take that deduction and will have to pay capital gains on the appreciation. Whenever possible, the best idea is to recommend that their client seek the advice of a tax accountant and not attempt to offer any tax advice on their own.

3) Become knowledgeable of the rental industry before completely committing to a lease purchase option. The seller should be thoroughly knowledgeable of what is involved in being a “landlord”. The seller should study and become familiar with the local laws regarding the landlord-tenant relationship and they need to be certain that the role of landlord is what they really want to assume.

Carry Back Financing

Sometimes referred to as Seller Carry-back, in simplest of terms, this is an agreement in which the finance is provided by the property owner along with an assumed mortgage. There are always instances where a seller agrees to make a home loan to enable another person to buy a home. When a seller agrees to finance all or part of the purchase price, they receive documentation that evidences the terms and the conditions of the loan.

These seller carry-back documents are normally filed and recorded in public records. Seller carry- backs can be in the form of:

• land contracts • lease purchases • mortgages • promissory notes • trust deeds

Why do sellers do carry-back mortgages? There are a number of reasons that a seller chooses to go this route, but the main one realistically is that a buyer has asked them to act as the lender and carry the financing. This type of financing not only becomes apparent when credit guidelines get tightened, but also when interest rates get too high. The seller may carry all the financing if the home is owned free and clear. But if it isn’t, then they will carry part of it and the buyer will get approved for as much conventional financing (at a fixed-rate) as possible.

Although the loan will remain in the seller’s name, sellers will occasionally let the buyer take over the existing loan should one exist and be secured to the property. Usually, the seller will carry the difference between the sales price less the down payment and the existing loan. This is the equity that the seller would carry as the loan.

The main reasons why the seller agrees to carry either all or only part of the financing are as follows:

• the real estate market is down or “soft” as it is often called, in which case we see owner- carried financing attracting a larger pool of buyers • buyers are unable to qualify for conventional financing • The seller is facing capital gains on the sale of the property and can defer that portion which is financed • The financing gives the seller a better rate of return than a money market account • Sellers sometimes want a monthly income • The property is non-conforming and no lender will loan on it • Often sellers can receive a higher sales price in exchange for offering owner financing

There are three big drawbacks for a seller with carry-back mortgages:

• The buyer might default on the payments, causing the seller to initiate foreclosure proceedings. • After foreclosure, making up back payments to the existing lender, if there is an existing loan, paying closings costs and real estate commissions, the seller might not be left with any equity. • Sellers who carry back mortgages have tied up cash by securing it to the property.

Surprisingly, there is a sizable group of investors in the marketplace who focus on buying carry-back mortgages on a regular basis. They do not pay face value since they are looking at the possible yield over the term of the investment. And of course, the yield can be increased if the investor pays less than the outstanding balance that is due. Discounts on carry-back mortgages vary, but the seller can anticipate a loss of 10-30% of the remaining balance. The following always influences the amount of loss that a seller will have to tolerate:

• Seasoning. This means the length of time that a seller has received payments on the carry- back financing. If the seller has received timely payments over a 12-month period, they will normally receive more cash than a seller holding a brand new mortgage. • Interest rate. Usually the higher the interest rate, the lower the discount. Characteristically, lower interest rates attract investors who want higher discounts. • Mortgage term. Long-term mortgages (i.e. 30-year mortgages) are not as attractive to investors as a short-term mortgage. Therefore, long-term mortgages are typically sold at higher discounts than short-term. • Prepayment penalties and late charges. Those carry-back mortgages that contain a prepayment penalty and a late charge clause are more attractive to investors because it affects the discount rate applied. • Loan-to-Value Ratio. If there is a lower loan-to-value ratio, this will receive more favorable discounts. A higher ratio is considered to be a greater risk so the discounts tend to be steeper.

Other aspects that investors look at are:

• Amenities • Appraised value • Condition • Buyer’s credit-worthiness • security

No-doc / Low Doc Loans

The terms are shortened versions of “No Documentation” and “Low Documentation”.

A no documentation loan is one in which the borrower supplies a minimal amount of information to the lender. The lender’s decision then hinges on the borrower’s credit history and the size of the down payment. These particular loans normally have a higher rate of interest attached to them.

The no-doc loan is one in which the borrower, by virtue of the higher interest rate, is paying for the ease of application and privacy issues. No-doc loans are popular among borrowers who are willing to pay for these conveniences. In most cases, the borrower furnishes their name, social security number, and information about the property that they are trying to purchase. Also, no-doc loans are usually tailored to meet the needs employment and income situations.

Low documentation loans are those that are designed for persons' that are self employed, recent immigrants, or entrepreneurs that may not want to reveal information of their incomes. These loans require exceptional credit history, a substantial down payment, and incur a higher interest rate. Low doc loans are popular among home buyers interested in getting a mortgage fast without having to provide extensive personal information.

Low-doc loans are also referred to as stated-income loans and usually attract borrowers that don’t earn a regular salary. Most of the time, they work on a commission or a cash basis. Requirements for these types of loans include records of earnings for up to the past two years, tax returns, and bank statements. A good portion of these people are also self-employed. The qualifying process is usually more flexible in that no income verification is needed. Again, the higher interest rate is acceptable to the borrower in that it affords the borrower a certain amount of privacy and convenience.

There different types of no-doc/low-doc loans but the main three are as follows:

• Stated-income mortgages tend to be for people who work but don't draw regular wages or salary from an employer. That includes self-employed people or those who make a living off commissions or tips. • No-ratio loans are often the right call for wealthy people with complex financial lives, retirees who live off investments and people whose lives are in flux because of divorce, recent death of a spouse, or career change. • No-doc or NINA (no income/no asset verification) mortgages are for creditworthy people who want maximum privacy and can afford to pay for it. In order for a person to apply for a stated-income mortgage, they need to supply at least a two year earning history. Rather than provide documentation like W-2’s or pay stubs, the borrower is usually asked to show bank statements, tax returns, and (sometimes) profit and loss statements. The terminology “low-documentation” is not always accurate since the borrower still has to show assets and debts when applying.

Hugh McLaughlin, president and CEO of KMC Mortgage Services Inc., a lender and broker in Naples, Fla. states that “stated-income mortgages are for people who make the money they say they make, but that amount doesn't show up on the bottom line of their income taxes.”

"They work for cash. They might be cleaning people or people who work in restaurants," McLaughlin says. "It is also good for self-employed borrowers who actually make gross sufficient amounts of income, but write off a lot on their taxes.”

The listing of debts is required because the lender needs to determine their debt-to-income ratio, i.e., the percentage of gross income used to pay off debts. Most lenders normally look at two ratios --- 1) the percentage of income that goes toward the mortgage payment, and 2) the percentage that goes toward all debt, including mortgage, credit cards, auto loans and other loans.

An unwritten rule of thumb with stated-income mortgages is that the interest rate runs about a half- point higher than the comparable conventional rate. However, where rules of thumb are concerned, sometimes this is the case, but most often it isn’t. The rate of interest is dependent on a number of factors such as income stability, debt-to-income ratio, credit score, and size of the down payment and appraised value of the property. A borrower with a stated-income mortgage could pay anywhere from one-eighth of a percentage point above the conventional rate to more than 1 percentage point above.

Normally, the borrower does not reveal income when applying. No pay stubs, W-2’s, or income tax statements are presented. The lender doesn't ask how much the borrower earns, and the borrower doesn't tell. They’re called no-ratio loans because the lender doesn’t compute the borrower’s debt- to-income ratio. Actually, the lender can’t compute it because they don’t know the borrower’s name. And sometimes, the borrower doesn’t list their debts either.

Assets are listed though. These include money in bank accounts, stocks and bonds, real estate, and so on. No-ratio loans do provide quicker processing for the creditworthy borrower however, and is not designed to qualify marginal borrowers. An example of a person who would apply for this type of loan would be someone who owns multiple car dealerships. The conventional loan might require the submission of personal and corporate tax returns and a year-to-date profit-and-loss statement for all the dealerships.

Borrowers who might benefit from a no-ratio loan could be the person experiencing a big change in their life, or lifestyle. They may have recently experienced the death of a spouse, been going through a divorce, switched careers, or retired. Depending primarily on credit score, size of down payment, and appraisal of the property, the borrower will usually have to pay anywhere from a half- point to over three points above the conventional rate.

The third category of these loans is the No-income/no-asset verification mortgages, also called NINA’s. These loans require the least amount of documentation. Normally, the borrower supplies their name, social security number, amount of their down payment, and the address of the property they intend to purchase. The lender gets a credit report and a property appraisal --- and that’s it.

There is a fine line that separates a no-ratio loan from a NINA loan. Since a lot depends on the borrower’s credit score, the better their score, the less documentation they have to provide. In most cases, the lender will inquire as to what the person does for a living and for how long they’ve been doing it, and they are usually more comfortable with a person who has at least a two year history on their job.

In still other cases, the lender may require an excellent credit history, in other words, people who have never failed to pay their bills on time. But just like with the other two types, the less documentation required, the higher rate of interest incurred. "It's always a layered risk situation," McLaughlin says. The size of the down payment is one layer -- the bigger the down payment, the lower the risk and the lower the rate. The same goes for credit score, willingness to show ownership of assets, and the degree of openness about what the borrower does for a living.”

If it appears that some caution should be taken with these types of loans, that’s a safe assumption to make. They always have certain conditions and extra costs attached to them. Here are some things that the borrower needs to look out for:

• a higher interest rate, although the more financial documentation you can produce, the lower the rate often is • additional and inflated fees and charges • compulsory mortgage insurance • a higher deposit is required - often up to 20% of the property value needs to be provided by the purchaser • added security could be required, such as a car or other investments • a shorter loan period - some loans require the applicant to refinance after a set period of time, sometimes as short as 1 year

Key things to remember are that these types of loans are based almost entirely on credit score with near-perfect to perfect ones being the standard requirement. Interest rates typically run anywhere from a half-point to over three points in some cases. To quote an article found in MortgageNewsDaily.com, “most people don't mind divulging sensitive credit, employment and financial information in order to secure the best rates on their home loan. But for those who either can't provide such information or would rather not, in order to protect their privacy, a no documentation mortgage loan or low documentation home loan is often the solution.”

1031 Exchange

In the simplest of terms, Internal Revenue Code 1031 provides investors with one of the last available tax shelters by allowing them to avoid paying any taxes when an investment property is exchanged. This is referred to as a 1031 Exchange. To quote the IRS’ most recent update (12/10/02) found at http://www.meocpa.com,

“The general rule is that if property is sold in a typical sale transaction, gain or loss may be recognized. However, Section 1031 basically provides an exception to the general rule by providing that gain or loss will not be recognized on the exchange of business or investment property if it is exchanged for "like kind" property. The gain is not forgiven but is simply rolled into the new property and may be recognized later when a typical sale takes place. The non-recognition in an exchange is not elected it is mandatory if the conditions are met.”

In reality, no two individuals would normally want to exchange their properties. Usually this form of “creativity” involves three parties:

• the taxpayer who wants to dispose of his property but delay taxation • the buyer for that property • a seller who has property that the taxpayer wants to acquire

Technically, should the taxpayer sell his property and invests in the new property, he will be responsible for the capital gains on the property he sold. As a result, he won’t have the full value to invest in the new property. If he exchanges the property, he is getting the full value rather than one depleted by taxes.

The easiest way to explain this is that the buyer purchases the property that the seller wants to acquire and then the buyer exchanges it with the seller. The seller disposes of his property and gets a replacement property without paying taxes, the buyer parted with his money and got the property that he wanted, and the third party simply sold his property. Realistically, all three parties have a closing on the same day. They enter with the properties they have, and they leave with the cash or the properties that they want.

There are a few stipulations mandated by the IRS so this type of real estate transaction is not granted to just anybody. Typically, the properties have to have been designated either for productive use in a trade or business, or held for investment purposes. They must also be classified as “like-kind”, which the IRS defines as “of the same nature or character, even if they differ in grade or quality.”

Loan Assumption – with this method, the buyer basically steps into the seller’s shoes and takes over the existing loan. Unless the seller gets a lender’s approval and the buyer gets qualified, this option is only available with certain older FHA and VA loans. In addition, a “subject to” assumption defines an assumption wherein the buyer takes title to the property, but the seller remains liable for the loan.

Seller Carry-Back or All Inclusive Trust Deed (AITD) – this is sometimes referred to as a “wrap- around” transaction. The seller deeds the house to the buyer and then carries back a single loan from the buyer in an amount that includes the existing financing on the property. The seller then continues making payments on the existing mortgage out of the payments that he receives from the buyer. The loan from the seller’s original lender is still secured by the property.

Contract for Deed – this is sometimes referred to as a “land contract” or an installment sale. In this method, the seller retains the title to the property until the buyer has completed making the payments. Again, the loan from the seller’s original lender is secured by the property, and the seller makes payments out of the installment payments made by the buyer.

