A mortgage is a loan provided to a borrower by a lender in exchange for the borrower paying back the principal loan balance amount with interest. Mortgage financing is at the cornerstone of most real estate purchases. Without loans, most borrowers would not have the necessary capital to purchase a property.
The following page will provide a detailed breakdown of all terms and components related to mortgages including parties involved, the mortgage origination process, mortgage laws, various loan programs, and fees and terms.
In California, the most common form of a mortgage is a trust deed. This means that the title of a borrower’s property is held by an independent third party (usually a trustee or escrow company) as a means of securing a lender’s mortgage loan.
How Collateral is Used to Approve Borrowers for Mortgages
To qualify for a mortgage, a borrower’s collateral must be hypothecated. To hypothecate means to use a property as collateral for securing a mortgage without exchanging the property’s title or ownership. When a borrower agrees to a mortgage, a lender secures its financial investment with a voluntary lien on the borrower’s property; a lien gives a lender legal interest in the property and allow the lender to foreclose on that property in the event that the borrower defaults on mortgage payments.
Mortgages have a statute of limitations of four years. This means if a borrower hasn’t made a mortgage payment in four years without action from the lender, a lender can no longer go after that borrower for defaulted debt.
A lender’s interest in a property is secured through a security agreement. A security agreement is a legal document that secures a lender’s interest in a property being used as collateral for a refinance or purchase loan. It sets forth the terms of the agreement between the parties, including what happens if the property is sold or foreclosed.
A security agreement gives a lender partial ownership of a property. This ensures that in the event of a borrower’s default, a lender can seize and foreclose on the property in order to recover its investment. Therefore, a security agreement substantially reduces a lender’s risk.
A financing statement is a filed document that gives notice of a lender’s security interest. Such a statement must be publically registered/filed in order to “perfect” a lender’s interest in a property. (A lender’s interest is automatically “perfected” for purchase loans. However, a lender must manually “perfect” its interest for a refinance loan.)
A lender must also provide a prospective borrower with a uniform settlement statement. This statement itemizes all fees and charges.
A negotiable instrument is a document that guarantees a borrower’s payment of debt to a lender. Negotiable instruments can be banknotes, bills of exchanges, or promissory notes.
The document should be in writing, provide clear and straightforward terms, and be signed by both parties.
A negotiable instrument may be transferred to a third party — such as a collection agency or lawyer — in order to allow a lender to recoup its investment. When a borrower defaults on a debt, it is common for the lender to sell the negotiable instrument below market value to other lenders who attempt to collect the debt.
Holder in Due Course
A holder in due course refers to a party who has accepted a negotiable instrument and exchanged something valuable for it. More simply, such a party “holds” a negotiable instrument, which in the case of real estate is a mortgage note.
It is common for lenders to sell mortgage debt to interested buyers prior to a borrower’s default on the debt as a way of protecting its financial interests, cutting financial losses before they get any worse or to make a profit. It is usually sold for less than the principal loan amount.
A holder in due course may purchase a note with the intent of collecting interest or foreclosing on the note and recouping payment through a foreclosure and subsequent sale. A note holder may sell the debt to another party to free up capital for new mortgage originations to reduce liability from bad debt.
A holder of due course may purchase a negotiable instrument held by a lender, therefore becoming the new “lender”. This entitles the holder in due course to receive the borrower’s future payments.
A holder in due course is granted superior protection to other governing or conflicting laws.
When Debt is Sold
In the event that a borrower’s debt is sold, the lender is not required to give that borrower notice. Should a borrower pay the old lender not knowing of the transfer to the holder in due course, the wrongful payment must be transferred to the new lender. In this situation, payment to the old lender qualifies as a valid attempt by a borrower to make a payment.
Valid defenses against a holder in due course:
Incapacity: The seller of the debt lacked the capacity to sell the debt
Illegal: The transfer of the debt was illegal
Forgery: The transferee was forged and not the intent of the maker or payee
Alteration: Alteration of the terms of the sale without the approval of either party is illegal and serves as a valid defense
A promissory note — sometimes known as a “note payable” or simply a “note” — is a signed document that contains a written record of the sum a borrower owes to a lender. A note protects the interests of a lender by establishing a clear record of debt.
