This article discusses the use of special note provisions to protect the mortgage holder while providing flexible repayment options to the borrower. This article is an excerpt from first tuesday’s upcoming book, Real Estate Finance, Seventh Edition.
Beyond fundamental debt obligations
A note contains a borrower’s promise to pay the lender or carryback seller the principal amount of the debt entered into, plus any interest. Special provisions added to a note serve to:
- protect the mortgage holder against risk of loss due to late payments, early payoff or other defaults on the note;
- comply with rules for consumer mortgage transactions; and
- give the property owner payoff flexibility and limited liability.
Special provisions to be considered for inclusion in a note include:
- a prepayment penalty, when allowed;
- a due date extension;
- compounding on default;
- a final/balloon payment notice, when a balloon payment is included;
- a grace period and late charges;
- a payoff discount option;
- a right of first refusal on the sale of the note;
- reference to a guarantee agreement;
- an exculpatory clause; and
- governing law.
Classifying mortgages as consumer or business
Whether a special provision may be included in the note and to what extent it can then be used depends on:
- the purpose financed by the mortgage, consumer or business;
- the security for the mortgage, one-to-four residential units or any other type property;
- the mortgage volume of the lender or carryback seller; and
- the borrower.
Federal laws and regulations prohibit the use of some in connection with a consumer-purpose debt secured by one-to-four unit residential property, called a consumer mortgage. [12 Code of Federal Regulations §1026.43]
Lenders who originate consumer mortgages are subject to federal ability-to-repay (ATR) rules, which restrict the use of some special provisions.
Federal Regulation Z also requires sellers who carryback a consumer mortgage (shelter for the buyer’s family) on the sale of one-to-four residential units to hold a real estate license and mortgage loan originator (MLO) endorsement unless they fall under one of two exclusions:
- the 1-in-12 exclusion which limits the seller to one carryback transaction per 12-month period; or
- the 3-in-12 exclusion which limits the seller to three carryback transactions per 12-month period.
Each exclusion from licensing and MLO compliance by a seller carrying back a consumer mortgage comes with its own different restrictions on the terms allowed in the note.
California mortgage laws apply to all aspects of mortgage originations not covered by federal rules, the result of preemption. Thus, California lending laws apply to:
- business mortgages secured by any type of property;
- consumer-purpose debts secured by real estate other than one-to-four unit residential property; and
- mortgages made to entities.
A prepayment penalty is a charge a property owner voluntarily incurs by prior agreement when they pay off the principal balance on a mortgage before it is due under the payment schedule in the note.
For consumer mortgages, prepayment penalties are only allowed if:
- the annual percentage rate (APR) does not increase after closing (i.e., prepayment penalties are not allowed on adjustable rate mortgages (ARMs));
- the APRdoes not exceed the average prime offer rate for a comparable consumer mortgage by:
- 1.5% on a first mortgage with a principal amount no more than the conforming loan limits set by Freddie Mac;
- 2.5% or more on a first mortgage with a principal amount more than the conforming loan limits set by Freddie Mac; and
- 3.5% or more on a second or other subordinate mortgage;
- the loan is a qualified mortgage (QM); and
- the loan is not a Section 32 high-cost mortgage. [12 CFR §§1026.43(g)(1); 1026.32(d)(6)]
For consumer mortgages which qualify to include a prepayment penalty, the terms of the prepayment penalty are limited to:
- payoffs during the three-year period following closing;
- 3% of the outstanding balance on the loan during the 1st year of payment following the mortgage origination;
- 2% of the outstanding balance on the loan during the 2nd year of payment; and
- 1% of the outstanding balance on the loan during the 3rd year of payment. [12 CFR §1026.43(g)(2)]
When including a permissible prepayment provision on a consumer mortgage, MLOs are required to offer comparable alternative mortgage arrangements which do not contain prepayment provisions. [12 CFR §1026.43(g)(3)]
Further, under state law, any mortgage with a prepayment penalty which is secured by an owner-occupied, one-to-four unit residential property may be prepaid up to 20% of the original principal balance in any 12-month period without penalty.
When more than 20% of the original amount of the note is prepaid in any 12-month period, the prepayment penalty is limited to no more than six months’ advance interest on the excess, unless limited to a lesser rate under consumer mortgage rules. [Calif. Civil Code §2954.9(b)]
Thus, a mortgage holder who enforces a prepayment penalty provision on any prepaid principal on a mortgage originated with an owner-occupant of a one-to-four unit property needs to calculate the penalty to be charged under both the “six months’ advance interest” and the percentage caps set by the ATR rules. The penalty charged is limited to the lesser of the two penalty amounts. For sellers carrying back a consumer mortgage, the 1-in-12 exclusion, unlike the 3-in-12 exclusion, does not require the carryback seller to adhere to ATR rules. However, when the seller includes a prepayment penalty in any consumer carryback mortgage, the carryback note needs to comply with QM standards.
