Financing Concepts and Components

Financing is a core part of most real estate transactions. This section covers loan types, mortgage structures, and the basic mechanics behind how real estate is financed.

Methods of Financing

There are two broad categories:

• Mortgage financing - Conventional and non-conventional loans.
• Seller financing - The seller acts as the lender, often through a land contract or contract for deed.

Mortgage Financing Basics

A mortgage is a pledge of real property as security for a debt. The borrower is the mortgagor, and the lender is the mortgagee.

A deed of trust is similar, but it involves a third-party trustee who holds legal title until the loan is paid off.

Lien Theory vs. Title Theory

Table: Lien vs. Title Theory

Most states are lien theory states. This affects foreclosure processes and who technically holds title during the loan term.

Primary vs. Secondary Mortgage Markets

• Primary market - Lenders originate loans directly to borrowers.
• Secondary market - Loans are sold to investors, creating liquidity.

Government-sponsored entities like Fannie Mae and Freddie Mac are major players in the secondary market.

Types of Loans and Loan Programs

Common loan types include:

• Conventional loans - Not insured by the government.
• FHA loans - Insured by the Federal Housing Administration.
• VA loans - Guaranteed by the Department of Veterans Affairs.
• USDA loans - Rural development loans backed by the government.

Common Mortgage Clauses

• Acceleration clause - Allows lender to demand full payment if borrower defaults.
• Alienation clause (due-on-sale) - Loan becomes due if property is sold.
• Defeasance clause - Requires lender to release the lien when paid in full.
• Prepayment clause - Allows early payoff, sometimes with penalties.

Seller Financing Basics

Seller financing can help buyers qualify when traditional financing is difficult. Common forms include:

• Land contract / contract for deed - Buyer receives equitable title but legal title remains with seller until paid in full.
• Purchase-money mortgage - Seller provides a loan to the buyer.

Applied Scenario: Choosing Financing

A buyer with limited cash qualifies for an FHA loan with a low down payment. Another buyer in a rural area uses a USDA loan. The type of financing affects down payment, insurance, and closing costs.

Summary

Know the difference between lien theory and title theory, primary and secondary markets, and conventional vs. government-backed loans. Mortgage clauses appear frequently on exams.

Amortization Basics

Most residential loans are amortized, meaning each payment includes principal and interest. Early payments are mostly interest, while later payments are mostly principal. This concept appears in exam questions about loan balances and equity over time.

Fixed vs. Adjustable Rates

• Fixed-rate mortgage - Interest rate stays the same, payment is predictable.
• Adjustable-rate mortgage (ARM) - Interest rate changes after an initial period.

ARM questions often mention caps or adjustment periods.

Loan Features to Recognize

• Balloon payment - Large final payment due at the end of the loan term.
• Interest-only loan - Payments cover interest only for a period.
• Buydown - Temporary reduction in interest rate, often paid by the seller.

Exam Application Check

If a question asks which clause releases the lien when the loan is paid off, the answer is the defeasance clause.

Loan Type Comparison

Table: Loan Type Comparison

Acronym Reference

Table: Financing Acronyms

Exam Application Check

If a question asks which loan requires mortgage insurance premiums (MIP), the answer is FHA. If it asks which loan is for eligible veterans, the answer is VA.

Points and Discounting

Points are prepaid interest. One point equals one percent of the loan amount. Borrowers can pay points to reduce the interest rate over the life of the loan.

Points may be paid by the buyer, seller, or lender. On the exam, points are usually discussed in relation to closing costs and APR.

Exam Application Check

If a question asks how points affect a loan, the answer is that they reduce the interest rate but increase upfront cost.

Equity and Loan Paydown

As borrowers pay down principal, equity increases. Equity is the difference between the property's market value and the loan balance. This concept appears in exam questions about refinancing and sales.

Mortgage Payment Components (PITI)

Most exam questions use PITI to describe payment components:

• Principal - Reduces the loan balance
• Interest - Cost of borrowing
• Taxes - Property taxes, often escrowed
• Insurance - Hazard insurance, often escrowed

Understanding PITI helps with affordability and qualification questions.

Exam Application Check

If a question asks what happens when interest rates rise, the answer is that borrowing becomes more expensive and buyers may qualify for smaller loan amounts. If it asks which component reduces the loan balance, the answer is principal.

Payment Shock and ARMs

Adjustable-rate mortgages can lead to payment shock when the rate resets. Borrowers should understand caps and adjustment schedules before choosing an ARM.

Exam Application Check

If a question asks why ARMs are riskier, the answer is that payments can increase when rates adjust.