A negotiable instrument is a type of note that can easily be bought or sold without conditions.
Promissory notes are used in real estate by lenders, banks, and government lending agencies, such as Fannie Mae or Freddie Mac.
The provisions included in a valid promissory note depend on the terms of the agreement and the type of credit being extended. In general, however, a note includes:
Principal debt amount
Payment terms, including the amount that must be paid to stay current on the note and options on how to pay it off
The date on which the loan must be paid off
A note may include a monthly interest rate on the principal loan amount. If a borrower defaults on a debt, the lender may have the option to increase the interest rate.
A defeasance clause is a provision that cancels a debt upon the payment or settlement of the promissory note.
A mortgage broker is a mortgage professional who acts as an intermediary between a borrower and lender. Mortgage brokers assist borrowers in qualifying for mortgages and in finding the most compatible lenders and loan programs available.
The California Business and Professions Code defines a mortgage broker as one who “engages as a principal in the business of making loans or buying from, selling to, or exchanging with the public, real property sales contracts or promissory notes secured directly or collaterally by liens on real property, or who makes arrangements with the public for the collection of payments or for performance of services in connection with real property sales contracts or promissory notes secured directly or collaterally by liens on real property.”
A mortgage broker has a duty to provide all vital loan information to a prospective borrower, including commissions and fees. A mortgage broker is also responsible for delivering copies of a deed to all involved parties, including the lender, borrower, and investor, if applicable.
Any individual who solicits mortgage business is subject to the regulations set forth by the Real Estate Commissioner. Any individual, property owner, or other party involved in more than eight trust deed transactions or promissory notes in a year must be a licensed broker.
In return for assisting the client find a loan, the mortgage broker is compensated by the client and/or lender, typically through points or fees. The maximum commission a lender/broker can earn in commission for a first position loan is 5% of the principal loan amount for a program of three years or less, and 10% for programs that are three or more years.
Mortgage Terms and Requirements
California’s Business and Professions Code has further regulations relating to mortgage brokers and mortgages:
Real estate licensees are prohibited from advertising or offering prospective lenders or clients a gift, or any other item of value, with the intent of inducing the lender to make a loan, or purchase a promissory note. (10236.1)
A real estate broker who benefits directly or indirectly from obtaining the use of funds other than the commission and fees must disclose this to the Department of Real Estate and the lender providing the loan. (10231.2)
It is unlawful for mortgage brokers to accept funds from lenders, unless the borrower has been approved, or a loan has been arranged for the broker’s client. (10231)
A mortgage broker who services a promissory note/mortgage that is secured by real property must have written authorization from all parties including the borrower, lender, or owner of the note. A broker who acts as the servicer for the lender is responsible for all accounting related items that affect the lender. Accounting includes keeping track of the unpaid principal balance, disbursements, payments, collections, the status of a notice of default, and other accounting items. (10233)
If a real estate broker who services a loan receives payment other than the scheduled payment, the broker must inform the note holder within 10 days of acceptance of such payment. In addition to disclosing acceptance of payment, the broker must inform the source of payment, who the payment was directed to, and the reason for making the payment. (10233.1)
It is the duty of every real estate licensee who negotiates the approval of a loan to have the loan recorded with the local county recorder’s office. Prior to the release of funds, the broker must verify the loan’s recording, unless otherwise indicated by the lender in writing. (10234)
In an attempt to equip consumers with as much necessary information about their loan as possible the Real Estate Commissioner’s office requires the borrower’s mortgage broker to provide their clients with a copy of the deed of trust within a reasonable amount of time of the loan’s recording. The rule also requires the copy of the deed to be given to any other parties who hold an interest in the loan including the investor and lender. (10234.5)
It is unlawful for real estate licensees to knowingly mislead consumers in advertising, including print, internet, published, televised advertising, and other advertising mediums. (10235)
Bait and switch advertising is an illegal practice in which a broker advertises a product or inventory that it does not have the aim of selling with the intent of “baiting” customers into buying another product.