Lease Purchase or Lease Option – the seller the property and the tenant makes rental payments until the contract has been fulfilled. With a lease-purchase, the tenant is obligated to buy the property. With the lease-option, the tenant can either purchase the property or walk away at the end of the agreement. The loan from the seller’s original lender is secured by the property, and the seller still makes payments on the loan out of the rent payments received from the tenant under the lease.

A Few Words about

If a buyer lies in any way, shape, or form on a real estate application, this constitutes mortgage fraud --- even if it’s the tiniest of “white lies.” Should a lender discover any falsities on a buyer’s application, they have the right to demand the immediate full payment on the loan. In addition to this, the buyer could get fined heavily, possibly be paid a visit by the FBI, or even go to jail. To say the least, the penalties are nothing short of severe.

The FBI defines mortgage fraud as "any material misstatement, misrepresentation or omission relied upon by an underwriter or lender to fund, purchase or insure a loan." The following examples are the most significant forms of mortgage fraud:

• Silent second mortgage - a buyer can commit mortgage fraud by borrowing the down payment from the seller in exchange for giving the seller a silent second mortgage, which is unrecorded (or records after closing) and hidden from the lender • Falsifying employment income – because some self-employed individuals income is often difficult to verify, “stated income” loans were originally created, but borrowers have committed mortgage fraud because they inflated their income over and above their W-2’s • Non-owner occupant claiming occupancy – if a buyer doesn’t intend on living in the property, and they promise that they will, this is mortgage fraud; and they usually do this since lenders often charge a higher rate of interest to non-owner occupants due to the lender’s risk being higher • Repaying down payment gifts – the giver and the recipient are both guilty of fraud if there is an agreement made for the recipient to repay the gift; gifts cannot be repaid • Inflating the purchase price – if the buyer creates a false purchase contract with an inflated purchase price and presents that to the lender in hopes of receiving a higher appraisal, that is mortgage fraud • Falsifying deposits – if a borrower does not have an earnest money deposit, they state in the contract that a deposit was made outside of escrow, they are guilty of mortgage fraud

On a closing note, here are a couple of incidents/notes taken from “How to Avoid Mortgage Fraud” by Elizabeth Weintraub at About.com:

Professional Mortgage Fraud ---

“Length of time in the business is no guarantee that your ‘trusted adviser’ isn't a crook. A Pennsylvania mortgage broker got 30 years behind bars after defrauding more than 800 borrowers in a Ponzi scheme, which somehow kept all the balls in the air for 20 years. A Kansas City, Missouri, appraiser pleaded guilty to mortgage fraud and was sentenced to 20 years in prison, plus a $500,000 fine. Schemes are happening every day. The newspapers are filled with similar stories.”

Review

Creative Financing refers to the non-traditional types of financing, or those less common financing techniques that are used.

Hard Money Loans are categorized as asset-based loan financing because the borrower receives funds based on an asset --- in this case a parcel of property. The positive aspects of HML include a quick solution to distressed finances, it involves private lenders (not banks), the credit score of the borrower is insignificant, and they are approved easier with fewer denials. Negative aspects are a lower LTV, a higher rate of interest and points, they must be repaid quickly, and defaulting results in immediate loss of property.

Private Mortgages always involves a private lender and is a mortgage that is secured by real estate. They are often called “land contracts” or “contract for sale” and the last payment on this type of mortgage is referred to as a “balloon payment” because it is so large compared to the regular payments. A Land Contract (also called “contracts for deed”) is basically a security agreement between a seller (vendor) and a buyer (vendee).

The positive aspects of a private mortgage include the buyer with poor credit being approved more frequently, it is an excellent investment vehicle for investors, it allows anxious sellers to sell property faster, and the seller controls mortgage. The negative aspects include a lower LTV, a higher rate of interest and points, the final payment is a balloon payment, and the buyer does not receive title until loan is paid in full.

A Wrap-Around Mortgage is a form of secondary financing in which a seller extends to a purchaser a junior mortgage which wraps around and exists in addition to one or more superior mortgages. With a Wrap-Around contract, the buyer will make monthly payments to the seller, plus an additional payment which covers the balance of the buyer’s purchase price for the home.

All loans issued today contain acceleration and alienation clauses. An acceleration clause is specific terminology “that fully matures the performance due from a party upon a breach of a contract.” An alienation clause “allows a lender to call a loan immediately due and payable in the event the owner sells the property or transfers title to the property.”

A Simultaneous Closing is a real estate seller technique wherein the mortgage created by the seller is simultaneously sold to a note buyer at the time of closing. Normally, the seller and buyer agree on the terms with some input from the note buyer. Two transactions take place on closing day - literally simultaneously, hence the name. There is the real estate transaction and a note purchase transaction. The investor and the loan originator tend to benefit the most from this use of the simultaneous closing.

A Land Trust is an agreement wherein one party, called the trustee, agrees to hold ownership over a piece of real property for the benefit of another party called a beneficiary.

When someone takes over property in this method, they are taking it over “subject to” an existing loan. Most lenders today have a “due on sale” clause in the agreement or contract. The due on sale clause allows the lien holder to demand full payment of the loan immediately rather than continuing to accept payments.

“A lease option (or lease purchase) is the abbreviated form of the appropriate term lease with option to purchase. The contract is typically between two parties: the tenant (also called the lessee), who will occupy a house or apartment, and the landlord (lessor), who owns the property.” The biggest negative falls on the tenant in that, at the end of the lease agreement, should they decide against purchasing the property, all the money paid to date has gone to waste.

Sometimes referred to as Seller Carry-back mortgages, this is an agreement in which the finance is provided by the property owner along with an assumed mortgage. Usually the three big drawbacks for a seller with carry-back mortgages.

1. The buyer might default on the payments, causing the seller to initiate foreclosure proceedings. 2. After foreclosure, making up back payments to the existing lender, if there is an existing loan, paying closings costs and real estate commissions, the seller might not be left with any equity. 3. Sellers who carry back mortgages have tied up cash by securing it to the property.

A No Documentation Loan (called a no-doc loan) is one in which the borrower supplies a minimal amount of information to the lender. Low Documentation Loans (called Lo-Doc or Low-Doc Loans) are those that are designed for persons' that are self employed, recent immigrants, or entrepreneurs that may not want to reveal information of their incomes. These loans are categorized as follows: There different types of no-doc/low-doc loans but the main three are as follows:

• Stated-income mortgages tend to be for people who work but don't draw regular wages or salary from an employer. That includes self-employed people or those who make a living off commissions or tips. • No-ratio loans are often the right call for wealthy people with complex financial lives, retirees who live off investments and people whose lives are in flux because of divorce, recent death of a spouse, or career change. • No-doc or NINA (no income/no asset verification) mortgages are for creditworthy people who want maximum privacy and can afford to pay for it.

In the simplest of terms, Internal Revenue Code 1031 provides investors with one of the last available tax shelters by allowing them to avoid paying any taxes when an investment property is exchanged.

The easiest way to explain this is that the buyer purchases the property that the seller wants to acquire and then the buyer exchanges it with the seller. The seller disposes of his property and gets a replacement property without paying taxes, the buyer parted with his money and got the property that he wanted, and the third party simply sold his property.

Mortgage Fraud occurs when the borrower falsifies any information on a loan application, or as the FBI defines it, "any material misstatement, misrepresentation or omission relied upon by an underwriter or lender to fund, purchase or insure a loan." Should the lender discover these falsifications, they can demand the immediate full payment on the loan. In addition to this, the buyer could get fined heavily, possibly be paid a visit by the FBI, or even go to jail.

Chapter 8 Finance and Escrow Formulas

Introduction Math is the fundamental tool that is used by real estate agents on a daily basis. Mastering math skills is important in providing service in all aspects to buyers and sellers.

Interest Formula Almost all real estate loans are calculated as Annual Simple Interest. This means that if the lender charges a 9% rate of interest it refers to 9% of the principle amount of the loan, per year. Simple Interest means that the interest is paid only on the principle amount of the loan. Compound interest is actually where the borrower is paying interest on the principle, and interest on the accumulated unpaid interest.

For example: Compound interest means that during the first year, 9 % interest on a $112,000 loan would equal $10,080 in interest. In other words --- $112,000 x .09 = $10,080 But the second year interest will be paid on $112,000 PLUS $10,080 which is $122,080 x 9%= $10,987.20 or in other words --- ($112,000 + $10,080 = $122,080) x .09 = $10,987.20 And so on each year. For our purposes, we will use simple interest in all questions unless the question specifically asks for compound interest. Other loans may be calculated on a semi-annual, biannual, semi-monthly, or bimonthly interest rate. Please learn how to distinguish between the following time period terminologies: • Semi-annual / semi-annually means twice a year • Bi-annual / bi-annually means every two years • Semi-monthly means twice a month • Bi-monthly means every two months

The “PART” is the principle loan amount, the “RATE” is the percentage of interest, and the “TIME” is the duration of the loan. So the formula for calculating interest using the above terminologies would look like this: Principle loan amount x percentage of interest x duration of the loan = the interest or in other words, PART x RATE x TIME = INTEREST

As an example, Paul gives Lenny a note for $5,000. The note bears an interest rate of 11% per annum and will amortize over one year. Lenny wants to know how much interest he will be paid in that year. So in order to calculate everything correctly, Lenny needs to do the following:

1) Use the formula (P x R x T = I), but turn it around to fit the question 2) Write down the formula and replace with known numbers so that P x R x T = I 3) Calculate the formula as follows: $5,000 x .11 x One year = $550 paid to Lenny

Here’s another example: Buck took out a loan and repaid it over 9 months. His rate of interest was 10.5 % per annum and he paid a total of $750.00 in interest. He wants to know the principle amount of the loan. Buck must do the following:

1) Use the formula (P x R x T = I), but turn it around to fit the question, so in this example the formula would look like this: I ÷ R x T = P 2) Write down the formula and replace it with known numbers so that the formula looks like this: I ÷ R x T = P. When you insert the numbers, the result is that it will look like this: $750 ÷ 9/12 x 10.5% =P. You will first need to convert the fraction of the year to a decimal (top number ÷ bottom number). So since the time factor is 9/12 of a year, 9 ÷ 12 = .75. Next, convert 10 1/2% to a decimal by dropping the % and moving the decimal point 2 places to the right to look like .105. The formula now looks like this: $750 ÷ .105 x .75 = P. 3) Now, when you calculate the formula the result is: $750 ÷ 105 x .75 = $5,357.14. This then is Buck’s principle loan amount.

Loan-to-Value Ratio Formula Always begin with “known” numbers and then carefully read the question to determine how to calculate the known numbers, to arrive at the unknown number. The Loan-to-Value (LTV) Ratio formula looks like this: % x Value = Loan As an example of how this works, let’s assume that a lender would make a loan on 70% of a property's value, and the property was appraised (or sold) at $100,000 minus whichever is less, then: .70 x $100,000 = $70,000 Here are a few assumptions that can be made. When a lender makes a loan in relationship to the value of the property, the lender will use either the appraised value of the property, or the sales price, whichever is the lesser of the two. If the lender will make a loan of 75% LTV (loan to value) this means that the lender will loan 75% of the amount that a property appraised and/or sold for, whichever is less. IF the property gets appraised for $119,950, BUT sells for $116,500, then the loan amount will be: 75% x $116,500 = $87,375 loan amount because the sold value was less than the appraised value. Also, if the property appraised for $116,500, but sold for $119,950, the loan amount will still be: 75% x $116,500 = $87,375 loan amount, because the appraised value was less.

Here’s an example to illustrate the use of the LTV formula: Desiree bought a house for $82,500, but it was appraised for only $79,900. The lender will give Desiree a loan to value ratio of 80%. Desiree wants to know what the amount of her loan will be, so using the formula, % x Value = Loan, we arrive at the following result: 80% x $79,900 = L, or .8 x $79,900 = $63,920 being the amount of Desiree’s loan. Now Desiree wants to know what her down payment will be. So you would subtract the Loan of $63,920 from the $ 82,500 sale price. The math would look like this: $82,500 Sale Price - $63,920 Loan $18,580 Down payment required

This is very important: if the sale price is higher than the appraised value, the lender will use the appraised value to base the loan amount. However, if the buyer agrees to pay a sales price higher than appraised value, the down payment will be the difference between the sale price and the loan amount. The buyer will have to pay the difference between the sale price and appraised value in cash. Loan Fee Formula Lenders usually charge a loan origination fee, or discount “points”, when making the loan. So they use a formula that looks like this: % x Loan = Fee. So if the lender were to charge a 1% loan fee on a loan of $70,000, the result would be .01 x $70,000 = $700.