For business mortgages, a prepayment penalty is enforceable if it is reasonably related to money losses suffered by a mortgage holder. Reasonably related money losses include the payment of an amount equal to the profit taxes incurred by a carryback seller on a premature reduction in principal or final payoff if called for in the note. [Williams v. Fassler (1980) 110 CA3d 7]
However, on both business and consumer mortgages secured by one-to-four unit residential property, if the mortgage holder intends to collect a prepayment penalty on a call under a due-on clause in their trust deed, the property owner needs to have agreed in a separate prepayment penalty provision that they waive their right to prepay without a penalty. [CC §2954.10]
Late charges and grace periods
A late charge provision in a note permits collection of an additional one-time fee or interest accrual on the amount of interest in the delinquent payment. A typical late charge provision takes the form of a flat fee or a percentage of the monthly payment or mortgage balance.
On consumer mortgages other than home equity lines of credit (HELOCs), mortgage holders are required to provide the borrower with a periodic mortgage statement each billing cycle. The periodic mortgage statement will include:
- the payment due date;
- the amount of any late charge and the date it will be imposed; and
- the amount due, shown more prominently than other disclosures on the statement. [12 CFR §1026.41(d)(ii)]
Additionally, on a consumer mortgage secured by the borrower’s principal residence, late charges may only be imposed for delinquent principal and interest payments. A late charge may not be imposed for nonpayment of late charges, a practice called pyramiding. [12 CFR §1026.36(c)(2)]
For business mortgages and consumer mortgages secured by property other than owner-occupied single family residence (SFR) or not arranged by a mortgage loan broker, the late charge assessed for the delinquent payment of an installment is required to be an amount reasonably related to:
- the mortgage holder’s actual out-of-pocket losses incurred in pre-foreclosure collection efforts; or
- the value of the lost use of the delinquent funds. [CC §1671; Garrett v. Coast and Southern Federal Savings and Loan Association (1973) 9 C3d 731]’re saying here]
A late charge provision in a note specifying an increased interest rate on the entire remaining principal on default of any monthly installment, called a default interest rate, is an unenforceable forfeiture. Here, the late charge is a disguised penalty provision. The rate of interest on a default may only be applied to the delinquent principal and interest payment since only an installment is delinquent, not the entire principal balance of the note. [Walker v. Countrywide Home Loans, Inc. (2002) 98 CA4th 1158]
Further, a penalty provision is void if it fails to reasonably estimate compensation for the mortgage holder’s losses caused by the default.
The amount of a late charge on any note secured by an owner-occupied SFR is limited to the greater of:
- 6% of the delinquent principal and interest installment; or
- $5. [CC §2954.4]
For loans made or arranged by a real estate broker and secured by any type of real estate, a late charge on delinquent monthly payments is limited to the greater of:
- 10% of the delinquent principal and interest payment; or
- $5. [Bus & P C §10242.5(a)]
A default on the final/balloon payment
When a consumer or business mortgage is arranged by a broker and contains a due date for a final/balloon payment, a late charge may be assessed if the final/balloon payment is not received within ten days after the due date.
The maximum enforceable late charge assessed on the delinquency of a final/balloon payment on a broker-arranged loan is an amount equal to the maximum late charge imposed on the largest installment payment scheduled in the note.
A late charge may be further assessed for each month the final/balloon payment remains unpaid. [Bus & P C §10242.5(c)]
On an installment sale of real estate, except for a buyer-occupied SFR, an increased interest rate on the remaining principal triggered by a delinquency of the final/balloon payment is an acceptable late charge provision. [Southwest Concrete Products v. Gosh Construction Corporation (1990) 51 C3d 701]
However, any increase in the interest rate triggered by a delinquency is still controlled by reasonableness standards, similar to the handling of a late charge. [Garrett, supra]
For carryback SFR notes and broker-arranged loans, an installment is not late if paid within ten days after the installment is due, called a statutory grace period. [CC §2954.4; Bus & P C §10242.5]
Also, on an SFR mortgage or broker-arranged mortgage, the mortgage holder is not allowed to charge more than one late charge per delinquent monthly installment payment — no matter how long the payment remains delinquent. [CC §2954.4(a); Bus & P C §10242.5(b)]
Compounding on default
A compounding-on-default interest provision is triggered by a delinquency in a payment. Compounding is the accrual of interest on the amount of interest contained in the delinquent installment at the note rate until the delinquent payment is paid.
Compounding interest provisions are used in lieu of flat fee or percentage late charge provisions.
A compounding interest provision is a type of late charge since it penalizes the borrower and is triggered by a delinquency in a payment. As a late charge, the limitations on amounts and grace periods for late charges and a demand for the late-payment fee apply to the enforcement of provisions calling for compounding on default.
Balloon payment notice
A balloon payment is a final lump sum payment of remaining unpaid principal which is due on an earlier date than had the principal been fully amortized by periodic payment terms. [See Chapter XX]
A balloon payment note secured by an owner-occupied, one-to-four unit residential property contains provisions for:
- a final payment more than twice the amount of any of the six regularly scheduled payments preceding the date of the balloon payment; or
- a call provision. [CC §2924i(d); CC §2957(b),(c)]
A call provision gives the mortgage holder the right to demand final payment at any time after a specified period.
