A Purchase Agreement will almost always contain a description of the amount and type of Financing that will be used in the purchase of the property. There are many styles and types of options for Financing that are relatively common such as the conventional mortgage, the adjustable rate mortgage, the FHA mortgage, as well as various types of commercial financing. As you can see, the list of types and methods of Financing is long. Each type of Financing will apply to certain situations with certain factors such as the age of the borrower, whether the property being purchased is Commercial or Residential, the amount of money being paid directly out of the buyer’s pocket, or the interest rate that the borrower desires. In fact, it is probably a fair statement to say that for most situations in which there is a Purchase and Sale of Real Estate, there is likely to be a type of Financing to go along with it. Here, we are only going to discuss the bread and butter types of Financing Arrangements, the methods that are most common and most applicable to the average Purchase and Sale of Real Estate; cash payment, the contract for deed, the standard mortgage, and assumption of a mortgage.

1) Cash Payment

First, the cash payment is the most basic form of Financing the Purchase and Sale of Real Estate. The cash payment style of Financing is as simple and to the point as it sounds. The buyer and the seller agree on a price to be paid and the buyer pays that price in full out of their own funds. Cash payment has the advantage of giving the buyer 100% equity in the property from the date of purchase. In other words, the buyer takes on no debt. On the other hand, the amount paid by the buyer is no longer able to be immediately drawn upon at a moments notice. Instead, if the buyer paying cash in full for a property desires to use some of the equity stored in their property, they would have to sell the property or take out a mortgage or some other type of loan secured by the property first. Nonetheless, the prospect of owning something like a piece of Real Estate free and clear of any obligations to a lender is sweet indeed, and for that reason the cash payment remains as a method of Financing the Purchase and Sale of Real Estate.

2) The Contract for Deed

The second common method of Financing in our discussion is the contract for deed. The contract for deed is a lot like a mortgage, but also a lot different. In the usual contract for deed, the buyer and the seller of the property agree that at the time of sale, and we use that term loosely here, the buyer is entitled to take possession of the property and is required to maintain it, pay the taxes on it, and treat the property as if it is their own. Title to the property, however, is not passed from the seller to the buyer at the time of sale. In other words, the buyer does not receive a Deed to the property. Instead, the seller retains the Deed and keeps title to the property and the buyer agrees to make some predetermined amount of regular payments to the seller, much like a mortgage, at the completion of which the seller is obligated to sign over the Deed and give title to the property to the buyer. In other words, the buyer gets to use the property as their own in practically every respect while making payments to the seller. When the property is all paid for the buyer gets title to the property free and clear, but until that time, the seller keeps title to the property and the buyer does not own the property outright. Sounds a lot like a mortgage right? Well, it is close, but there is usually one MAJOR difference between a mortgage and a contract for deed.

If a buyer has a mortgage on a piece of property and fails to make the required payments, the individual or entity that acted as the lender in the mortgage (the mortgagee) is able to foreclose upon the property. If, on the other hand, a contract for deed is used, should the buyer prove unable to make their required payments, the seller does not have to initiate lengthy foreclosure proceedings, instead their recourse lies in the forfeiture clause of the contract for deed. The traditional forfeiture clause of a contract for deed stipulates that should the buyer prove unable to make the required payment the seller is immediately able to declare the buyer in breach. The seller could then terminate the contract for deed 60 days after serving a written notice of cancellation upon the buyer, take back actual possession of the property (kick the buyer out), and keep all of the payments that the buyer may have previously made on the contract for deed. Even if a buyer were to miss only one payment, and even if that payment was the very last payment on the property, the seller gets to keep all of the money, the property, and is able to do so without spending time and money jumping through the hoops of a foreclosure action.

