Creation of Paper
CREATION OF PAPER
Let’s change this scenario slightly. It’s the same property and the same people that are involved.
Bob still wants to buy Mary’s property All the amounts are the same but instead of going to the bank for a loan of $80,000, Bob goes to Mary and asks here to hold the $80,000 first mortgage.
When Mary says, “Yes, Ill hold the mortgage,” she is creating paper—a personally held mortgage. Mary would then be lending Bob $80,000, though she would not give it to him in cash.
The technical term for this is a purchase-money mortgage —this is a mortgage that is given to assist the purchase of real estate. It is a fairly universal term used for paper. Even in trust-deed states, we refer to this kind of transaction as a purchase money mortgage.
Mary gave Bob an $80,000 mortgage to assist in the purchase of real estate.
Let’s look at this deal from both sides and see why Bob and Mary might want to arrange financing between themselves and not involve a bank.
Why would Bob rather go to Mary than the bank? There are many reasons. One could be that it takes a lot less time to arrange a mortgage with Mary that it does to get a bank loan.
Mary doesn’t have to go to a loan committee to get approval to lend Bob money. Mary won’t charge Bob points or fees for the loan. Mary won’t check Bob out the way a bank might. Sure, she should do a credit report to make sue he is a good risk, but it won’t be anything like the bank might do. Bob and Mary can sit down and work out all the terms and conditions that are agreeable between themselves. They can decide the interest rate, the terms of the mortgage, and how much Bob will pay Mary each month. The bank is not nearly as flexible as Mary can be.
It’s clear it would be a great deal for Bob to go to Mary instead of the bank. But is it a good deal for Mary to hold the mortgage>
If Bob had gone to the bank and cashed Mary out, she would have had an additional $80,000 cash. What’s she going to do with this money? Unless she has something specific in mind, like paying cash for another home, she’ll probably put it in the bank and earn 5 or 6 percent on the money. If she holds the mortgage herself, she’ll earn more than 11 percent on her money, using the figures in out example. She’ll collect $775.00 each month for the next 360 months. (30 years).
There aren’t many investments around that will guarantee you a return in excess of 11 percent. So, one reason Mary might hold the paper herself is for the cash flow over time. If she’s looking for retirement income, this is a wonderful deal for her.
Even if she plans to buy another house, she might want to carry the paper for income. Her $50,000 in direct cash from Bob’s down payment would be more than enough for a down payment on another house, especially if she’s looking for something smaller. She might find it a tax advantage to deduct mortgage payments on here new house while collecting interest from her loan to Bob’s..
Another reason this might appeal to Mary is that she will be getting a lot more than $80,000 back over the next thirty years. In fact it will be over three times the original $80,000, for a total of $279,000. This makes holding paper very attractive.
The third reason Mary might hold this paper is the tax advantage involved. She may go to her Tax advisor and ask his opinion. He will weigh the benefits of taking the $80,000 now and paying capital gains and the other associated taxes against collecting the money over time. Mary’s tax position may change over the years, but it may be wiser to collect the money over time instead of cashing out. Now Mary has three very good reasons to hold the note herself.
Mary has agreed to hold the mortgage. She is now acting like the bank. Since this transaction is just between Mary and Bob, they could have negotiated any kind of deal they wanted. The loan could have been amortized for twenty years, or ten, five or any other period mutually agreeable. They could have computed payments as if the loan were amortized over thirty years but required that the full remaining balance be paid after five years—a balloon payment. They could write the loan in any legal way they agreed to. No one else is part of this deal. It’s just the two of them. At the closing there is no banker, just Mary and Bob, and possibly their attorneys.
Art gives Mary his $50,000 and signs the promissory note and mortgage or trust deed for the balance of $80,000. Bob then owns the real estate and Mary owns the $80,000 promissory note, mortgage and $50,000 cash. The actual mortgage and note used by Mary is exactly the same as the one the bank uses, except that Mary’s name it on it and there is no bank involved.
Mary is now free to move to the other side of town or the other side of the U.S. and as long as she stays in the fifty states, it will only cost Bob a first-class stamp to send her the $775 check each month. If Mary moves out of the country, she’ll probably set up a U.S. bank account to handle her funds so Bob will mail his check to the bank or the trustee of the account. Either way, Mary gets her money and Bob has no hassle making his payments.
Let’s skip forward and assume that twelve months have gone by since Mary sold the property to Bob. He’s made 12 payments, always right on time. Everything is going fine.
Mary has just heard about a great new investment she would like to get involved with, but she will need more cash than she has available. She may need cash for any reason, but let’s assume that her Brother is starting a business and needs cash. She trusts his judgment and sees it as a great investment, with a possible return far greater than she’s getting from Bob’s payments.
