Real Estate Financing
Understand mortgage types, government-backed loans, discount points, qualifying ratios, and the lending process.
1. Mortgage Basics: Promissory Note vs. Mortgage
In real estate financing, two key documents are executed at closing: the promissory note and the mortgage (or deed of trust, depending on the state). The promissory note is the borrower's personal promise to repay the debt — it creates personal liability. The mortgage (in lien theory states) or deed of trust (in title theory states) is the security instrument that pledges the property as collateral for the loan. If the borrower defaults, the lender can foreclose on the property.
The borrower is the mortgagor (one who gives the mortgage). The lender is the mortgagee (one who receives the mortgage). Remember: mortgagOR = bORrower. A common exam trick is reversing these terms — don't fall for it.
In lien theory states, the borrower retains title to the property and the mortgage is a lien. Foreclosure requires judicial process. In title theory states, the lender holds legal title until the loan is paid. Foreclosure can be non-judicial (trustee sale). Some states use intermediate theory — lender holds title only upon default.
2. Types of Mortgages
Fixed-Rate Mortgage: The interest rate remains constant for the entire loan term (typically 15, 20, or 30 years). Payments are level and predictable. The 30-year fixed-rate mortgage is the most common loan product in the United States. Early payments primarily go toward interest; later payments shift toward principal. This shift is tracked using an amortization schedule.
Adjustable-Rate Mortgage (ARM): The interest rate changes periodically based on a financial index (such as the SOFR, formerly LIBOR, or the Constant Maturity Treasury rate). ARMs typically start with a lower initial "teaser" rate. Key ARM features include the index (benchmark rate), the margin (lender's markup added to the index), adjustment period (how often the rate changes), and caps (limits on rate increases — periodic cap and lifetime cap). A 5/1 ARM means the rate is fixed for 5 years and adjusts annually thereafter.
Interest-Only Mortgage: The borrower pays only interest for a specified period, after which payments increase to include principal. Balloon Mortgage: Features regular payments for a short term (e.g., 5 or 7 years) with the remaining balance due in a large lump sum at maturity. Reverse Mortgage: Available to homeowners aged 62+, it allows them to convert home equity into cash without monthly payments — the loan is repaid when the borrower moves out, sells, or dies.
Purchase Money Mortgage: The seller provides financing to the buyer, typically as a second mortgage. Also called seller financing or a "take-back" mortgage. Blanket Mortgage: Covers multiple parcels of land. Package Mortgage: Includes both real property and personal property (appliances, furniture) under one loan. Wraparound Mortgage: A new mortgage that includes the existing loan balance plus additional funds.
3. Government-Backed Loan Programs
| Program | Agency | Key Features | Down Payment |
|---|---|---|---|
| FHA | Federal Housing Administration | Insures loans made by approved lenders; lower credit requirements; MIP required (upfront + annual) | As low as 3.5% |
| VA | Department of Veterans Affairs | Guarantees loans for eligible veterans, active-duty, and surviving spouses; no down payment required; funding fee applies | 0% |
| USDA | U.S. Department of Agriculture | Rural housing loans for low-to-moderate income buyers in eligible rural areas; 100% financing available | 0% |
| Conventional | Fannie Mae / Freddie Mac | Not government-insured; conforming loan limits apply; private mortgage insurance (PMI) required if <20% down | Typically 5-20% |
The FHA 203(b) program is the most common FHA loan for purchasing a primary residence. FHA 203(k) allows the borrower to finance both the purchase and rehabilitation of a property in one loan. The VA loan guarantee protects the lender against loss, not the borrower — the VA guarantees a portion of the loan, which enables 0% down payment and competitive rates.
The FHA insures loans; the VA guarantees loans. Neither agency lends money directly — they work through approved private lenders. Also: FHA loans require MIP (Mortgage Insurance Premium), conventional loans with less than 20% down require PMI (Private Mortgage Insurance). Know the difference.
4. Discount Points and Loan Costs
Discount points are prepaid interest that the borrower pays at closing to reduce the interest rate on the loan. One point equals 1% of the loan amount. The general rule: each point paid reduces the interest rate by approximately 0.25% (though this varies). The decision to pay points depends on how long the borrower plans to keep the loan — it typically takes several years to break even on points.
Origination fee is charged by the lender for processing and underwriting the loan, typically 1% of the loan amount. This is separate from discount points. Prepayment penalty is a fee charged if the borrower pays off the loan early. The Truth in Lending Act (TILA) requires lenders to disclose the Annual Percentage Rate (APR), which reflects the total cost of the loan including interest, points, and fees expressed as an annual rate. The APR is almost always higher than the stated interest rate because it includes points and fees.
5. Qualifying Ratios
Lenders use two primary ratios to determine whether a borrower qualifies for a loan:
Housing Expense Ratio (Front-End Ratio): The monthly housing payment (principal, interest, taxes, and insurance — PITI) divided by the borrower's gross monthly income. Conventional lenders typically look for a ratio of 28% or less. FHA allows up to approximately 31%.
Debt-to-Income Ratio (Back-End Ratio): The total of all monthly debt obligations (housing payment plus car payments, credit cards, student loans, etc.) divided by gross monthly income. Conventional lenders typically look for 36% or less. FHA allows up to approximately 43%, though compensating factors can push this higher.
If a borrower earns $6,000/month gross income, what's the maximum monthly housing payment under the 28% front-end ratio? Answer: $6,000 × 0.28 = $1,680. The maximum total monthly debt under a 36% back-end ratio is $6,000 × 0.36 = $2,160.
PITI = Principal + Interest + Taxes (property tax) + Insurance (homeowners insurance, plus PMI if applicable). This is the total monthly housing expense used in qualifying ratios. Lenders also consider HOA dues as part of housing expense in many cases.
6. Foreclosure and Alternatives
When a borrower defaults, the lender may initiate foreclosure — the legal process of terminating the borrower's right of redemption and selling the property to satisfy the debt. There are two types: judicial foreclosure (court-supervised, used in lien theory states) and non-judicial foreclosure (trustee sale under a deed of trust, used in title theory states).
Before foreclosure, alternatives include loan modification (changing loan terms), forbearance (temporary payment reduction or suspension), short sale (selling the property for less than the loan balance with lender approval), and deed in lieu of foreclosure (borrower voluntarily transfers title to the lender). The borrower's equitable right of redemption allows them to cure the default and reclaim the property before the foreclosure sale. Some states also provide a statutory right of redemption allowing the borrower to reclaim the property for a period after the sale.
📖 Key Terms
- Mortgagor — Borrower (OR = bORrower)
- Mortgagee — Lender
- Amortization — Gradual repayment of loan through regular payments
- PITI — Principal, Interest, Taxes, Insurance
- Discount Point — Prepaid interest; 1 point = 1% of loan amount
- APR — Annual Percentage Rate (includes interest, points, fees)
- ARM — Adjustable-Rate Mortgage
- LTV — Loan-to-Value ratio (loan amount ÷ property value)
- PMI — Private Mortgage Insurance (conventional, <20% down)
- MIP — Mortgage Insurance Premium (FHA loans)
- Short Sale — Sale for less than loan balance with lender approval
- Redemption — Borrower's right to cure default before foreclosure sale
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