This article reviews the types of notes used in real estate secured transactions.
Evidence of the debt
Almost all real estate sales hinge on the financing of some portion of the purchase price. The buyer promises to pay a sum of money, in installments or a single payment at a future time, either to the seller of the real estate or a lender who funds the sales transaction.
Given in exchange for property or a loan of money, the promise to pay creates a debt owed by the borrower in favor of the seller or lender to whom the promise is made.
Usually, the promise to pay is set out in a written document called a promissory note, signed by the buyer/borrower. A promissory note merely represents an underlying debt owed by one person to another. The signed promissory note is not the debt itself, but evidence of the existence of the debt.
The borrower, called the debtor or payor, signs the note and delivers it to the lender or carryback seller, also called the creditor.
The note can be either unsecured or secured. If the note is secured by real estate, the security device which should always be used is a trust deed. When secured, the debt becomes a voluntary lien on the borrower’s real estate or the property purchased, as described in the trust deed.
The promissory note
Notes are categorized by the method for repayment of the debt:
installment notes; and
The installment note is used for debt obligations with constant periodic repayments in any amount and frequency negotiated.
Variations of the installment note include:
Finally, notes are further distinguished based on interest rate calculations:
fixed interest rate notes; and
variable interest rate notes, commonly called adjustable rate mortgages (ARMs).
Installment note, interest included
An interest-included installment note with constant periodic payments produces payments containing diametrically varying amounts of principal and interest. Principal reduction (on the loan) increases and interest paid decreases with each payment. [See first tuesday Form 420]
Each payment is applied first to the interest accrued and owing on the remaining principal balance through the end of the payment period, typically monthly. The remainder of the payment is then applied to reduce the principal balance of the debt.
Interest-included installment notes may either:
be fully amortized through constant periodic payments until paid; or
include a final/balloon payment after a period of installment payments, called a due date.
Installment note, interest extra
Interest-extra installment notes call for a constant periodic payment of principal on the debt. In addition to the payment of principal, accrued interest is paid concurrently with the principal installment.
The principal payments typically remain constant, from payment to payment, until the principal amount is fully paid or a due date occurs. Accordingly, the interest payment decreases with each payment of principal since the interest is paid on the remaining balance. [See first tuesday Form 422]
Thus, unlike an interest-included note, the amount of each scheduled payment of principal and interest on an interest-extra note is not constant from payment to payment.
For example, the first payment of interest is based on the entire original unpaid balance of the interest-extra note. The second interest payment will be on the principal amount remaining after the principal reduction resulting from the first payment. To set the amount of each periodic payment, recalculation of the accrued interest paid with each principal payment will continue until the entire note is fully paid.
A straight note calls for the entire amount of its principal to be paid in a single lump sum due at the end of a period of time, perhaps five years after close of escrow or on a fixed future date. No periodic payments of principal are scheduled, as in the installment note. [See first tuesday Form 423]
Interest usually accrues unpaid and is due with the lump sum principal installment, financing sometimes referred to as a “sleeper” trust deed. Occasionally, the interest accruing is paid periodically during the term of the straight note, such as monthly payments of interest only with the principal all due in seven years.
The straight note is typically used by bankers for short-term loans, called a signature loan, since a banker’s short-term note is not usually secured by real estate.
While the installment note and the straight note are common, variations on the interest rate and repayment schedules contained in the installment and straight notes are available to meet the specific needs of the lender and borrower. The variations include the:
adjustable rate note (ARM);
graduated payment note (GPM);
all-inclusive note (AITD); and
shared appreciation mortgage (SAM).
The adjustable rate note (ARM), as opposed to a fixed-rate note, calls for periodic adjustments to both the interest rate and the amount of scheduled payments. The interest rate will vary according to a particular index, such as adjustments every six months based on the cost-of-funds index for the 11th District Federal Home Loan Bank.
The ARM provides the lender with periodic increases in his yield on the principal balance during periods of rising and high short-term interest rates.
When an upward interest adjustment occurs, the note’s repayment schedule should call for an increase in the monthly payment to maintain the original amortization period. If the amount of the original monthly payment is retained without an increase compared to an increase in the interest rate, a longer or negative amortization results.
Graduated payment (GPM) provisions are in greater demand when interest rates or home prices rise too quickly. Fewer buyers are able to currently meet increased cost of financing home ownership.
A graduated payment schedule allows buyers time to adjust their income and expenses in the future to begin the eventual amortization of the loan. Often a GPM has a variable interest rate, called a GPARM loan.