Here’s an example to help illustrate the loan fee formula: Old US Mortgage is charging Tina 2 points for her loan of $166,800. “Points” means percentage. Tina wants to know how much the fee is. So let’s plug the numbers into the formula. Using the loan fee formula, we come up with 2 % x $166,800 = $3,336.

Property Value after Profit or Loss This formula will help an investor determine the percentage of increase or decrease of the value of a property after the investor has realized a profit or taken a loss. If the investor made no profit, but also had no loss, the property value would remain the same. However, if the investor makes a profit, the value of the property will then be more than it was originally. If the investor shows a loss, the value the property value will be less than the original value. The percentage of the profit or loss is the comparison of the property “value before” the profit or loss, to the property “value after” the profit or loss is taken. The value of the property before the profit or loss was taken is 100% of its value. This 100% figure is called the “value before”. If the investor realizes a profit, the property is valued at 100% of its “value before” plus the percentage of profit. Of course, if the investor shows a loss, the property is valued at 100% of its value before minus the percentage of profit.

Value before and Value after Formula The Value before and Value after formula looks like this: % x Value before + 100% of VB = Value After, or to simplify it, % x VB + 100% of VB = VA (NOTE: always remember to convert the percentage to a decimal when doing this formula or any other.) Let’s do an example to illustrate how this formula works. Jack bought duplex seven years ago for $169,500. He sold it to Kip for 40% more than he paid. Jack wants to know the property’s “value after” this profit. 1. Use the formula to find value after: % x VB + 100% of VB = VA. The first step is to convert the percentage to a decimal, 40% becomes .4 so that, 2) When you write down the formula by plugging in the known numbers, it looks like this: .4 X $169,000 + $169,000 = VA. 3) Now when you calculate the formula, it looks like this: .4 X $169,000 + $169,000 = $236,600. The $236,600 that results is the property’s value after the profit.

Here’s another example: Rich sold his apartment house for $73,500. He bought it three years ago for $125,000. Rich knows the value BEFORE was $125,000 and that the “value after was $73,500. He took a loss, BUT he needs to know the percentage of that loss. In order to figure this out, here is what he has to do:

1. Use the formula VA ÷ VB = %. 2. Write the formula and replace with known numbers. It will read as follows: VA ÷ VB = % OR $73,500 ÷ $125,000 = % 3. Calculate the answer. It should look like this: VA ÷ VB = % OR $73,500 ÷ $125,000 = .59 Remember to convert the decimal to a percentage by moving the decimal point two places to the right and adding a %. Rich’s property value after the loss was 59% of the value before the loss. Now that you have established the percentage of the property’s after the loss, all it takes is simple subtraction to figure out the percentage of LOSS on the property as follows: 100% of property value before (prior VB of property) - 59% value after the loss (new % of VA of property, not % of the loss) =41% is the percentage amount of his loss.

Here’s another example to illustrate this: Dr. Harvey sold his condo for 27% more than he bought it for 1 year ago. He received $174,300 at closing. Dr. Harvey needs to calculate what he originally paid for the condo. He knows the “value after” is $174,300 and that the percentage of profit is 27%. Let’s do the math. 1. Use the formula VA ÷ % + 100% =VB 2. Write the formula and replace with known numbers. Since VA ÷ % + 100% = VB is our formula, the calculation starts off like this: $174,300 ÷ 27% + 100% =1.27 = VB 3. When we calculate things using the known numbers plugged into the formula, we come up with: VA % + 100 = VB OR $174,300 ÷ 27% + 100% =1.27 = $137,244 So, Dr. Harvey originally bought his condo for $137,244.

Capitalization Formula Capitalization is a method used in the evaluation of property as an approach to its value. The “cap rate” of a property is the desired rate of return, multiplied by the property value, to calculate what the income of the property must be. The formula for determining the cap rate looks like this: % Rate x Value = Income OR % R x V = I The annual net income of the property is the Income. The capitalization rate, or “cap rate” is the desired percentage of return that the investor is looking for. If a property produces $15,000 per year income, and the investor wants a cap rate of 12, the investor could pay $125,000 for the property. However, if the investor wants a higher cap rate, he/she would have to buy the same property for a lesser value with the same income. Let’s say that the investor desires a cap rate of 10%. Now the investor could pay $150,000 for the same property with the same income. There are many types of investment properties where the Net Income should allow for vacancy factors and operating expenses that must first be deducted from the Gross Income.

Here’s an example of how the cap rate is calculated: Sarah’s apartment building has an annual net income of $53,000. Roger wants to buy an investment property that has an 11% capitalization rate of return. Roger decides to make an offer on Sarah’s Apartment building so he must figure out how much to pay for it. 1. Use the formula % Rate x Value - Expenses = Net Income 2. Write the formula replacing the letters with the known numbers. You must turn the formula around to fit the question so it appears like this: NI ÷ % R = V OR $53,000 ÷ 11% = V 3. Calculate the formula as follows: $53,000 ÷ 11% = V Convert 11% to .11 $53,000 ÷ .11 = $481,818 So in order to arrive at a cap rate of 11%, with a net income of $53,000, Roger should pay $481,818.

Another example of calculating the cap rate can be done with the following example: Using his annual Net Income, Mickey recently valued his triplex at $150,000 using a cap rate of 9%. Bud wants a cap rate of 11% so he has to figure out how much to pay for Mickey’s triplex. Mickey must calculate things in the following manner: 1. Use the formula NI ÷ % R = V 2. Write the formula and replace with the known numbers like this: % Rate x Value = Net Income .09 X $150,000 = Net Income 3. Calculate the formula as follows: % Rate x Value = Net Income .09 X $150,000 = Net Income $13,500 This shows Mickey’s net income to be $13,500. But hold the phone! Bud explained that he wants an 11% capitalization rate, and Mickey has calculated it at only 9%. 4. Now Bud must use the formula so here we go again. Following our procedure, we arrive at our new cap rate --- NI ÷ % R = V $13,500 ÷.11 = $122,727 Bud could pay $122,727 for Mickey’s property to get the higher rate of 11%. You can see that if an investor demands a higher cap rate from an investment property that produces X amount of income, the investor will have to pay less for it than an investor who requires a lower cap rate from the same property with the same income. . Dan has a twenty-unit office building with 12 offices that rent for $750 per month, and eight offices rent for $1200 per month. He has a 6% vacancy and bad debt factor. Dan’s operating expenses include annual of $8,600, monthly utilities of $1,150, and a

maintenance cost of approximately $2,100 per year. Dan owes a mortgage balance of $18,000 at 7% interest, with monthly payments of $279. Pat wants to buy the office building to produce a 12% rate of return. Pat can add up the Income and he knows his cap rate, so he must use the formula to figure out how much to pay for the property. If Dan’s property will provide Pat with a 12% rate of return, at a price of less than $2,000,000 Pat will buy the property. Pat must do some calculations to find the Net Income before using the formula: Net Income ÷ % Rate = Value 1. Calculate to find the annual income from rent. 12 x $ 750 x 12 months = $108,000 8 x $1,200 x 12 months = $115,200 Total Gross Income is $ 223,200 2. Calculate the 6% vacancy and bad debt factor and deduct it. 6% x $223,200 = $13,392 3. Deduct the $13,392 from the Gross Income. $223,200 - $1,339 =$209,808 $209,808 is the Effective Gross Income. 4. Calculate the operating expenses and deduct from the Effective Gross Income The operating expenses for the property are as follows: Property taxes $8,500 per year Utilities $1,150 per month x 12 months = 13,800 per year Maintenance $2,100 per year Total annual operating expenses $24,500

REMEMBER: Mortgage payments are NOT an operating expense and MAY NOT be deducted. $209,808 Effective Gross Income -$24,500 operating expenses $185,308 is the annual Net Income Net Income is the number you use to calculate “cap” rates. 1. Now you can use the formula. NI ÷ % R = V 2. Write the formula and replace with known numbers. NI ÷ % R = V $185,308 ÷ .12 = V 3. Calculate. NI ÷ % R = V $185,308 ÷ .12 = $1,544,233 Pat would have a cap rate of 12%, so he pays $1,544,233 for Dan’s office building.

Let’s follow this with another example, only this time we’ll assume that Pat paid $1,950,000 for Dan’s office building and the income and expenses were the same. Now what would Pat’s cap rate be?

1. Use the formula: NI ÷ V = % R 2. Write the formula replacing the letters with the known numbers. NI ÷ V = % R $185.308 ÷ $1,950,000 = % R 3. Calculate. NI ÷ V = % R $185.308 ÷ $1,950,000 = .95 When you convert .95 to a percentage the result is 9.5%, meaning that Pat’s cap rate at this price would be 9.5%.

Pro-ration Formula Pro-ration means figuring out the share of each party's expenses “per diem” which means “per day” according to the period of time that each will or have already benefited from the expense. This is usually required to figure costs for the real estate closing. Cost of insurance and taxes are pro-rated according to the amount paid and the amount left by the closing date. The pro-ration formula is: Rate per day x Number (of days) = Share The formula can be turned around to fit the question. R x N = S N ÷ S = R S ÷ R = N 2 x 3 = 6 3 ÷ 6 = 2 6 ÷ 2 = 3 The “per diem” for monthly expenses must be calculated to at least 4 decimal places. The “per diem” for annual expenses must be calculated to 5 decimal places. At a real estate closing, it may be necessary to find pro-rations to divide certain costs. What if the seller of a house paid for the entire year’s insurance on January first? The insurance is paid for the entire year, but then the seller sells the house on May 15th. The seller will want some money back. If the buyer wants to assume this insurance, first we need find out how much the insurance cost for the year, and divide that number by 365 days to find the per diem or cost per day. Then we would count the number of days there are from January first to the date of the closing when the buyer takes over. Then take the number of days left, and multiply that by the cost of the insurance per day. Then, at closing the seller would be credited the amount that the buyer took over. To find the per diem or cost per day of a monthly expense, divide the expense by the number of days in those particular months. Getting started with our examples again, Roberta makes an offer to purchase a home. As part of her terms she agrees to pay the prepaid interest, OR “interim interest”, at closing. This is the amount of interest that will have accrued from the date of the closing, which will be August 11th, until the end of the month, August 31st. The principle amount of the loan is $163,000. Roberta wants to figure out her share of the cost. She must: First calculate the annual interest cost. Use the formula: Part x Rate x Time = Interest P x R x T = I Part x Rate = Interest ÷ Time

P x R = I ÷ T $163,000x.08=$13,040÷365=$35.73 per diem Now Roberta must count the number of days in the month of August from the date of closing to the end of the month. August 11, 12, 13, 14, 15, 16, 17, 18, 19, 20, 21, 22, 23, 24, 25, 26, 27, 28, 29, 30, 31 = 21 days. 1. Use the Pro-ration Formula: Rate per day x Number (of days) = Share 2. Write the formula, replacing the letters with the known numbers. Rate per day x Number (of days) = Share R x N = S $35.73 x 21 = S 3. Calculate. Rate per day x Number (of days) = Share $35.73 x 21 = $750.33 Roberta’s share will be $750.33

Here’s another example, going into a little more detail: Ginger buys Frank’s house, which will close on March 16th. The annual property taxes of $1,652 were due on January 1st, BUT have not been paid. Ginger will have to pay taxes to bring them current at closing. Frank owes Ginger for taxes from January 1st to March 16th. Frank wants to know what his share will cost. First divide the annual rate of his taxes by 365 days to find the per diem: $1,652 ÷ 365 days = $4.53 Then count how many days there are from January first to March 16th. There are 75 days. Now use the Pro-ration Formula: Rate per day x Number (of days) = Share. R x N = S 2. Write the formula replacing the letters with the known numbers: Rate per day x Number (of days) = Share R x N = S $4.53 x 75 = S 3. Calculate $4.53 x 75 = $339.75 Frank’s Share is $339.75

Depreciation/Appreciation Formula Appreciation is when a property rises in value. Depreciation is when a property has a loss in value. Buildings and land can appreciate or depreciate at different rates. An appraiser looks at depreciation as an actual loss that affects the appraised value. An accountant will look at depreciation as a hypothetical loss that affects the investor’s financial statement and income taxes. Straight line depreciation means that the property will depreciate in equal annual amounts throughout its useful life. Straight Line Depreciation Formula 100% ÷ Number of Years=Annual Rate of Depreciation 100% ÷ N = D The formula can be turned around to fit your question: 100% ÷ N = D N x D = 100% 100% ÷ D = N 6 ÷ 2 = 3 2 x 3 = 6 6 ÷ 3 = 2

For Total % for months, years, etc. use: Number of Years x Annual Rate of Appreciation = Total %, or N x A = T% And of course, here’s the example: Brenda has a building with a “useful life” of 20 years. She wants to know the Rate of her annual depreciation. 1. Use the formula. 100% ÷ Number of Years=Annual Rate of Depreciation 100% ÷ N = D 2. Write the formula and replace with known numbers. 100% ÷ N = D 100% ÷ 05 = D 3. Calculate. 100% ÷ N = D 100% ÷ 20 = .05 Her building will depreciate at a rate of 5% per year.