All balloon payment notes secured by an owner-occupied one-to-four unit residential property are to include a reference to the borrower’s right to receive a balloon payment notice 90 to 150 days before the due date. [CC §2924i(d); CC §2957(b),(c)]
Failure to include the balloon payment notice provision in the note does not invalidate the debt. Further, if the notice is not timely delivered, the note’s balloon payment due date is extended and enforcement delayed until the 90-day notice requirements have been met. [CC §2966(d)]
Extension of due date
A provision in a note may grant the borrower an extension of the due date for a final/balloon payment.
For example, a due date by prior agreement may be extended on the borrower’s payment of all scheduled installments without delinquency, or on other consideration agreed to, such as a charge or change of terms.
In the instance of a due date on a carryback note, the buyer needs to consider negotiating a provision to extend the due date when:
- the term of the note is for a short period of time (less than seven years); and
- the buyer is uncertain about the source and availability of funds for payoff.
Discount for early payoff
Typically in carryback financing situations, either on a consumer or business mortgage, a buyer’s right to pay off the note early is usually documented as an option to buy the note at a discount.
A carryback seller who prefers to be cashed out before the due date set in the note may include a discount provision to encourage the buyer to pay off the note within a lesser time period than the due date period. The provision may be structured to give the buyer several months to exercise the option to pay off the debt at a discount on the face value (or remaining balance) of the note.
By exercising the option, the buyer who executed the note may either:
- buy the note and trust deed from the seller by an assignment; or
- request a reconveyance of the trust deed.
Right of first refusal
When the mortgage holder, typically limited to a carryback seller, decides to sell the note, a right of first refusal provision contained in the note or a separate agreement allows the owner of the secured real estate to purchase or pay off the note.
If the mortgage holder decides to sell the trust deed note, the borrower is notified of the amount necessary to purchase or pay off the note.
The payoff amount will be the sales price of the note and is set based on the lesser of either:
- the mortgage holder’s listing of the trust deed note for sale, or their offer to sell the note; or
- an offer from an investor to purchase the note, which, if accepted, is to be contingent on the borrower declining to exercise their right of first refusal to pay off the note.
The borrower, to exercise the right of first refusal, then matches the price.
However, when granting the right of first refusal, the mortgage holder needs to be careful not to set the price in advance by stating a price in the right of first refusal provision.
If the payoff amount is set by a prior agreement, the seller is bound by the amount, even if market conditions allow for a higher value when the seller decides to sell the note.
To protect the mortgage holder from loss due to a default on the trust deed note, they may require a third-party guarantor with sufficient assets to become liable on call for all amounts due under the mortgage, called a put option.
By guaranteeing the mortgage, a guarantor literally agrees to buy the note from the mortgage holder in the event of default, a legal process called subrogation or equitable assignment.
The mortgage holder has three types of third-party assurances:
- a co-owner’s signature on the note and trust deed;
- a co-signer’s signature on the note only; or
- a personal guarantee of the note by someone other than the borrower.
When a third party signs the note, the third party becomes liable for repayment of the note, subject to anti-deficiency rules protecting:
- co-owners on any type of foreclosure; and
- non-owner co-signers on a trustee’s foreclosure. [Calif. Code of Civil Procedure §580b]
However, if a third party agrees to guarantee the mortgage, a guarantee agreement is signed by the third party and is enforceable separately from the mortgage.
Guarantors on a consumer mortgage are not required to meet ATR or QM debt or credit requirements. [12 CFR §1026 Supplement I Official Interpretation to 43(c)(2)(vi)]
If the mortgage is guaranteed, a provision is included in the note to reference the separate guarantee agreement.
By referencing the separate guarantee agreement in the note, everyone involved is on notice of the additional security for the mortgage provided by the guarantee.
An exculpatory clause in a note converts a mortgage holder’s recourse paper into nonrecourse paper.
When the carryback mortgage is either separately or additionally secured by property other than the property sold, the note automatically becomes recourse paper. Thus, the buyer providing other security needs to consider negotiating for inclusion of an exculpatory clause as a provision in the note.
When an exculpatory clause is included in a note, the mortgage holder may not obtain a money judgment for any deficiency on a judicial foreclosure of the secured properties. Thus, the exculpatory clause in the note provides the buyer with anti-deficiency protection.
A lender or carryback seller involved in negotiating a mortgage with an out-of-state buyer needs to include a choice-of-law provision to assure judgments arising from disputes on the mortgage will be based on existing California law. [See Chapter XX; seeFigure 4 §2.3]
If the state law to be applied is not agreed to, the state law applied will be based on the state with the greater interest in the result.
Editor’s note — The governing law provision has no impact on federal laws and regulations which pre-empt state laws.