As she tries to figure a way to get some cash in a hurry, she realizes, or a financial advisor tell here that the paper she holds could be a way to get some fast money. Mary wants to sell the paper and cash out.
Mary searches the newspaper classified ads and the internet. She comes across the National Note Buyers web page, e-mails them and says “I have a mortgage I’d like to sell. Do you want to purchase it?” Richard from National Notebuyers calls Mary and asks for the details of the mortgage.
Mary explains that a year ago she sold a house to Bob and took back a mortgage for $80,000, with monthly payments of $775.00 for thirty years, but now she would like to sell it. After giving Richard all the information, Mary tells him that at the closing a she was given an amortization schedule listing each of the 360 payments she was to receive. According to her amortization schedule, after 12 payments have been made, the remaining principal balance is now $79,658.84. Mary says that if Richard gave here a check for $79,658.84 she would sell him her mortgage.
At this point Richard has a little explaining to do. Richard doesn’t plan to buy this mortgage for $79,658.84. Richard won’t pay that amount because he’ll be receiving his money over the next twenty-nine years. the time value of money affect the time value of money the value of paper. Richard has to explain to Mary why here mortgage is not worth face value, and why the dollars she receives, twenty-none years from now will be worth as much as the dollars she receives today.
Richard still isn’t quite sure Mary understands, so he asks her how much she paid the last time she saw a movie. Mary says it was about seven dollars. In ten years, the cost of a movie has gone up five dollars! The only real difference is that it’s now ten years later. Have movies gotten so much better that they can justify a five-dollar increase? Or is the dollar just buying less today?
With this or similar examples, Richard can show Mary that the money her mortgage will earn ten, twenty or thirty years from now will be worth much less that it is today. This is how Mary will see that Richard’s offer is a fair price.
Richard is not discounting Jane’s paper because he just wants to. He’s discounting it because he has to, for sound economic and financial reasons. Now Richard has to make an offer to Mary. There is no fixed amount, nor legal amount, no amount he is required to offer.
If Richard were to buy a used car, he might go to one the blue books and decide from that what he would offer to buy the car.
Before Richard begins his actual negotiation, he get as much information about the mortgage, the property and Bob’s payment record as Mary can give him. If Mary doesn’t have the all the information, he will ask her to get it and call him back.
Richard uses a Mortgage Quote Sheet to ensure that he remembers to ask all the questions and get all the answers. When he has the information he needs, he’s ready to negotiate. He doesn’t negotiate from lack of knowledge, which would be terribly risky.
The mortgage quote sheet is also one of Richard’s most important tool because it enables him to get all the information he needs on one sheet of paper. It provides him with a chart of the things that will determine whether or not the deal is worth doing.
Because he’s making an offer based on what Mary tells him, and Richard doesn’t know whether the information is accurate or whether Mary is hiding something from him, his off is conditional upon the validity of the information and the appraisal, and his approval of everything.
Richard tells Mary he can offer $50,000 for her $80,000 mortgage. Mary, understandably, is shocked. Even with Richard’s explanation of the time value of money she’d expected a lot more.
Mary may decide she doesn’t need to sell, or she may realistically look at the benefits of cash now versus cash twenty-nine years from now. For this example, we’ll keep it simple and assume Richard offered and Mary accepted.
When Mary first called Richard, she expected to get the full face value of her mortgage, but she didn’t understand the time value of money. Now she does and realizes that if she wants to cash out, she’ll have to take a discount to sell her mortgage. She needs the money, so she decides to go ahead with the deal at $50,000.
At the closing Mary will get $50,000 in cash, everything conditional on whatever Richard has stated when he made his offer. To name a couple of conditions they would be a appraisal on the property and a credit check on Art.
When the deal closes, Mary assigns her mortgage to Richard and/or Assigns or Assignee. She is paid $50,000. and walks away. She has nothing further to do with the note or Bob or her old house. Richard now owns the mortgage, the right to twenty-nine years of $775 per month payments, and all other rights written into the mortgage. The title company goes to the county recorder’s office and request it to record an assignment of mortgage, which shows that Mary has assigned her mortgage to Richard, and Richard is now the owner of that mortgage.
This deal is not DREAM. Deals like it take place all over the country each and every day
Does Mary really feel the discount? It depends. If Mary takes the money to Las Vegas and gambles it away, did she lose the value of those dollars? Yes. But suppose she take that money and invests it in a growing company her Brother has started up. The company prospers and within two years she triples her money. Did she effectively see the discount on that mortgage? No, because she used the money wisely. In two years she earned more that 50 percent of the money she’d have gotten in thirty years from the mortgage.
Who are we, Richard, or anyone else to judge what she should or should not do with the money? It’s totally up to her. We do know one thing: she’s going to sell her mortgage, not because of ignorance, but because she needs the cash now! Richard is able to provide that service. A bank will not provide it. No lending institution can provide it. They will not lend against a personally held mortgage.