Another example for calculating straight-line depreciation is as follows: Henry has a rental house with an estimated useful life of 35 years. What annual rate will the house depreciate, using straight-line depreciation? 1. Use formula. 100% ÷ Number of Years = Annual Rate of Depreciation 100% ÷ N = D 2. Write the formula and replace the letters with known numbers. 100% ÷ N = D 100% ÷ 35 = D 3. Calculate. 100% ÷ N = D 100% ÷ 35 = D, the formula which equals .02857, which could be rounded up to 3% annual Rate of depreciation. Henry’s house will depreciate at annual rate of .02857 or rounded up to 3%. So let’s take this a step further with another example: Steve’s office building has an estimated economic life of 20 years. To find out how much will it have depreciated after 4 years, Steve must: 1. Use the formula. 100% ÷ Number of Years = Annual Rate of Depreciation 100% ÷ N = D 2. Write the formula and replace with known numbers. 100% ÷ N = D 100% ÷ 20 = D 3. Calculate. 100% ÷ N = D 100% ÷ 20 =.05 Then to calculate the amount for 4 years: .05 x 4 years = .20 or 20% total loss from depreciation.

Straight line Appreciation The formula for appreciation is the same, except that the annual rate is added to, rather than subtracted from, 100% of the property value. The formula looks like this: Number of Years ÷ Annual Rate of Appreciation, or 100% ÷ N = A The formula can be turned around to fit the question in the following manner: 100% ÷ N = A N x A = 100% 100% ÷ A = N 6 ÷ 2 = 3 2 x 3 = 6 6 ÷ 3 = 2 Here’s an example of the how the straight line appreciation formula works: Rob’s triplex has appreciated by 7.5 % of its original value each year for the last 8 years. Rob wants to know how much appreciation has occurred. 1. Use the formula. Number of Years x Annual Rate of Appreciation Total % N x A = T % 8 x .075 = T % 2. Write the formula and replace with known numbers. Number of Years x Annual Rate of Appreciation Total % N x A = T % 8 x .075 = T % 3. Calculate. Number of Years x Annual Rate of Appreciation Total % N x A = T % 8 x .075 = .60 OR 60% Rob’s total appreciation equals 60%.

Amortization Formula Amortized loans are repaid with payments that include both principle and interest. In the beginning, the payments are nearly all interest and very little is applied to the principle. This is because interest is always deducted first, and then interest is only charged on the remaining principle balance. Every monthly payment will reduce the loan balance, so that less and less is applied to interest while more and more is applied to principle, until the entire loan is completely paid off.

The following is an example with an explanation of how amortization works: Caitlin takes out a loan for $110,000 at 12 ½ %, which will be amortized over 30 years. Her first monthly payment is $1,173.98 with interest of $1,145.83 being applied to the interest. $1,173.98 total payment $1,145.83 interest payment $ 28.15 You can see that $28.15 of her first payment was applied to the principle of Caitlin’s loan balance. Her loan was for $110,000.00. So now deduct $ 28.l5 principle payment from the balance. $110,000.00 original loan - $28.15 paid to principle $109,971.85 new balance Interest for the 2nd payment will be calculated on the new balance of $109,971.85. The formula for calculating the principle and interest amounts of each payment is complex. However, there are two easy methods to find the amounts. The first and most practical way is to use a calculator to figure payments, interest, and principle amounts. The second best method is to use an amortization book. Agents can get these small booklets from lenders and title company representatives. To calculate a loan balance after a specific number of payments, you need to know the loan balance, the annual interest rate, and the combined principle and interest payment. The amortization process, if done without a calculator or booklet, is tedious and complex. We will describe the formula for amortization for questions that ask for loan balances up to the third year. Amortization Formula Each part of the amortization formula will be explained in four steps. You can see how they are done in the following example: Louis borrowed $92,500 at 9% interest amortized over 30 years with principle and interest payments of $744.28. After making just three payments, he was transferred and had to sell the home. What was his loan balance after three payments? Formula to calculate the first month’s principle balance: 1. Calculate the interest for the initial loan amount PV x I% = AI $92,500 is the original loan or principle value or PV Multiply by the annual interest rate, or 1% $92,500 x.09 = $8,325.00 annual interest or AI 2. Determine the monthly interest using: AI ÷ N of months = MI $8,325.00 ÷ 12 = $693.75 MI 3. Then, deduct the monthly interest from the combined monthly principle and interest payment. $744.28 principle and interest payment - $693.75 interest part of the first monthly payment $ 50.53 applied to principle 4. Next, subtract the first principle payment from the original loan. $92,500.00 original loan - $ 50.53 first payment on the principle $92,449.47 balance of principle after the first payment The interest part of the second payment is based on the declined principle balance. Remember that the principle balance was reduced by $50.53, making the new principle balance $92,449.47. This means that interest for the second payment is calculated on the basis of the new principle balance. There will be a declining principle balance each month, so it is necessary to calculate the interest part of the payment on the new principle balance each month.

Formula to Calculate the Second Month’s Principle Balance: 1. Calculate the interest for the balance after the first payment. $92,449.47 loan balance after first payment x .09 = $8,320.45 annual interest 2. Calculate the monthly interest by dividing the annual interest by 12 months. $8,320.45 ÷ 12 months = $693.37 monthly interest 3. Next, deduct the monthly interest from monthly principle and interest payment $744.28 principle and interest payment - $693.37 interest part of second payment $ 50.91 of the second payment applied to principle 4. Then, subtract the amount of the second payment that was applied to the principle balance after the first payment. $92,449.47 was the principle balance after first payment. Then, $50.91 was applied to that balance. $92,449.47 balance after first payment - $50.91 amount applied to principle from the second payment $92,398.56 new principle balance to use for the calculation of the next interest payment

Formula to Calculate the Third Month’s Principle Balance: 1. Calculate the interest for the balance after the second payment. $92,398.56 loan balance after second payment x .09 = $8,315.87 annual interest 2. Calculate the monthly interest by dividing the annual interest by 12 months. $ 8,315.87 ÷ 12 months = $692.99 monthly interest 3. Next, deduct the monthly interest from monthly principle and interest payment. $744.28 principle and interest payment - $692.99 interest part of the third payment $ 51.29 of the third payment applied to principle 4. Subtract the third payment applied to the principle balance after the second payment. $92,398.56 principle balance after second payment $51.29 of third payment applied to that balance. $92,365.51 balance after second payment - $51.29 amount applied to principle from the third payment $92,347.27 new principle balance to use for the calculation of the next interest payment This four-step process can be repeated as many times as necessary to answer an amortization question. The example above asked for the loan balance after the third payment, so to find the balance after six months, you would need to repeat the process three more times. So taking this a step further, we use the following example: Louis wants to know how much interest he will pay on this loan if it runs the entire 30 years. Louis must: Use the formula to determine Total Interest Paid. Monthly Payment x Number of Months of the loan = Total Principle and Interest, minus the Principle Balance = I paid. MP x N = PI - PB = Interest paid $744.28 x 360 = $267,940.80 P and I minus $92,500.00 = Principle Balance = $175,440.80 $175,440.80 is the Total amount of Interest Louis will pay over 30 years!

Review The following formulas are the more important ones to be knowledgeable of. The formula for calculating interest: Principle loan (part) x percentage of interest (rate) x duration of the loan (time) = interest Or more simply, PART x RATE x TIME = INTEREST Loan-to-Value Ratio: % x Value = Loan Loan Fee formula: % x Loan = Fee The Value before and Value after formula: % x Value before + 100% of VB = Value After, or more simply % x VB + 100% of VB = VA

The formula for determining the cap rate: % Rate x Value = Income or % R x V = I The pro-ration formula is: Rate per day x Number (of days) = Share

Straight Line Depreciation Formula: 100% ÷ Number of Years = Annual Rate of Depreciation, or put more simply 100% ÷ N = D Straight line Appreciation Formula: Number of Years ÷ Annual Rate of Appreciation, or put more simply 100% ÷ N = A The remainder of the review focuses on the different calculations involved with the Amortization Formula. To calculate the first month’s principle balance: PV x I% = AI Determine the monthly interest using: AI ÷ N of months = MI Deduct the monthly interest from the combined monthly principle and interest payment. Subtract the first principle payment from the original loan.

Formula to Calculate the Second Month’s Principle Balance: 1. Calculate the interest for the balance after the first payment. 2. Calculate the monthly interest by dividing the annual interest by 12 months. 3. Next, deduct the monthly interest from monthly principle and interest payment 4. Then, subtract the amount of the second payment that was applied to the principle balance after the first payment.

Formula to Calculate the Third Month’s Principle Balance: 1. Calculate the interest for the balance after the second payment. 2. Calculate the monthly interest by dividing the annual interest by 12 months. 3. Next, deduct the monthly interest from monthly principle and interest payment. 4. Subtract the third payment applied to the principle balance after the second payment.

To calculate how much interest will be paid if the loan runs the full 30 years: Monthly Payment x Number of Months of the loan = Total Principle and Interest, minus the Principle Balance = Total Interest paid, or putting it more simply, the formula would look like this, MP x N = PI - PB = Interest paid.

Chapter 9 Property Evaluation and Appraisal

Glossary Arm's length transaction A full disclosure of property condition including advantages and disadvantages, without duress, within a reasonable marketing time. Capitalization rate The rate of return on the investment in the property Cost approach Method used to estimate the replacement cost of the building minus depreciation, plus the value of the site Depreciation Decrease in value of the property over time, or from any cause Deferred maintenance Deterioration, lack of maintenance, repairs and upkeep Effective gross income The potential gross income minus debt and/or vacancy factor External or economic obsolescence Depreciation caused by factors surrounding the property that could influence value. Noise, environmental issues, nuisance, decline, etc Functional obsolescence Inadequate or obsolete design or use, such as a four bedroom house with one bathroom in an area of two bath homes, or poor floor plan in an office building The use of the property that provides the greatest profit over a period of time Income approach An appraisal method to determine value by dividing net income by a capitalization rate- commonly used in appraising income property Market value The probable selling price of a property in a competitive market under normal conditions, without unusual circumstances

Net income The effective gross income minus operating expenses Principle of change Ongoing changes such as deterioration, disintegration or rejuvenation, caused by internal and external factors that affect the property Principle of substitution A buyer will not pay more for a property than they could pay for an equally acceptable substitute Sales comparison approach Comparison of the subject property to similar properties that have recently sold in the same or similar area

Introduction Real estate sales are dependent on the value placed on the property. The most reliable and systematic estimation of a property’s value is the process. An appraisal is an educated opinion and explanation of its value based on many different factors and approaches. The estimated value results are for a specific purpose and valid as of a specific date. The appraisal could be for the present value of the property, or an estimate of what is was worth, or will be worth as of another date. Property has many different types of values. The appraiser’s job is to determine the purpose and actual value of the property, without “emotional” influences such as needs and desires or the seller’s memories. When a buyer applies for a loan, the lender usually requires an appraisal. The lender uses the appraisal to determine if the property is worth enough to provide sufficient security for the loan amount. The lender wants to know if the purchaser can afford the loan, but they also want to know if the property is worth enough to secure the loan if the buyer defaults. The estimated opinion of value can be different depending on the purpose or objective. The purpose of the loan can be for an evaluation to determine tax assessments, rent, exchanges, condemnation, insurance, probate, bankruptcies, etc. An appraiser can also help to establish a reasonable list price. The person who hires the appraiser is the client, and the appraiser is the agent of the client. This creates an agency relationship between the appraiser and client and all agency laws apply.

Licensing of Appraisers

The Uniform Standards of Professional Appraisal Practice allows only state licensed or certified appraisers to prepare appraisals used in "federally related" loan transactions.

FIRREA, or Financial Institutions Reform, Recovery and Enforcement Act, is the Federal law that requires that appraisals used in federally-related transactions meet standards set by the Appraisal Foundation and must be performed by a person who is licensed or certified by the state.