So why would any buyer in their right mind use a contract for deed to purchase a piece of property? In truth, buyers request a contract for deed, believe it or not. Often, a contract for deed is utilized in the Purchase and Sale of Real Estate because the buyer is unable to find adequate Financing from a more traditional mortgage lender. The reason may be because the buyer does not have enough money to make the down payment required to get a mortgage, or the buyer could have bad credit due to some circumstance beyond their control. The fact is, banks are not always willing to lend money to everyone for a variety of reasons. Whether the investment is not good, they are already overburdened, or there are just too many red flags coming up for the proposed borrower, banks have learned before, and have recently learned again, that it is not always a good idea to give someone a mortgage. A contract for deed usually saves the buyer substantial sums in the payment of closing costs ordinarily charged by banks such as operational fees and loan origination fees. So, if the buyer is willing to accept the fact that they could lose their property in 60 days if they don’t meet their obligations, and the seller is willing to wait on collecting the full amount of their payment for a bit, then the contract for deed is not necessarily a bad option.

3) Assumption

Another common way to finance the Purchase and Sale of Real Estate is known as an assumption. Under an assumption, the buyer agrees to assume the current debt obligations of the seller as to the property being sold. Therefore, if the seller has a mortgage in place on the property, then the buyer simply takes over the mortgage. Similarly, if the seller has a contract for deed on the property, or some other form of Financing, the buyer takes over the obligations of the seller and makes payments thereon. Essentially, the buyer just steps right into the shoes of the seller, rather than having to go out and find their own Financing.

The reason that assumptions are less common is that they are not always available options under existing loans. Many, if not most mortgages, contain what is called a due on sale clause. The due on sale clause stipulates that if the property to which the mortgage is applied is ever sold, the entirety of the mortgage balance that remains is due and owing immediately. Thus, if the mortgage is due on sale, a buyer cannot very well assume the mortgage. Additionally, the mortgage may stipulate that it will not be assigned, or that it will not be assigned without the express consent of the lender. Finally, the seller may be forced, given certain other language that may appear within the note, to remain liable for the debt until the debt is fully paid off. So, if this is the case and the buyer forgets to make a payment or cannot make a payment, the lender may pursue the buyer, the seller, or both in order to recover whatever monies are due and owing on the debt. Therefore, assumptions have their drawbacks as methods of Financing the Purchase and Sale of Real Estate as much as they have their advantages.

4) The Standard Mortgage

The last common method of financing the Purchase and Sale of Real Estate is the most common method, the standard mortgage. The average standard mortgage is nothing more than a loan which has Real Estate given for collateral. Thus, if you buy a house and mortgage it, you are getting money from a lender and the lender is getting your promise to pay back the money, plus interest. If the money is not paid back per the terms specified in the loan agreement (the mortgage) then the lender is given the right to foreclose upon the property that was offered as collateral for the loan, and eventually to force its sale or purchase the property itself.

Generally, there are two main types of standard mortgages, the fixed rate mortgage (FRM) and the adjustable rate mortgage (ARM). These two mortgages get their names from the way in which they deal with the interest that is a part of the loan. Every mortgage has certain terms within it that deal with the rate and amount of interest that will be paid by the borrower back to the lender in exchange for the loan. In a fixed rate mortgage, the interest rate that is specified in the mortgage is fixed at that rate for the life of the loan. Take for example a mortgage that specifies that it is a 30 year $300,000 loan at a fixed rate of 6.5%. The mortgage is to last for a term of 30 years. The borrower is receiving $300,000 from the lender. The lender is receiving a promise from the borrower, which is secured by the property, that the borrower will repay the lender the $300,000 lent as well as an additional 6.5% in interest over the 30 year life of the mortgage. However, the total amount of interest that will be repaid is far above 6.5% of $300,000.

In the standard loan with a fixed rate, interest is compounded monthly and the payments that you make are always weighted more heavily towards paying off interest first. Thus, in our above example of a 30 year mortgage for $300,000 at a rate of 6.5%, the average monthly payment is likely to be about $1,900. By the time the first payment is due, after a period of only one month, you will already have accrued about $1,650 in interest. In fact, you will pay more than $1,000 in interest every month for more than 17 years! Ultimately, a loan such as this will result in interest payments of over $382,000.