UNDERSTANDING A MORTGAGE NOTE
This section is added to help understand how and why a deal is put together and what makes it work or not work. This includes knowing how real estate is financed, how and why privately held mortgages also known as “paper” and trust deeds come into existence.
Let me introduce the players who are part of our hypothetical deal. First meet Mary, has a piece of real estate she wants to sell. Next is Bob.. He wants to buy Mary’s real estate.
Mary real estate is a single-family home, which she is selling for $130,000. Bob has agreed to purchase it at that price. He has $50,000 cash to use as a down payment. He needs to finance an additional $80,000 in order to buy the house.
Mary owns the house outright, free and clear. There are no liens or back taxes against the property. This means Mary will have $130,000 cash out of the deal, less here closing costs.
I’m assuming, to make this transaction simple, that Mary owns the house free and clear. You don’t have to have a transaction free and clear of other debt. In most cases you won’t be dealing with free-and-clear property, but to make the numbers simple, lets make it free and clear.
Bob needs to borrow $80,000 to make this deal work. Where does he go for the money?
More often than not, Bob will go to a bank for his loan to purchase Mary’s house. And why not? That’s what banks are for; that’s what everyone else does.
Bob sits down with the banker, describes the property, and explains how much down payment he has. The banker does a little figuring and tells Bob his payment on a fixed-rate loan of $80,000 will be $775.00 a month for the next thirty years, assuming the property appraises okay and he qualifies for the loan.
Before the bank agrees to lend Bob the money, it checks him out and approves or disapproves his loan. This normally could take anywhere from four to eight weeks. The bank goes through Bob’s financial life with a fine-toothed comb. It wants to be very sure Bob has the means to actually repay the money. The bank will ask for a net-worth, two years of tax returns, a credit report, verification of employment, etc. The process takes a long time. The bank does not want to lend money to just anyone, especially someone who has bad credit or little net worth. The bank also wants to make sure Bob has enough money, somewhere, for the down payment.
That’s why banks are very careful, take a lot of time, and, as you know if you’ve ever bought a piece of property, are always asking for one more piece of documentation about something or other as the loan gets close to funding.
The bank also checks out the property itself. They have an appraisal on the property to learn whether the true value of the property supports the loan Bob is requesting. They also do a title report on the property. The title report tells them what other liens, if any, are against the property, what positions those liens hold (whether first, second, or third mortgages), for example) and whether property taxes have been paid. If there are taxes or outstanding liens when Art buys the property, then at closing those taxes and liens must be paid off. so that the bank has first position. The title report also reveals whether Mary holds a clear title, whether there are any covenants, conditions, and restrictions on the deed, and whether there are any easements on the property, among other information vital to determining the value of the property that will secure the bank’s loan.
The bank will be very happy with Bob’s $50,000 down payment provided the appraiser confirms the accuracy of the selling price. But it also wants to be sure Bob has an income/debt ratio that will allow him to make the payments.
Finally the bank calls Bob and tells him his loan has been approved and the banker goes over the details with Bob one more time. A date is then set for closing. At the closing, in mortgages states, Mary, Bob and their attorneys, and a representative of the bank sit around a large table to review the documents and sign the papers that transfer ownership of title to the property from Mary to Bob.
When the closing is completed, Mary has $130,000 cash to use as she pleases. Bob now owns the house and has signed a mortgage and promissory note. This is a legal promise to pay back the money. In this document all the terms are stated, such as interest rate, monthly payment, amount borrowed, as well as the parties’ names and addresses, and of course the address and legal description of the property. Bill signs this document at closing and the bank puts it in a safe place. The promissory note is like a check worth $80,000 plus interest, payable at $775. a month for thirty years.
The note is combined with another legal document called the mortgage or trust deed, which is recorded—placed on public record—at the county recorder’s office. It spells out, in detail, what Bob has agreed to. It also includes the legal description of the real estate Bob has purchased—the collateral the bank uses to secure the loan—listing the lot and block number of the property. It details what will happen if Bob doesn’t make his payments.
The mortgage document is a contract between Bob and the bank. It’s fairly standard all across the United States and Canada. In a number of states, mostly in the West, this contract is called a trust deed.
A trust deed serves the same purpose as a mortgage. It too, has a promissory note associated with it, but instead of two parties (Bob and the bank) there are three parties Bob, the bank, and a neutral third party, the trustee. The trustee is an independent person or company who hold the legal documents in trust for Bob and the bank.
When the closing is completed, Mary has her $130,000 cash, Bob has the property, and the bank has the mortgage or trust deed and the promissory note.
|-All rights reserved. Revised: December 30, 2015 .|