The majority of real estate loans are federally related, including loans made by federally regulated or insured banks, or savings and loan associations. Transactions for $250,000 or less are exempt from this requirement. Washington State does not require a person to be licensed or certified to make appraisals. However, the person must be licensed or certified to be called a "licensed" or "certified" appraiser. To qualify for licensing or certification, the appraiser must satisfy the requirements set by state law under the guidelines adopted by the Appraisal Foundation. State-licensed real estate appraisers may appraise: • Non-complex 1- 4 family residential units valued under $1,000,000 • Complex 1-4 family residential units valued less than $250,000 • Non-residential property valued less than $250,000 • State-certified real estate appraisers may appraise • All residential property 1-4 units regardless of value or complexity • Non-residential property valued less than $250,000 • State-certified general real estate appraisers • May appraise all types of real property regardless of value

Professional Conduct The person who hires the professional appraiser is referred to as the “client”. This means that the laws of agency apply to the appraisers just as they do to agents and brokers. Like Realtors, professional appraisers have and abide by a strict code of ethics and conduct. Professional appraisers: • DO NOT charge appraisal fees based on appraised value. • Usually charge a flat fee for residential appraisals. More complex appraisals are sometimes based on time, effort, expense and degree of difficulty. • DO NOT accept referral or finder fees, percentages of real estate commissions, or ANY type of rebate as an inducement to give a predetermined value. • DO NOT pay referral or finder fees for their business. Professional appraisers • DO NOT appraise property they own or have a personal interest in. • DO NOT appraise types of property that they are not trained for, without first disclosing this fact to the client. • If accepted, appraiser usually requests the assistance of a qualified appraiser. Professional appraisers: • Will not falsely claim membership in an appraisal group affiliation or profess professional qualifications if non-existent; or affix professional appraisal designations, such as M.A.I. or S.R.A., to credentials if designations have not been granted.

Competitive Market Analysis (CMA)

An appraisal is usually ordered after the actual sale of the property, but a real estate agent's expert advice is valuable and important to sellers to determine a realistic listing price.

C.M.A., Competitive Market Analysis is an estimate of value of a property to determine a fair listing price. It is the real estate agent’s opinion of value. The analysis includes recent sales of similar properties as well as properties that are currently available for sale. It will also show listings of properties that were recently exposed to the market but failed to sell. The CMA should show how many days the property was marketed before it sold or was taken off the market. This gives sellers a good overall picture of what buyers are willing to pay, as well as letting the seller see the competition and the results of overpricing. Overpricing a property usually results in it not selling at all, or only after lowering the price below the market. Under-pricing property can result in the loss of hundreds, or thousands of dollars. A real estate agent can also help sellers maximize their profit by offering advice on many easy, inexpensive improvements or repairs that can increase a property's value. C.M.A.’s are most commonly used in the evaluation of residential property for the purpose of marketing. The C.M.A. is not designed to be as comprehensive or technical as an appraisal, BUT they are similar to an appraiser’s market data approach. The real estate agent’s use of a well-prepared C.M.A can also provide valuable assistance in relocation. For instance, if a person is transferred to an unfamiliar city many miles away, the agent can provide a list of recently sold homes as well as available homes, to help the transferee become more familiar with the area’s values. The agent can also include valuable information on schools, employment, attractions, shopping centers, fire and police protection, transportation and economy.

Uses of Real Property Real property has many different types of uses and values. Owner occupied, residential property can be valued subjectively, or “emotional valuation”, or objectively, by using the “market approach” appraisal. Rental homes, apartment buildings and commercial buildings and land that are used for income are usually appraised using an “income approach” or “gross multiplier” method of appraisal. Real property is also used for speculation, investment and other special purposes. These properties are sometimes difficult to appraise using a market or income approach. When there is no recent market history or income, it is obvious that the market approach or income approach cannot be used. The method used in these cases would be the “cost” or “replacement” approach. There are many different reasons to appraise property and each has its own purpose. The purpose of the appraisal can influence the appraiser to use a certain approach. Each approach measures value differently so each evaluation of the same property can be different. Appraisals are usually ordered to determine: Market Value - What a typical buyer would pay in cash to purchase the property, used when a person is buying or selling a property. Financing-Loan-Credit Value - For loan commitment purposes. Important if the lender is forced to repossess and sell the property in case of default. Damage and Insurance Value - Cost to replace the property in case of a casualty loss, usually done prior to writing or renewing a casualty policy.

Inheritance and Estate Tax Value - For IRS, inheritance, and tax calculation purposes. Condemnation Value / Value - "Fair and just compensation" where the government is buying property from an unwilling seller. Ad Valorem Tax Value - Real estate property tax calculation purposes. Liquidation Value - The value of assets if sold under a forced sale or auction. Investment Decisions - And other situations that require an informed decision of real estate value - market potential of a proposed project, rent or lease schedules, real estate investment analysis, etc.

Market Price / Cost / Market Value Market price is the price a person paid for the property whatever the circumstances. It is a price based on the relationship between the property and the potential purchaser’s value of it’s “worth”. A property may be “worth” much more to one person than another if that person has a specific “use” for that piece of property. This often applies where the property will be used for income. Cost is the price to replace the property and all improvements without considering supply, demand, use or transferability. It is the cost the buyer paid even if it is over-improved! When there are no comparable sales the appraiser estimates the value by using the cost of reproducing the property just as it is today. Market value is what a seller could expect to be paid if a property is sold under an “arm's length transaction”, meaning that all required conditions to a fair sale have been met. The market value is the estimated selling price of a specific property, for a specific reason, at a specific time and is usually used in residential property appraisals. The buyer applies for a loan and the lender wants to be sure the home is worth an amount to secure the loan. Value is a term that has many meanings. We will use two general classifications. 1. Market Value – objective value of a property based on data 2. Value in Use - subjective, or emotional value of the potential buyer or seller of the property Market Value Market value is also known as exchange value and is a more reliable type of value. The Uniform Standards of Professional Appraisal Practice’s definition of market value is: “The most likely price that a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimuli.” Here’s an example of the market value concept:

Guy bought a home in a high demand market 3 years ago, for $160,000. His promotion will require a job transfer out of town. After comparing similar homes in the same area, Guy could see that the market had changed and homes like Guy’s that sold in the last 6 months averaged $155,000. Similar homes, in the same area were being offered for sale at list prices between $150,000 and $157,000. Even though Guy paid more for his home, the comparison of like features and condition showed the “market value” of approximately $155,000. Value of Use When a buyer has a specific use for a property, that use may influence how much the prospective purchaser would pay for the property .The “use” may not influence another buyer’s value. The following example illustrates the value of use: The Nielsens, who are computer consultants and antique car collectors, built a home with a large office and a 10-car shop. They designed it with a very small living room and only two bedrooms. This home works perfectly for the Nielsens, so the “use value” is more to these owners than to a prospective buyer. Potential buyers will likely expect more living area and bedrooms for the same price. The Principle of Substitution When two properties are similar, the lower priced property will be in greater demand. A buyer will NOT pay more than the lowest price property that is equally desirable as a substitute, if the terms and conditions of the purchase are about the same. An example of the principle of substitution would look like this: Kevin finds a house that he likes in an area that he wants. It is listed at $125,000. The same day he sees two other homes within a few blocks of the first home, with the same number of bedrooms, baths, and square feet and with very similar amenities. They are listed at $117,500. Kevin will buy one of the second homes. Principle of Anticipation The anticipation and/or expectation of a future benefit can create value which is also important to appraisers. This means that the informed expectations and anticipations of buyers and sellers can have an effect on the value of property in the future. Property values usually tend to increase, but a decline in value can also occur due to deterioration, environmental issues, or other factors. The following would be an example of the principle of attraction: Kip learns that a shopping mall is going in across from his . His property will probably increase in value because of the added exposure. The Principle of Conformity The conformity of the size, age, and quality of the homes in a neighborhood are taken into consideration in the estimate. The value of a property will increase if there is a certain amount of conformity without being monotonous. Areas that have no conformity of style, appearance or use can decrease the value of the home.

The following is an example of the principle of conformity: The Jeffersons spend the day looking at homes. They drive by a lovely home that appeals to them. As they drive on, they can see that the homes in the area are all different types and ages. Some are very high quality and others are unkempt and small. They drive to another area and purchase a home where all of the homes are similar to the one they chose. The Principle of Regression Regression is the lowering of value of a superior property because it is located in area of lower valued homes. The lower valued homes in the area have a regressive effect on the superior property. If there are several high quality homes in an area, and then later, several lower quality homes are built nearby, the lower quality homes will have a regressive effect on the value of the higher quality homes in the surrounding neighborhood. The following is an example of the principle of regression: Gregg builds seven homes and sells five of them for $300,000 - $500,000. A couple of months later someone else builds 12 homes in the same area in the $89,000 - $95,000 range. The lower priced homes will lower the value of the more expensive homes and Gregg may have to sell the last two at a reduced price. The Principle of Progression Progression is the increase in value of an inferior property, because it is in an area of superior properties. The superior quality homes cause a progressive effect on the value of the lower quality properties. It is better to buy the “worst home” in the best neighborhood, rather than the best home in the worst neighborhood. You can change the home to make it more valuable, but you cannot change the location! For example: Larry has a poorly maintained 700 square foot home in a neighborhood of 2,400 square foot well maintained homes. His home lowers the value of the surrounding homes. However, his small home is worth more in this neighborhood than if it were in a neighborhood of other small homes. Principle of Contribution Contribution is the value an improvement may add to the property. Some improvements increase the property’s value more than the cost of the improvement and some of the improvements cost more than they will contribute to properties value. Redecorating the living room will not usually increase value of the home enough to cover the cost. However, the addition of a second bathroom or updating the kitchen could increase the home's value by much more than the cost of the improvement. Here’s a good example to illustrate this: Martha has a lovely home on the park, but it had a dated, obsolete kitchen. The house was valued at $225,000 with the outdated kitchen. Martha has the entire kitchen remodeled and updated at a cost of $17,000. However, once the kitchen was completed, the house appraised at $265,000. Principle of Competition Competition is the financial impact that other businesses have on the value of income producing properties. Businesses that are making a profit tend to encourage competition, but excessive profits can also create excessive competition and eventually destroy profit. Here’s an example to demonstrate this point: A retail business in a community becomes extremely profitable. The success is obvious and this attracts a similar competing business into the area. The competition will probably cause lower profits for the first business because of the new business’ share of the same market. The first property’s value decreases as profits decrease. Principle of Change Principle of change is the theory that values can increase or decrease depending on changes that constantly affect value through a four-phase life cycle. • Integration • Equilibrium • Disintegration • Rejuvenation • Integration is a first phase of the property development. • Equilibrium is the stability (no or very few changes). • Disintegration is the decline of the property. • Rejuvenation or revitalization is the renewal, or restoration to the property’s highest and best use. The physical life of a property is measured in years and the economic life cycle is measured in profitability. The appraiser will estimate the remaining time period that the property can produce income greater than ground rent. Market, Supply and Demand The principle of supply and demand for real estate has the most dramatic affect on the value of a specific piece of property. Appraisers and agents use these principles of value, as important factors in the valuation process. 1. Increasing supply or decreasing demand = buyer’s market and decreased value 2. Increasing demand or decreasing supply = seller’s market and increases value 3. Demand is the desire accompanied by ability = buying power 4. Desire created by advertising, marketing and education = awareness The following example illustrated the concept of high demand: A community builds a new school that is technically advanced and offers students more advantages than other community schools. An investor develops a subdivision near the school with affordable 3 and 4 bedroom homes. The homes are marketed, using high profile advertising describing the benefits of the school. These homes become high in demand, however, there is only 50 homes built, causing a low supply. As the supply decreases, the builder is able to offer the decreasing number of homes at an increased price.

The following example illustrates the concept of supply: After selling nearly 50 homes he adds 75 new homes. BUT the public responds to demand for better schools by updating technology and benefits of an existing nearby school. Seventy homes are for sale near the newly updated school, BUT they are priced 18 - 20% lower than the new homes. The existing homes are 7 - 8 years old, BUT they have mature landscaping and more square feet. The existing homes are advertised and the public is informed of the improved school. The demand decreases for the new homes and the prices begin to come down. HOWEVER, the existing homes have now increased in demand and these prices will rise. The following is a list of the more common supply factors that you should familiarize yourself with: • Construction costs • Available new construction • Price and availability of land • Available existing homes • Owner / tenant ratio • Vacancy rates • Building- zoning -environmental issues • Ecology issues • Tax structure and assessments

In addition to the previous list of supply factors, you should also be familiar with these demand factors: • Social standards/customs • Population density • Geography • Transportation • Employment • Retirement/ disposable income • Interest rates • Education, hospitals, fire and police

The following four factors are what are primarily responsible for creating value: • Use • Supply • Demand • Transferability Because so many factors affect property values, the value of the property can change. A home may be worth MORE OR LESS today than it sold for last year and can change many times over time. Appraisals are estimates of value for a specific point in time. It could be the date of the appraisal in the past or future. This date is the effective date of the appraisal. Highest and Best Use The Highest and Best Use of a property is the most profitable use. It is the use that will produce the greatest net return over a certain period of time. The maximum value of property is achieved when it used for the highest profitable net return or income. Return also means amenities, such as a view, waterfront, educational or recreational features that increase desirability. Deed restrictions, zoning ordinances and other possible or feasible uses may also affect highest and best use. “Use density” is the relationship between the supply and demand for property that has a particular use. The ideal density of use is reached when the supply of land is equal to the demand for that use. “Consistent use” must be used in evaluation if the property is changing to another classification of use. The appraiser cannot value the land on basis of one use plus the proposed improvements of another use. There can be only one use.