Conversely, a controlled business arrangement allows a mortgage broker to offer multiple services — such as financial products, hazard insurance, title insurance, and other services or products — through various subsidiary companies that act under the umbrella of that broker.
Case Review: Direnfield v. Stabile (1988)
The case, Direnfield v. Stabile (1988) 198 Cal.3d 126., involved a real estate agent who arranged a loan transaction with a high interest rate without being employed by a broker.
A real estate agent (Stabile) arranged for two borrower loans with a private lender (Direnfield). Shortly after, Stabile ended his employment with his broker, but failed to acquire a new broker. Without disclosing this to Direnfield, Stabile approved a third borrower loan for Direnfield at an interest rate of 30%.
When the borrower discovered that Stabile was not working with a licensed broker, he sued Direnfield for charging a usurious — or illegally high — interest rate. (In California, a private lender cannot charge more than 7% interest unless the transaction is under a licensed broker.) A settlement of the case resulted. Direnfield subsequently initiated a lawsuit against Stabile to recoup its losses.
The Superior Court contended that Stabile was guilty of concealing his unlawful employment status. Direnfield ultimately prevailed as the court ruled in his favor. Stabile could not pay back the funds, so Direnfield applied to the Department of Real Estate. The court ordered the Real Estate Recovery Fund to make payments to Direnfield for the money he lost.
Truth in Lending Act (TILA)
The Truth in Lending Act (TILA) is a federal law passed in 1968 that created a uniform system for calculating and disclosing loan interest rates. Initially regulated by the Federal Reserve Board, the Act’s provisions are now enforced by the Consumer Financial Protection Bureau.
Prior to the Act, the ways lenders calculated and advertised their loan rates were not standardized. Consequently, consumers were unable to accurately compare loan products from different lenders. The creation of a standardized system allows consumers to better understand and compare available loan products.
Lenders must provide borrowers with documentation about the specific loan they are receiving. For example, if a borrower is applying for an adjustable rate mortgage, the lender must provide him or her with a copy of the Federal Reserve’s Consumer Handbook on Adjustable-Rate Mortgages.
A Truth in Lending Disclosure Statement must be given to the borrower. Mortgage disclosures must be provided within three days of a borrower’s submission of an application. This statement provides borrowers with a simplified version of the mortgage terms, including:
Annual Percentage Rate (APR)
Monthly mortgage payments
One of the Truth in Lending Act’s main provisions requires lenders to use an annual percentage rate (APR) as the standard mortgage description term for mortgage products. The cost of credit is referred to as the cost to borrow money on a yearly basis as the annual percentage rate (APR).
A borrower can cancel the loan they retained within a 3 day period after the execution of the close of the loan. This applies to refinances and line of credit’s.
Case Review: Pacific Shore Funding v. Lozo (2006)
The case, Pacific Shore Funding v. Lozo (2006) 138 Cal.4th 1342., involved a lender who violated the Truth in Lending Act.
A borrower (Lozo) was granted a mortgage by a lender (Pacific Shore Funding) in the amount of $28,000. Less than three years later, Lozo got a second mortgage from the lender-Pacific Shore Funding- for $71,600. Lozo used the second loan to pay off the balance of his first mortgage, then rescinded the first loan.
Pacific Shore Funding brought suit against Lozo, alleging that borrowers are not entitled to rescind a first loan after they refinance a second loan with the same lender. Lozo filed a cross complaint. He argued that the first loan was subject to the Truth in Lending Act, which had been violated by the lenders. Lozo contended that Pacific Shore Funding did not provide disclosures. Therefore, Lozo argued that he was able to rescind the loan.
The Superior Court argued that Lozo’s repayment of the first loan terminated his rights to rescind the loan under the Truth in Lending Act. It ruled in favor of Pacific Shore Funding. Lozo appealed.