For example, the GPM provision allows low monthly payments on origination. The payments are gradually increased over the first three- to five-year period of the loan, until the payment amortizes the loan over the desired number of remaining years.
However, any accrued monthly interest remaining unpaid each month is added to the principal balance on the carryback note, called negative amortization. The negative amortization causes the unpaid interest to bear interest as though it were principal, called compounding.
The all-inclusive trust deed (AITD) variation is used more often in carryback transactions than money lending. Lease-options, land sales contracts and AITDs become popular in times of recession, increased long-term rates and tight credit.
The lease-option and land sales contract are security devices which do not use a note to evidence the debt. Instead, they are themselves evidence of the debt owed the seller on the price. However, the lease-option and the land sales contract contain greater legal risks than the AITD, due to their recharacterization as mortgages, while producing the same financial function and tax result as the AITD.
The AITD “wraparound” note typically calls for the buyer to pay the carryback seller constant monthly installments of principal and interest. The carryback seller then pays installments due on the underlying (senior) trust deed note from the payments received on the AITD.
Another variation, the shared appreciation mortgage (SAM), is designed to help sellers attract buyers during times of tightening mortgage money, prior to a general decline in real estate sales, when no lack of buyers exists. The SAM is an example of a split-rate note. [See first tuesday Form 430]
Under a SAM note, the buyer pays a fixed interest rate, called a “floor” or “minimum” rate. The floor rate charged is typically two thirds to three fourths of the prevailing market rate but not less than the applicable federal rate (AFR) for reporting imputed interest.
In return, the carryback seller receives part of the property’s appreciated value as contingent interest when the property is sold or the carryback SAM is due.
A note documents the terms for repayment of a loan or payment of a portion of the sales price carried back after a down payment, including:
the amount of the debt;
the interest rate;
the periodic (monthly) payment schedule; and
any due date.
The amount of the note carried back on an installment sale is directly influenced by whether the carryback is:
an AITD note; or
a regular note.
An AITD note carried back by a seller will always be of a greater amount than a regular note in any given sales transaction. The AITD note includes the amount of the wrapped loans while a regular note is only for the amount of the seller’s equity remaining after deductions of the down payment.
Interest rate limitations on loans
California’s usury law limits the interest rate on non-exempt real estate loans to the greater of 10% or the discount rate charged by the Federal Reserve Bank of San Francisco, plus 5%. [Calif. Constitution, Article XV]
A non-exempt loan is usurious if the promissory note provides for an interest rate exceeding the ceiling rate on the day the note is agreed to.
All real estate loans made or arranged by a real estate broker, however, are exempt from the usury restriction. [Calif. Const. Art. XV §1]
Since seller carryback notes are not money loans but rather extensions of credit on a sale, they are not covered by the usury laws. [Boerner v.Colwell Company (1978) 21 C3d 37]
The trust deed
In most carryback transactions, the buyer gives the seller a trust deed lien on the real estate sold to provide security for payment of the portion of the price left to be paid.
The trust deed attaches the debt to the property as a lien on the property. The trust deed is recorded to give notice (and establish priority) of the seller’s security interest in the property. [Monterey S.P. Partnership v. W.L. Bangham, Inc. (1989) 49 C3d 454]
A trust deed alone, without a monetary obligation, is a worthless trust deed. Although the note and trust deed executed by a buyer in favor of the seller are separate documents, a trust deed can only exist when it secures an existing promise to pay or perform any lawful act. [Domarad v. Fisher & Burke, Inc. (1969) 270 CA2d 543]
Even though separate documents, the note and trust deed are for the same transaction and are considered one contract to be read together. [Calif. Civil Code §1642]
Satisfaction of the debt
The promissory note, once signed by the borrower and delivered to the lender or its agent, represents the existence of a debt. [Calif. Code of Civil Procedure §1933]
When a secured debt has been fully paid, the trust deed securing the debt must be removed from title to the secured property. [CC §2941]
The trustee under the trust deed will require the original note and a request for reconveyance from the lender before the trustee will release the lender’s trust deed lien from the real estate, a process called reconveyance.
If the original note has been lost or the note holder cannot be located, the trustee will require a bond be posted in its place before reconveyance.
If the lender or the trustee fails to reconvey the security interest after full payment, either may be subject to a civil fine of $300, a criminal fine of $400 and/or six months imprisonment. [CC §§2941; 2941.5]