Here is an example to illustrate this point: A coastline area quickly becomes a tourist attraction. New hotels are built as the demand increases. An investor buys an old grocery store in this area. When the store was originally built for the small town, the highest and best use to yield the highest net return was a retail food store. With change being constant, the most likely highest and best use for this property may now be for a hotel. The appraiser must evaluate the land for the use of building the hotel. If the highest and best use was still the grocery store, the appraiser would evaluate the land and the improvements as a grocery store. Since the store would have to be destroyed to build the hotel, the improvement (the store building) would not be added to the value. It would be deducted from the land value (now evaluated as highest and best as a hotel site), as a cost to demolish and remove to build the hotel. The Concepts of an Appraisal The Federal Housing Administration’s explanation of market value is, "The price which typical buyers would be warranted in paying for the property for long-term use or investment, if they were well informed, acted intelligently, voluntarily, and without necessity." The steps in the Appraisal Process are generally thorough, orderly and systematic: 1. Define the purpose - The appraiser must first identify the subject property and define the purpose and intended use of the appraisal as of a specific date. Uses for an appraisal include evaluation to purchase property or refinance, insurance, divorce, or probate and many other purposes. 2. Gather data - The appraiser will obtain data specific to the subject property as well as general area statistics. Specific data includes boundaries, type of construction, amenities, sizes, and other information of the subject property itself. The land and utilities make up the site. The improvements are usually appraised separately from the land. If the land is worth a lot more than the house, or if it is worth quite a bit less, the property would not be at its highest and best use. Rectangular lots are more useful than irregularly shaped or sloped lots for all types of use. Site Data Includes: • Frontage • Width • Area • Depth • Shape

Building Data includes: • Year built • Quality • Condition - good- average – poor • Workmanship • Square footage • Improved living area • Finished living

General Data General Data comes from the area surrounding subject property that could affect its value such as zoning, economy, population density and schools, etc. Economic Trends The appraiser looks for local, regional, national, or international level indicators of the property’s future value. If the area is growing and prospering, the trend would likely be an increase in property values. Decline could cause a trend of decreasing property values. Neighborhood Analysis For the purpose of appraisal, a neighborhood is defined as a group of similar property types. Properties can be grouped by physical boundaries, age, or by economic levels or they can be grouped by the type of use, such as residential, commercial, agricultural or industrial. The values of the surrounding properties will affect the value of the subject property. 3. Verify Data All data must be verified and documented with photos, records and other support. Appraisers often call the agents involved in recent sales of comparable properties for their opinions and other information. 4. Apply the Three Approaches The most commonly used methods are the sales comparison approach, the cost approach, and the income approach. When possible, the appraiser will use all three approaches and reconcile the results to arrive at opinion of value. In some situations it may be better to use only the method that seems most practical. The appraiser may determine how many methods to use. There are properties where a method cannot be used, such as vacant land that cannot be appraised by the cost approach. The sales comparison would be better, or if it were producing a crop, the income approach might be used. A property such as a fire station must be appraised by the cost method. It cannot be appraised by the income method, because it generates no income, and there can be no sales comparison because no market exists for it. 5. Reconciliation and Final Report The appraiser will consider the purpose, type and use of the property, as well as the reliability of the data gathered. The most appropriate and reliable approach to estimate the property for the specific purpose of the appraisal will be given the most weight.

The Market Data Approach The market data approach or sales comparison approach is the most widely used approach in the evaluation of residential property. It is also used whenever possible in the appraisal of other types of real estate. Recent sale prices of comparables are good indicators of what informed buyers will pay and what sellers have accepted. The value is estimated by comparing the subject property with actual properties that have recently sold. These properties are called “comparable sales” or “comps”. The appraiser gathers information about comparable sales and compares them with the subject property. The “subject property” is the property being appraised. Adjustments are made for the differences in the features and amenities found in the subject property compared to the features and amenities of the comparable properties. The adjustment in price is always made to the comparable properties and never to the subject property. The appraiser makes adjustments to compensate for the differences and then translates this data into an estimate of the market. The appraiser must use a high degree of skill, knowledge and judgment in adjusting the values of comparable properties. The appraiser will use the data from three or more comparable sales to evaluate a residential property. When adequate data on closely comparable properties is available, the market approach gives great reliance in evaluating residential properties. Inspect the property The appraiser thoroughly inspects the interior and exterior of the subject property. Measurements, sizes, quality, quantity and condition of the improvements and the land are used as the basis for comparing the subject property to the comparable properties. Find valid comparables The appraiser will search for three or more comparable properties that have recently sold. Sometimes there will not have been comparable recent sales, so the appraiser may have to use older data. If all available data is old, the appraiser will include an explanation in the appraisal that the age could affect the evaluation. Sometimes there will be no recent sales at all that are comparable sales. This usually happens when appraising a custom built home or an unusual property, such an historical mansion, or a lighthouse. When no comparables are available the market approach cannot be used. Appraisers get their information on recent sales from the MLS, recorders office, title companies, courthouse files, land from contacting local real estate brokers and agents. The appraiser usually makes a visual inspection of each comparable. These comparable properties must be from the same or similar area as the subject. Detailed information describing physical characteristics, sold price, concessions made by the seller or buyer, terms, type of financing, and any conditions that could have influenced the sale must be considered. Adjust the comparables The appraiser will then analyze the data and use typical adjustment factors for each difference in the comparable properties to the subject property. It is also crucial that the appraiser uses very similar properties and properly adjusts by increasing or decreasing the comparable properties according to the property’s features and amenities. Adjustments can never be made to the subject property. The next step is to determine the value and prepare the written report. This form is the “appraisal”. The adjusted comparable values are shown and compared to the subject. This report shows the appraised value of the property as of a certain date and for a certain purpose.

The Cost Approach The replacement cost approach is the method of evaluating vacant land alone. Next, the cost of all materials and labor are estimated to reproduce the building and all improvements exactly as the property exists at the time of the appraisal. Subtract the depreciation of the building and improvements. Then total the depreciated building, improvements and the land. This method could be used in high demand areas where there is an inadequate supply of new homes, or where there are few or no available building lots. The replacement approach is based on the assumption that a new building is worth more than an existing building, and that the price to replace the property would be in the upper ranges. However, there are many cases where the older buildings would have a higher value than a newly constructed building. This could occur in an area of historical buildings.

Replacement and Reproduction Replacement cost and Reproduction cost are not the same. Replacement value is the estimate of the current cost to build another building, with the same amenities, size and with the same use. Reproduction value is the estimated cost of building a replica. This means building an exact duplicate of the subject building, just the way it was originally constructed, at the current price of the labor and using the same materials. Sometimes reproduction and replacement can be the same. This is often true when the subject property is new construction. Reproduction cost is often used when the subject has “historical” or “cultural value” or is an older structure. The ornate workmanship as well as materials used in earlier days, are often much more expensive than used today, but to “reproduce” the structure, these important factors must be considered. The cost to reproduce a structure can be prohibitive, and usually does not reflect the current market value. Inspect the subject property. An on-site inspection must be made of the buildings and all improvements. The measurements, sizes, as well as quality and condition will be the basis for calculating an accurate replacement cost and the accrued depreciation. Value the Land An appraisal of the land itself is completed. This can often be done by the comparison method. Estimate Replacement Cost Building & Improvements The three methods used to estimate the replacement costs of the buildings and improvements are: • Square Foot

• Quantity Survey

• Unit-In-Place

Square Foot This is the easiest way to estimate replacement. The appraiser measures the square feet of each floor from the outside. The appraiser then determines the average cost per square foot of recently built new construction of similar type homes.

Then the appraiser multiplies the averaged cost per square foot times the number of square feet in the subject property. When there are no recent sales the appraiser will use the cost of materials and labor. Formula: Square feet of the subject property x average cost per square foot of similar homes (minus the land value) = estimated cost of replacing improvements Quantity Survey This method involves very detailed estimations of the quantity and price of specific materials as well as the cost of labor for each type of job. All costs to complete the job including surveys, building permit, environmental impact statements, and other related costs are added in. This is a highly accurate method but is costly and time consuming. Unit-in-Place This method uses the cost to replace specific components, such as electrical, plumbing, roof, siding, insulation and foundation. The appraiser totals all estimates to figure replacement cost of the building. Formula: Cost of roofing number per square feet + cost of concrete per cubic yard + cost of framing per square foot, etc. = replacement Identify and Deduct Accrued Depreciation Once the appraiser estimates the replacement cost of the building as though it was new, the appraiser must subtract for depreciation. Depreciation is the decrease of value. The appraisal of property assumes that a new property is worth more than a used property, because of depreciation or decrease in value because of: • Deferred Maintenance • Functional Obsolescence • External Obsolescence Deferred maintenance, or physical deterioration, wear and tear can be: Curable if cost of correction can be recovered in sales price Incurable if impossible or too expensive to correct Example • Worn roof, cracks in foundation • Need of paint • Worn carpet Functional Obsolescence , or adequacy for use, age, poor floor plan, or outdated can be: • Curable if cost of correction can be recovered in sales price • Incurable if impossible or too expensive to correct • Four-bedroom house with one bath, in area of two bath homes • Outdated kitchen External obsolescence refers to the decline of the area. These are conditions outside the control of the owner and are considered incurable because it is caused by external factors. • Noise • Traffic • Decline • Zoning changes OR • Safety hazards Estimating depreciation is a difficult part of the replacement cost appraisal that requires a great deal of skill and experience on the part of the appraiser. Add Land Value & Compute The value of the land is then added to the depreciated value of the structure and improvements. The land can be estimated by comparing recent sales of similar lots to the subject lot, which is the market approach. The appraiser totals the land value with the depreciated improvement value and prepares a final report of the subject property value as of a certain date.

Over-improvement These are improvements made by the owner with the intent to add not only pleasure or desirability, but also value. An example could be a basketball court that the owner installed in the back yard, and enjoyed. The owner probably thought that it would also add value. However, it could be that the new owner didn’t like sports of any type, and now has to remove the court to put in grass. This improvement may have actually reduced rather than increased the property value.

Straight-line Depreciation Straight-line depreciation is commonly used for income tax purposes and is a way of measuring loss in value in yearly increments that is caused by age. The thought is that as the building ages, it becomes worth less money. Formula: Replacement Cost ÷ Remaining years of Useful Life = Annual Increment After the number of years of “useful life” is over, the cost has been completely depreciated.

Accrued Depreciation

This is the difference in value between the current price of an item and the depreciated value of the item as of a certain date. This means that if an apartment building is valued at $300,000 today, and it is compared to a four year old apartment building, the four year old apartment building would have used up a percentage of its useful life and that difference would be the amount of accrued depreciation. • Physical life is the length of time the improvements will remain standing • Depreciation life is the length of time the IRS allows the investor to depreciate the property. • Economic life is the length of time the improvements will produce an income in excess of possible rent as vacant land. • Loan life is the length of time an investor use the property to security the loan.

The Income Approach

The Income Approach is much more complex than the others and should be used only by experienced real estate appraisers. The income approach bases the property value on the income that it produces. When using the income method, the appraiser determines the rent or income the property is currently earning. If the property is not currently rented the appraiser estimates what the rent should be based on the market, if it had no vacancies and all rent was collected. However, when appraising or buying rental properties, a percentage of vacancies and non- payments of rent must be expected. This is called the “vacancy factor”. It is a percentage that is deducted from the potential gross income to arrive at a more realistic income estimate. This estimated income is called the “effective gross income”. Once effective gross income is established, the appraiser will deduct the expenses to operate the building. These are the operating expenses, which fall into three categories: • Fixed - property taxes, insurance, etc. • Maintenance - repairs, utilities, services, supplies, cleaning, employee wages, etc. • Reserve - amounts set aside for replacement of systems, major repairs or replacements, etc. Personal income tax, reserves for depreciation, and mortgage payments are not considered operating expenses for appraisal purposes. After these operating expenses are deducted from effective gross income, the remainder is called “net income”. The net income will then be converted into a capitalization rate, or “cap rate”, to determine the property's value. The capitalization rate is the desired percentage of return on the purchaser’s investment. Formula: Annual Net Income divided by the (desired) Capitalization Rate = Value Residential property is not considered “income property”, so a residential appraiser might use the method if the residential property is being used as a rental. The appraiser calculates a multiplier for the subject property, by determining the relationship between the rents and the rent paid for similar properties in the same or similar area. Example Let’s say that a property recently sold for $100,000. It rents for $850 per month. Divide $850 by $100,000 = .01. Since this rental income was computed on a monthly rather than annual basis, the result is expressed as a monthly gross rent multiplier or MGRM. The MGRM is 0 .01 for this property.