The Court of Appeals reversed the lower court’s ruling. It contended that even one violation of the Truth in Lending Act (TILA), regardless of how severe or minuscule increased the right of rescission period. Therefore, Pacific Shore Funding’s failure to provide Lozo with the required disclosure forms extended Lozo’s rescission period from three days to three years, and his notice of rescission was timely. The court ordered Pacific Shore Funding to refund all interest and fees, including loan points, closings costs, and prepayment penalties.
Real Estate Settlement Procedures Act (RESPA)
Because each mortgage typically contains hundreds of pages of difficult to understand paperwork, the federal government passed the Real Estate Settlement Procedures Act (RESPA) in 1974. RESPA is a federal consumer protection law that helps borrowers be better informed while shopping for mortgage and loan services.
The Act requires lenders to disclose all pertinent loan information and mortgage costs during the loan process. It also restricts the types of fees that lenders may impose on borrowers.
RESPA applies to first mortgages, including purchases, refinancing, property improvement loans, and equity lines of credit. (It does not apply to second mortgages, loan assumptions, construction/home improvement loans, or land sales.)
Under RESPA, lenders must provide potential borrowers with the following information within three days of them submitting a completed loan application:
Mortgage Servicing Disclosure: indicates whether a lender will continue to service a loan, or transfer it to another lender.
Special Information Booklet: provides the rights of borrowers and the various settlement services.
Good Faith Estimate (GFE)
A good faith estimate (GFE) provides an estimation of a borrower’s loan settlement costs, or the costs a borrower will pay at the closing of a mortgage loan. This document allows borrowers to easily compare various lenders’ mortgage loan costs and terms in order to select the best one. A GFE includes:
the cost of running credit
property inspection and survey fees
title search and title insurance
A mortgage broker supplies the prospective borrower with a copy of the appraisal, the loan application, and a copy of the credit report.
In addition to RESPA’s requirements, California requires lenders to provide borrowers with a mortgage loan disclosure statement. This disclosure indicates all of a mortgage’s terms, including costs, fees, rates, estimated payments, and conditions of the mortgage. A lender must get the potential borrower’s signature on the disclosure statement in order to proceed with the loan.
RESPA prevents lenders from charging borrowers for services that are not rendered. It also makes it illegal for a lender to charge for services that are completed in order to comply with the Act, such as printing out additional forms or spending time preparing documents.
All fees charged by a lender must be necessary to the loan approval process. Section 8 of RESPA outlaws kickbacks and referral fees that make the process of applying for a loan more expensive. Should a lender, broker, or other party violate this provision, they could be subject to damages of up to $10,000 and face up to one year in prison. They could also be held liable for up to three times the fee for which the prospective borrower was charged.
The Mortgage Loan Compliance Manual, which was created by the Department of Real Estate, states that mortgage-related expenses for qualifying and obtaining a loan cannot exceed 5% of the total mortgage amount, or $390 if the amount is less than 5%. Regardless of the mortgage amount, costs of mortgages for a regulated loan cannot exceed $700. For example a loan amount of $15,000 can have maximum costs of $700, even if the broker attempts to charge 5 percent because that amount exceeds the maximum $700 cost.
Case Law As It Relates to Mortgages
Case Review: Warren v. Merrill (2006)
The case, Warren v. Merrill (2006) 143 Cal.4th 96., involved a buyer who sued his real estate agent for fraud, breach of fiduciary duty, and action to quiet title.
The buyer (Warren) did not have the necessary credit or down payment to qualify for the financing required to purchase a Los Angeles condominium property. The defendant, Merrill, was the real estate agent who assisted Warren in the transaction.
In order to prevent the loss of a sale, Warren’s real estate agent (Merrill) agreed to lend Warren the remaining down payment amount out of her commission. Merrill also offered to help Warren qualify for financing by applying for a loan through Merrill’s daughter, Charmaine. Warren agreed.