An adjustable rate mortgage or ARM is similar to the fixed rate mortgage except the rate is subject to change. The common ARM will contain five important terms; 1) the index, 2) the margin, 3) the adjustment period, 4) caps, and 5) limitations on exiting. For all practical purposes, the index is the prevailing market interest rate, usually referred to as the prime rate. The index need not be linked to the prime rate, but most often this is the case. The margin is some set number, most often between 2% and 3%, that will be added to the index in order to compute the amount of interest that the borrower will owe over the current adjustment period. The adjustment period is that time, often daily with commercial loans or monthly with residential loans, during which the interest rate (index + margin) remains fixed. Caps are limits that are put in place as a way of ensuring that a given interest rate will not rise or fall too steeply during a given time period. Caps are most often monthly, annual, or for the life of the loan and can set out maximum and minimum interest rates (called floors and ceilings) such as 4% minimum and 12% maximum, or the caps can set forth a fluctuation percentage that the interest rate cannot exceed during a given cap period such as 10%. Residential home loans are actually required to contain some sort of fluctuation percentage cap on the life of the loan. Finally, many ARMs will set forth certain limitations on exiting from the mortgage early. Often, borrowers do not realize this until after the interest rate has risen so significantly that selling the property or refinancing are the borrower’s only hope of paying off the ARM.

Mortgage lenders will usually choose an ARM over a fixed rate mortgage because they tend to generate more money for the lender. This is true mainly due to the way that most mortgage lenders operate. The average mortgage lender, like average banks and lending institutions, are often not in the business keeping a borrower’s loan for all that long. In actuality, the common lender is only involved in the mortgage for a short period, after which time they sell the mortgages off, usually in bundled packages of multiple mortgages with similar terms, to investors of various forms.

Banks, the usual mortgage lender, lend out money that has been deposited with the bank by its savings customers. In return for the use of their money, the savings customers of the bank receive interest on the money that they have deposited. For that reason, banks do not see long term loans with fixed rates of interest as wise investments. If the prevailing market interest rate were ever to skyrocket above the fixed rate that a bank may hold on a long term loan, the bank could end up losing money by having to pay it out to its savings customers as interest. However, short term loans at interest rates that are 2-3% higher than the prevailing market rate stand to earn banks that lend money a great deal of money. An ARM, does just this, it turns a long term mortgage with a fixed rate, into many short term mortgages with a fixed rate.

For example, if you were to take out a 30 year ARM for $250,000, the index is the prime rate, the margin is 3%, there is a monthly adjustment period, there is a life of the loan cap of 20% fluctuation, and there is a $25,000 prepayment exit penalty. In the first month, if the prime rate is 5.5% then the interest rate at which you will be paying will be the index (5.5%) plus the margin (3%), which would come out to be 8.5% in this case. At this interest rate, you would owe about $1,922 as your mortgage payment. In month two, let us assume that the prime rate increased a quarter percent to 5.75%. The interest rate you would be paying (index + margin) would now be 8.75%, and you would owe $1,966, or $44 more than the month before. Now, assume that ten years has passed and the prime rate has soared above 12%, your interest rate would now be 15% and your monthly payment would be around $2,930 (assuming no reduction in principal has occurred to date), more than $1,000 more than the monthly payment you started with ten years earlier. Thus, ARMs like the one set out in our example work the same as a bank or lender offering the same borrower a new mortgage each and every month, making a 30 year ARM a lot like a bunch of short term fixed rate mortgages.

Now you can see why an ARM is really a way to connect numerous short term fixed rate mortgages in a row. You can also see why lenders prefer ARMs. Assuming that caps are not set too low, no matter what happens to the index, the prevailing market interest rate, the lender will make money. If the prevailing rate falls from 8% to 5%, the bank has to pay out 4% (around the usual rate) to its customers, the borrower will see a 3% decrease in their interest rate and a lower monthly payment, but the bank will still earn 4% on the money they loaned out. If the market rate swings up the borrower will pay more and the bank will earn more. Basically, the ARM is for those borrowers that like to gamble on the fact that market rates will drop and not increase, as was the case through much of the 1990s and early 2000s. Ultimately, lenders only lose on ARMs when rates continuously drop for a long period of time, or when a large amount of borrowers prove unable to meet their obligations and inundate lenders with foreclosed properties.
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