Or if the same property sold for $100,000 and the rent is $850 per month, or $10,200 per year, the annual gross rent multiplier or AGRM, would be 0.10. The rent is multiplied by the gross rent multiplier to estimate its value as an income- producing property. The gross multiplier method is based on gross income figures so it doesn’t consider vacancies or the amount of operating expenses. Properties that rent for the same amount would be considered to be worth the same amount. Because operating expenses and vacancy factors can be very different, the gross rent multiplier can be an unreliable method to use. Example Marie rented a home four years ago for $500 a month. Market rents have increased over the past four years, and the property could now rent for $900 a month. If the appraiser uses the $500 rent to calculate the gross rent multiplier method, it would not be an accurate estimate of value. Reconciliation The GRM is quick but not very reliable method to estimate market value and should be used only as a “rule of thumb” until a more reliable approach is used. GIM, Gross Income Multiplier is much the same, using Income rather than rent. It is also unreliable. The final step in the appraisal process is called the reconciliation. Appraisers generally prefer to use all three appraisal approaches whenever possible as indications of value. The results of the three approaches are called “value indicators”. They only give indications of what the property is worth and will be used to help determine the final estimates. However, because sometimes data is unavailable, or the approach is not applicable, the method may not be included in the evaluation. The estimate of value is based on the most appropriate and reliable approach based on the specific purpose of the appraisal. The final estimate of value is weighed against the other approach values as indicators of value. Ideally, these values are in the same ranges.

The Appraisal Report Form

Residential property appraisals are usually completed on a preprinted form called the URAR, Uniform Residential Appraisal Report. The completed form will include: • The date of the appraisal • A description of the subject property • The purpose of the appraisal • Supporting data • Conditions • The appraised value • Appraiser's signature, certification, license or other credentials

Review

The most reliable and systematic estimation of a property’s value is the real estate appraisal process. An appraisal is an educated opinion of value based on factors that affect the property with the appraiser explanations of the results. When a buyer applies for a loan, the lender usually requires an appraisal. The lender uses the appraisal to determine if the property is worth enough to provide sufficient security for the loan amount. The Uniform Standards of Professional Appraisal Practice allows only state licensed or certified appraisers to prepare appraisals used in "federally related" loan transactions. FIRREA, is the Federal law that requires that appraisals used in federally-related transactions meet standards set by a non-profit organization called the Appraisal Foundation and must be performed by a person who is licensed or certified by state. Washington State does not require a person to be licensed or certified to make appraisals. However, the person must be licensed or certified to be called a "licensed" or "certified" appraiser. Real property has many different types of uses and values. Owner occupied, residential property, is usually valued subjectively “emotional valuation”, or objectively, by using the “market approach” appraisal. Rental homes, apartment buildings and commercial buildings and land that are used for income are usually appraised using an “income approach” or “gross multiplier method” appraisal. There are many different reasons to appraise property and each has its own purpose. The purpose of the appraisal can influence the appraiser to use a certain approach. Market price is the price a person paid for the property. It does not matter whether the parties were informed of the property condition or if there were unusual circumstances (such as a forced sale or the buyer needed that specific piece). Cost is the price to replace the property and all improvements without considering supply, demand, use or transferability. “Cost” is the price of putting together the building and the land with all improvements. Market value is what a seller could expect to be paid if a property is sold under an “arm's length transaction”, which means that all required conditions to a fair sale have been met. The principle of supply and demand for real estate has the most dramatic affect on the value of a particular type of real property, rather than property in general. Because many factors affect value, the value of property can change. A home may be worth more or less today than it sold for last year and this value will change many times over the years. The Highest and Best Use of a property is the most profitable use. It is the use that will produce the greatest net return over a certain period of time. The most commonly used methods are the Sales comparison approach, Cost approach and Income approach. When possible, the appraiser will use all three approaches and reconcile the results of the approaches to arrive at opinion of value. Residential property appraisals are usually completed on a preprinted form called the URAR Uniform Residential Appraisal Report.

Chapter 10 Escrow Process and Title Insurance

Glossary Actual notice Notice by an actual document or a written or verbal fact A complete record of all past property transfers including encumbrances, court proceedings, and liens Closing When the buyers and sellers come together for final accounting and settlement statements Constructive notice Notice is “implied” rather than written or verbal because the person could have easily known or should have known, using reasonable efforts Credit An amount that is due to be paid to the person at closing Debit A charge that must be paid by the person at closing Escrow A neutral third party holding funds and documents in the interests of both parties, to disburse as agreed Escrow agent An escrow agent is a neutral third party who carries out the closing process Escrow instructions Written instructions from the earnest money agreement given to the escrow agent to execute the conditions that must be completed prior to closing Prepaid interest The interest on a new loan that accrues from the date of closing through the last day of the month or until the first regular payment is due Prorate To divide an amount of money and distribute the cost to the seller and buyer proportionately

Recording Filing the deed, satisfaction of liens, and other information for public record in the county recorder’s office Reserve account A reserve of funds set up by the borrower to allow the lender to pay property taxes and insurance premiums for the borrower as they are due Settlement statement A detailed statement of all debits and credits showing the amount the buyer will need to pay to close and the amount that the seller will receive (or have to pay) at closing Title Insurance Owner’s policy protects buyer from unknown title defects, and a mortgagee policy protects the position of the lender Uniform Settlement Statement The closing statement form required by the Real Estate Settlement Procedures Act

Introduction

The Closing Process is the last stage of the transaction, when the escrow agent, or closing attorney, meets with the buyers and sellers, separately or together to close the transaction. Closings are typically done in the: • Escrow agent’s office • Attorney’s office • Broker’s office • Title company or • Other place as specified in the sales agreement Many times the real estate agent or broker will attend as well as loan representatives and, if desired, the seller's or purchaser's attorney. At closing, the buyer and seller will receive a detailed statement of debits and credits so that the buyer will know how much to pay and the seller will know how much he or she will receive. The escrow agent collects the funds and pays out all costs according to the escrow instructions. Then the escrow agent records the deed and other documents, and disburses the proceeds to the seller. A certified escrow agency must be licensed to do business under the Registration Act. To become certified, the owner, partner, or corporate officer must: • Pass exam and pay fee for Certificate from Department of Licensing • Provide a fidelity bond • Provide errors and omission insurance

• Provide commercial credit report-good credit • Provide three character references Certified escrow agents can hire escrow officers as employees. These escrow officers must also pass an exam and become properly licensed. • The Dept. of Financial Institutions licenses and inspects escrow agents under the Escrow Agent Registration Act, Chapter 19.44 RCW oversees the actions of escrow agents, and has the power to revoke the license of any agent or officer guilty of conversion (using trust funds for personal use), or committing dishonest or prohibited acts. It is the responsibility of the escrow agent to keep adequate records of all transactions.

Exceptions to the Registration Act Include • Attorneys • Title insurance companies • Trustees, executors, guardians or other authorized representative • Banks, S&L’s, insurance companies, credit unions, federally approved lenders • Real estate brokers, if the closing is for their own client and they charge no separate fee

Escrow Instructions The escrow instructions tell the closing agent what conditions must be met prior to closing. The closing agent makes sure that inspections, surveys, contingencies and all other conditions of the sales agreement are met by the specified date at the specific place. The parties should chose a closing date that will allow for enough time to complete the title search, appraisal, document preparation and the final accounting. Sometimes there will be a clause “time is of the essence”, that means the closing must be on a specific date. If there is a clause that says closing will be “ON OR BEFORE” a certain date, the closing can be as soon as all conditions are met, but no later that the certain date.

The Examination Procedures The title examiner will begin a title search to determine the condition of the title. This means that past sales and transfer records will be checked for “clouds”, encumbrances, judgments, title defects or other flaws. The examiner checks records at the title plant and the county recorder’s office that could go all of the way back to the original patent. However, most title searches go back only as far as the prior policy that was issued. The examiner will also check for any items recorded under the any of the names that appear in the title search. Plat maps are also checked for easements, such as for street widening, etc. Once the search is completed, the title company will issue a preliminary title report that will disclose the current title status to the buyer. The title policy is then prepared “subject to the exceptions” shown in the report.

The title company has the right to cancel, amend or supplement the policy prior to recording. There is a period of time allowed for the seller to correct any defects that may not be accepted by the buyer. The title company insures the condition of title upon recording, and assumes liability for any errors or omissions in the title policy.

The Purpose of Title Insurance Title insurance policies guarantee to satisfy any covered claims against previously undetected title defects. When undetected defects are discovered, the title company has the choice to either correct the defect or reimburse the insured up to the face amount of the policy. Law does not require title insurance, but it is customary for the seller to pay a one-time premium for an owner's title policy for the buyer. This premium is based on sales price of the property. When taking out a new loan, most lenders require the buyer to pay the one-time premium for a lender's title policy. This is usually written for the amount of the loan to insure a marketable title. The lender or the title insurance company could require the buyer to pay for a survey of the property to determine the exact location of the buildings, easements and boundaries. If both policies are bought at the same time, the lender’s fee is generally less than 30% of cost of the owner's policy premium.

Owner’s Title Policy Owner's Title Policy insures the buyer against undetected defects in the title. Unlike a homeowner's policy that insures the owner in case of damage caused by fire, weather, burglary, etc., it protects the buyer by giving assurance of good title. The policy is in effect until ownership transfers. All title companies have their own cost schedules but it is customary for the seller to pay the fee based on the sale price of the property, for the new owner’s policy at closing.

ALTA OR Lender's Policy The beneficiary of the Owner's Title Policy is the buyer, and the policy does not cover the lender. If the buyer is taking out a new loan, the lender will also want assurance of good title that will benefit the lender. The Lender’s policy is typically paid for by the purchaser and is based on the amount of the loan. When a buyer assumes an existing loan, this eliminates the charge for an ALTA policy. But, because the lender's coverage will decrease as the loan decreases, some escrow agents suggest an additional standard policy at a nominal charge for the benefit of the lender on assumptions. They may also recommend the standard policy coverage for a seller who provides financing of the property, by note and deed of trust or a land contract.

Standard Policies Standard policies provide coverage of matters of record and are subject to some exclusion. Exclusions in the standard policy include coverage for unrecorded documents, defects that the policyholder already has knowledge of, rights of parties in possession and verification of survey.

Extended Coverage A broader policy is the extended coverage policy. This policy covers unrecorded defects and clouds such as unrecorded documents, known defects, and rights of parties in possession. However, survey verification still may not be covered by this expanded policy. It is always a good idea for the buyer to request a survey prior to closing to verify the exact boundaries. Title insurance does not insure against all "pre-existing” conditions.

Realtor Services Title companies are a wonderful source of information to real estate agents. Not only do they provide title insurance, but title companies can furnish valuable information including plat maps, legal descriptions, parcel numbers, records of last date of sale, owner's and taxpayer's names and addresses, lot sizes, year built, and much more. Most title companies work closely with agents and are happy to provide this information. Many can also provide several printouts of comparable properties to assist agents with Comparative Market Analyses, and can also provide mailing labels, lists and assistance in setting up the agents “farms”.

Marketable Title Acts / Guarantees of Title Laws that disallow claims after long periods of time are referred to as Marketable Title Acts. The number of years required for a property to reach marketable title status varies with each state, but is usually between twenty and forty-four years. These laws are based on the assumption that if no claim was made during a long period of time a marketable title should be issued.

The “Chain of Title” A chain of title is a complete record of all recorded documents, such as conveyances, liens and encumbrances that affect the subject property. The chain of title will also show “clouds” on the title, such as claims of heirs, quit claim deeds, and other interests that may restrict the ownership of the property. A “quiet title” suit is a court action where these clouds can be removed or the ownership of the property can be decided. A person, who has a claim, can attempt to “remove” the cloud and keep ownership, or “validate” a pending claim, and take ownership. A buyer’s agent should always recommend that the buyer demand evidence of good title and a title insurance policy. The seller of a property can be held liable if the condition of the title is not good when it was sold. Also, the seller could disappear, or file a bankruptcy. Even though the seller is responsible for the title, it may not always be cost effective to take legal action.

Recording Recording the deed is necessary for the protection of the buyer. The date of a document has no authority over the date of recording. In Washington State, the first recorded deed has precedence over any other deed to the same property. Even though unrecorded deeds are considered valid, the recorded deed would be considered superior to the unrecorded deed. There are numerous cases where closings cannot be completed because of a lack of any evidence of ownership. In many cases the deed was never recorded or there was confusion of identity because of name changes. Example Sarah Campbell buys a home. The deed is recorded under Sarah Campbell. Five years later, Sarah marries Jed Robbins and takes the name Sarah Robbins. She decides to sell her home and move in to her husband’s home. At closing, Sarah signs the deed as Sarah Robbins. This will cause problems as to the identity of the grantor. Sarah should have signed as Sarah Robbins, formerly Sarah Campbell, or Sarah Campbell Robbins, to eliminate any question as to the identity of the grantor. The Recorder's office keeps and records all documents of ownership, liens, or other claims against property. The documents are copied and arranged by date into books. Recording must take place in the county in which the property is located, in order to give constructive notice. All types of deeds or mortgages, leases, and contracts may be recorded. Recording of a deed protects the purchaser from secret interests of others, but it does not validate an invalid deed or conveyance.