While applying for the loan, Warren’s name was not placed on the property title. Merrill promised Warren that upon the close of the transaction, she would have her daughter transfer the title to Warren. However, Charmaine never signed the promised deed that would transfer the property to Warren.
During this time, Warren was facing significant personal problems, including a divorce, health problems, and losing money in his business. As a result, Warren began using drugs. Warren was also experiencing neurological disorders, such as Tourette’s syndrome, which significantly affected his cognitive abilities. Warren checked himself into a drug rehabilitation facility. While in rehab, Warren stopped making mortgage payments (which he had done previously for 3 months). He had also fallen behind nearly $5,000 in H.O.A. fees, which nearly caused the property to go to foreclosure.
Merrill had begun making payments on Warren’s behalf to avoid this. After she had brought all property-related payments current, Merill filed an unlawful detainer action to evict Warren on the basis that Charmaine was the property owner, not Warren. Merrill got the judgment she requested against Warren, and evicted Warren through the writ of possession. When Warren left rehab and discovered the situation, he filed a lawsuit against Merrill.
The Superior Court found that Merrill’s testimony was “ unreliable and lacked credibility.” It quieted the title and found Merril guilty of fiduciary duty and fraud. Warren was awarded $15,000 in noneconomic damages and $50,000 in punitive damages. Merrill appealed.
The Court of Appeals affirmed the lower court’s ruling, holding that “substantial evidence supported the fact that the agent breached her fiduciary duty by fraudulently procuring title to property.” The court believed that Merrill had no intention of transferring the property title to Warren. The court deemed Merrill guilty. The court then answered the punitive damage claims by stating that “proof of actual damages to purchaser was sufficient to support punitive damages.”
Case review: Pepitone v. Russo (1997)
The case, Pepitone v. Russo (1997) 64 Cal.App.3d 685., involved a buyer who filed suit against their broker for fraud and a breach in fiduciary duty.
Pepitone bought a property on the advice from his agent, Russo. However, Russo never disclosed the presence of an acceleration clause in the second mortgage necessary to purchase the property. The acceleration clause, which required the loan to be paid in full upon the loan’s maturation, ultimately caused Pepitone to lose the property in foreclosure. Pepitone sued Russo for failing to disclose that the purchase of the property assumed a second mortgage that contained an acceleration clause.
The Superior Court held that Russo had violated his agency duties and awarded Pepitone $85,735 in damages. Russo appealed. The Court of Appeals upheld the lower court’s ruling, but reduced the damages to $25,000.
Case Review: Barry v. Raskov (1991)
The case, Barry v. Raskov (1991) 232 Cal.App.3d 447., involved a novice investor lender who brought action against a loan broker, alleging fraud and misrepresentation.
Barry was a retired person with a large savings account however had no investment experience. A mortgage loan broker (Raskov) told Barry about the benefits of investing in home loans. His company provided borrowers who could not obtain loans from banks or other loan institutions due to poor credit with a high interest loan. Raskov said that any investment Barry made would be guaranteed “one hundred per cent” and that he “would not lose one cent”.
Raskov said Barry could invest $55,000 into a borrower’s second mortgage that had a first trust deed of $100,000 and earn 23% on the investment, plus more over time. Raskov hired an appraiser who valued the borrower’s property at $400,000. Raskov told Barry that his investment would be protected as the property’s value was significantly higher than the totaling loan amounts. Barry agreed to invest the $55,000, and Raskov made $30,000 in commission.
However, the borrower immediately defaulted on the loan, and Barry began losing his promised monthly earnings. Upon further inspection, Raskov learned that the borrower’s property value was actually only $98,000, not the appraised value of $400,000. Barry filed suit against Raskov.
The Superior Court ruled in favor of Barry, but did not hold Raskov liable for punitive damages. Upon appeal, the Court of Appeals did rule that Raskov was liable to Barry for fraud and negligence in his failure to independently verify the appraiser’s property report. The court determined that the employer of an independent contractor — in this situation, Raskov employed the appraiser — will be liable for the contractor’s torts.