Actual and Constructive Notice Actual notice is notice through firsthand observation. It is an “act” that you can see. Let’s say that you called on a home ad and the agent said the house was vacant. You drove by and could see people living in the home. You have been given “actual notice”, that someone might have some type of interest in the home, because you actually saw them. Constructive notice is the notice given by recording an instrument. Let’s say you bought a property using only a quit claim deed. No search of the title was made that could have uncovered information that affects the status of the title. After closing, you discover that there is a lien on the property for back taxes. Whether or not the buyer had a title search, the fact that the information is on file serves as constructive notice to the buyer. The buyer is responsible for the lien. This type of notice is “constructed” and put in a place where a person could have or should have known. Most escrow agents will not disburse the proceeds of the sale to the seller until all documents have been recorded. This recording provides constructive or legal notice to the world of the property’s status. Most states require the acknowledgement of the grantor before recording a document. The acknowledgement is a notarized declaration by the grantor that the document was signed willingly and without duress.

The Tract and Grantor – Grantee Index There are two systems to index recorded documents. These are the: • Tract and • Grantor - Grantee The tract system is considered to be more effective and is less likely to lose a "wild deed” than the grantor-grantee index. The tract index is one page that gives all information concerning one tract of land and is referenced to recorded deeds, mortgages, etc., by the book and page number of the original document.

The grantor index is alphabetically arranged by grantor names on the recorded documents in each calendar year and includes the grantee’s names. A grantee index is also alphabetized according to grantee and gives the name of the grantor and the location and description of the document.

The Uniform Commercial Code This code requires the recording of a security agreement and financial statement to secure interests in personal property. These agreements are recorded, giving purchasers notice of the existing liens. This statute gives protection to both buyers and lien holders. This is commonly used in the transfer of a business that includes personal property, such as equipment, machinery, stock, etc.

The Deed of Reconveyance When a deed of trust has been paid in full, a deed of release and reconveyance should immediately be filed. This is often overlooked and many times even though the deed of trust is paid, the title search will show no such recording. The escrow agent often requires the seller to sign a deed of release and reconveyance in advance, and this release is held by the trustee until payment is made in full. Upon notification, the trustee will record the deed. When the seller is financing the property, the agreement should include instructions for recording as soon as the deed of trust, or mortgage, is satisfied.

IRS and Taxation The Tax Reform Act of 1986 requires the closing or escrow agent, broker or attorney to report the sale or transfer of residential property. This must include the: • Legal description • Name of the seller • Social security number or • Tax identification number • Closing date and • Seller's gross proceeds on 1099 form to IRS The act does not clearly define the terms “broker”, “attorney", and “escrow agent”. Whenever a real estate broker is involved, it is the broker’s responsibility that the report is filed, or to file it personally. A minimal charge is made to the seller for the filing of this report. FIRPTA is an act that requires the closing or escrow agent to deduct 10% of the seller’s proceeds and send it to the IRS, when the seller is a foreign investor. See U.S. Publication 924, Reporting of Real Estate Transactions to IRS and the publication "Instructions for Reporting Real Estate Transactions" on Form 1099-B.

The Role of the Real Estate Licensee Although brokers can close transactions for their clients, most prefer to use services of escrow agents. Since the broker is not obligated to close the sale and cannot be paid for this service, it usually is not worth the risk of being held personally liable for every calculation in the closing statement.

Instead, brokers prefer to have the escrow agent or closing attorney prepare accurate closing statements, make the disbursements, and keep the copies in their files. The role of the broker and agent is to provide complete and accurate information to the escrow agent. The easiest way to make sure the escrow agent has all necessary information is to begin by preparing a detailed sales contract that contains the correctly spelled names, addresses, and phone numbers of the buyers and sellers. When the name is common (Smith, Jones) the agent should include a social security number for identification and include Jr., or Sr. when appropriate. The sales agreement should include a clear and accurate legal description as well as the street address. The agent can also provide information about fire insurance, reserve accounts, assumption information, lender or escrow company names, account numbers, addresses, phone numbers, etc. The agreement should state which costs are to be paid by the seller and buyer, possession dates and prorations dates. The agreement should show the amount of commission and the split if there is a cooperating broker. In addition, the real estate agent should let the escrow agent know if the parties are ready or willing to close earlier than the date in the earnest money agreement. Many conditions must usually be met prior to closing (appraisals, inspections, loan approval, work requirements, etc.,) so it is very difficult to determine an exact closing date. Always check with the closing agent before giving your buyer or seller the exact closing date and time. Include: • Correct legal description • Street address • Parcel number if possible • Costs that are to be paid by each party • Insurance information (new or assumed policy, insurance agent’s name) Provide: • Amount of down payment and earnest money deposit • The trust account into which it was deposited • Purchase price • Personal property included in sale • Estimated proceeds for closing agent to check for accuracy Advise: • Seller to continue making payments • Do not discuss legal matters • Provide copy of existing contract, loan, mortgage • Identify lender and loan officer’s phone number and address • Inform the closing agent of loan approval Follow up: • Inspections and work requirements • Existing loan- loan numbers, contact person Indicate if balance is to be paid off, assumed, assigned, or wrapped. Inform closing agent of any addenda or change in terms or conditions. If there are special circumstances: • Divorced - provide final decree and any judgment to ex-spouse or child support • Widowed – provide death certificate to escrow agent In these cases always provide name of attorney, names and numbers of persons with power of attorney. Other agreements: • Submit any early possession agreements • Rent agreements, amounts, damage deposits, lease terms and conditions, and penalties

Closing Hints Always provide as much information as early as possible to the closing agent. It is crucial that the agent complete an accurate and detailed sales agreement to provide all information, changes and addendum to the closing agent. Cooperation between the real estate agent and the closing agent is vital to assure a smooth closing for the buyer and seller.

RESPA The final step is the presentation of the closing or settlement statement. This form shows the buyer and seller all charges and credits. The Real Estate Settlement Procedures Act (RESPA) provides that the buyer and seller may choose the escrow agent. They must have an agreement between them of the choice whenever federal money is involved, such as an FHA or VA loan, or any loan that will be sold to Fannie Mae, Ginnie Mae OR Freddie Mac. If the seller is the financing the property, the seller has the right to choose the escrow agent. This act requires the closing or escrow agent to show the buyer and seller the completed settlement sheet one day before the actual close of escrow.

Uniform Settlement Statement will show: • Purchase price • Earnest money deposit • Method of financing • ALL closing costs • Loan payoff • Prorations of buyer and seller costs • Broker commission • Buyer’s cash requirements • Seller’s proceeds

Basic Formulas for Closing These basic formulas will help you to calculate the costs and charges on a settlement statement.

1. Gross commission = Sold Price x % Rate The seller usually pays the commission, but purchaser or both parties can pay it if informed in writing.

2. Loan amount = Sold Price x % 90% Loan would be 90% x sold price

3. Prepaid Interest = % of Interest x Loan Amount x annual interest ÷ 365 (days per year) = per diem. Then take the per diem x number of days Example: $132,750 loan amount x 8% interest = $10,620 annual interest $10,620 ÷ 365 days = $29.10 per diem $29.10 x 34 days = $989.40

Prepaid interest on buyer’s loan: $989.40 4. Excise Tax = Sold price x excise tax rate Example: $147,500sales price x 1.78%excise tax rate = $2,625.50 Excise tax: $2,625.50

5. Prorate Interest on Seller’s Loan Balance Loan balance x current interest rate = annual interest ÷ 365 days = per diem x number of days Example: $79,900 loan balance x 11% interest rate on loan = annual interest ÷ 365 days = $24.07945 per diem x (assuming 28 days) 28 days from last payment to closing date= $674.22466 rounded to $674.22. Interest on seller’s loan balance: $674.22.

6. Origination Fee = Loan amount x % charged $132,750 (loan amount) x 1% origination fee = $1327.50

7. Prorating Property Taxes Annual tax amount ÷ 365 days = per diem Per diem x days owing = pro-rated taxes

Review The Closing Process is the last stage of the transaction, when the escrow agent, or closing attorney, meets with the buyers and sellers, separately or together to close the transaction. At closing, the buyer and seller will receive a detailed statement of debits and credits so that the buyer will know how much to pay and the seller will know how much he or she will receive.

The escrow agent collects the funds and pays out all costs according to the escrow instructions. Then the escrow agent records the deed and other documents and disburses the proceeds to the seller. A certified escrow agency must be licensed to do business under the Registration Act. The Director of the Department of Licensing oversees the actions of escrow agents, and has the power to revoke the license of any agent or officer guilty of conversion (using trust funds for personal use), or committing dishonest or prohibited acts. The escrow instructions tell the closing agent what conditions must be met prior to closing. The closing agent makes sure that inspections, surveys, contingencies and all other conditions of the sales agreement are met by the specified date at the specific place. The title examiner will begin a title search to determine the condition of the title. This means that past sales and transfer records will be checked for “clouds”, encumbrances, judgments, title defects or other flaws. The examiner checks records at the title plant and the county recorder’s office that could go all of the way back to the original patent. However, most title searches go back only as far as the prior policy that was issued. Once the search is completed, the title company will issue a preliminary title report that will disclose the current title status to the buyer. The title policy is then prepared “subject to the exceptions” shown in the report. The title company has the right to cancel, amend or supplement the policy prior to recording. Owner's Title Policy insures the buyer against undetected defects in the title. Unlike a homeowner's policy that insures the owner in case of damage caused by fire, burglary, etc., it is an assurance that the buyer is receiving good title. The policy is in effect until ownership transfers. This policy does not cover the lender. If the buyer is taking out a new loan, the lender will also want assurance of good title that will benefit the lender. This policy is typically paid for by the purchaser and is based on the amount of the loan. Standard policies provide coverage of matters of record and are subject to some exclusion. Exclusions in the standard policy include coverage for unrecorded documents, defects that the policyholder already has knowledge of, rights of parties in possession and verification of survey. A broader policy is the extended coverage policy. This policy covers unrecorded defects and clouds such as unrecorded documents, known defects, and rights of parties in possession. However, survey verification still may not be covered by this expanded policy. Laws that disallow claims after long periods of time are referred to as Marketable Title Acts. The number of years required for a property to reach marketable title status varies with each state, but is usually between twenty and forty years. A chain of title is a complete record of all recorded documents, such as conveyances, encumbrances, and liens that affect the subject property from their original sources. The chain of title will also show “clouds” on the title, such as claims of heirs, quit claim deeds, and other interests that may restrict the ownership of the property. A “quiet title” suit is a court action where the ownership of the property, or a part of the property, is decided. Recording the deed is necessary for the protection of the buyer. The date of a document has no authority over the date of recording. In Washington State, the first recorded deed has precedence over any other deed to the same property. Even though unrecorded deeds are considered valid, the recorded deed would be considered superior to the unrecorded deed.

Actual Notice is notice through firsthand observation. It is an “act” that you can see. Constructive Notice is the notice given by the recording an instrument. This type of notice is “constructed” and put in a place where a person could have or should have known. There are two systems to index recorded documents. These are the “tract” and “grantor – grantee”. The tract system is considered to be more effective and is less likely to lose a “wild deed” than the grantor-grantee index. The Uniform Commercial Code requires the recording of a security agreement and financial statement to secure interests in personal property. These agreements are recorded, giving purchasers notice of the existing liens. When a deed of trust has been paid in full, a deed of release and reconveyance should immediately be filed. The Tax Reform Act of 1986 requires the closing or escrow agent, broker or attorney to report the sale or transfer of residential property to the IRS. Whenever a real estate broker is involved it is the broker’s responsibility that the report is filed, or to file it personally. FIRPTA is an act that requires the closing or escrow agent to deduct 10% of the seller’s proceeds and send it to the IRS, when the seller is a foreign investor. Since the broker is not obligated to close the sale and cannot be paid for this service, it usually is not worth the risk of being held personally liable for every calculation in the closing statement. The easiest way to make sure the escrow agent has all necessary information is to begin by preparing a detailed sales contract that contains correctly spelled names, addresses, and phone numbers of the buyers and the sellers. Always provide as much information as early as possible to the closing agent. Cooperation between the real estate agent and the closing agent is vital to assure a smooth closing for the buyer and seller.