Mortgages and Finance Instruments

The rule: the note and the mortgage

A financed purchase creates two documents:

• The promissory note — the borrower's personal promise to repay the debt; it is the evidence of the loan and states the amount, rate, and terms.
• The mortgage (or in some states a deed of trust) — the security instrument that pledges the property as collateral, giving the lender the right to foreclose if the borrower defaults.

The borrower who pledges the property is the mortgagor; the lender is the mortgagee. (Memory aid: the borrowER gives the mortgage; the lendEE... reverse of intuition — so just memorize: mortgagor = borrower, mortgagee = lender.) New York uses the lien theory: the borrower keeps title and the lender holds a lien, not title.

The rule: common mortgage clauses

• Acceleration clause — on default, lets the lender declare the entire balance due at once (the prerequisite to foreclosure).
• Due-on-sale (alienation) clause — the balance becomes due if the owner sells or transfers the property; it blocks a buyer from assuming the loan without lender consent.
• Prepayment clause / penalty — a charge for paying the loan off early (lenders lose future interest); many consumer loans limit or bar these.
• Defeasance clause — requires the lender to release the lien (issue a satisfaction) once the debt is fully paid.
• Subordination clause — a lender agrees its lien will take lower priority to another.
• Escrow (impound) clause — the lender collects 1/12 of annual taxes and insurance with each payment and pays those bills; the account is the escrow/impound account.

The rule: amortization, LTV, and points

• Amortization — a fully amortized loan is repaid by equal periodic payments that cover interest plus principal, so the balance reaches zero at term's end. Early on, most of each payment is interest; over time the interest portion falls and the principal portion rises. A term (interest-only) or balloon loan is not fully amortized and leaves a lump sum due.
• Loan-to-value (LTV) = loan ÷ value (or price, whichever is lower). It measures risk. A higher down payment = lower LTV = less lender risk.
• Private mortgage insurance (PMI) — required on a conventional loan when the borrower puts less than 20% down (LTV above 80%); it protects the lender against default and can be removed once enough equity builds.
• Discount points — prepaid interest to buy down the rate; one point = 1% of the loan amount.

The rule: loan types and the secondary market

• Conventional loan — not insured or guaranteed by the government; the lender relies on the borrower's credit and the collateral.
• FHA-insured and VA-guaranteed loans — government-backed programs with lower down-payment requirements (FHA) or benefits for veterans (VA).
• Fixed-rate (rate constant for the whole term) vs. adjustable-rate (ARM) (rate periodically resets to an index + margin, within caps).
• Secondary mortgage market — where lenders sell existing loans to investors (including Fannie Mae and Freddie Mac), replenishing cash so they can lend again and keeping mortgage money liquid. Fannie/Freddie do not lend to consumers directly; they buy loans and set the conforming standards lenders follow.

Worked example — interest portion of the first payment

A borrower takes a $300,000 loan at 6% annual interest. What is the interest portion of the first monthly payment?

• Annual interest = 300,000 × 6% = 300,000 × 0.06 = $18,000.
• Monthly interest = 18,000 ÷ 12 = $1,500.

The first payment's interest is $1,500. (Any amount paid above $1,500 that month reduces principal.) Recomputed: 300,000 × 0.06 ÷ 12 = $1,500. ✓

Worked example — down payment, LTV, and points

A home sells for $250,000; the buyer puts 20% down.

• Down payment = 250,000 × 20% = 250,000 × 0.20 = $50,000.
• Loan amount = 250,000 − 50,000 = $200,000.
• LTV = 200,000 ÷ 250,000 = 0.80 = 80%. At exactly 80% LTV, PMI is generally not required (PMI triggers above 80%).

Now the buyer pays 2 discount points on the $200,000 loan:

• Cost = 200,000 × 2% = 200,000 × 0.02 = $4,000. (One point would be $2,000; two points, $4,000.) ✓

Worked example — how an amortized payment splits

Take that $200,000 loan at 6% with a fixed monthly payment of, say, $1,199 (principal + interest).

• Month 1 interest = 200,000 × 0.06 ÷ 12 = $1,000. So $1,000 of the $1,199 payment is interest and $199 reduces principal. New balance = 200,000 − 199 = $199,801.
• Month 2 interest = 199,801 × 0.06 ÷ 12 = $999.01. Now $999.01 is interest and $199.99 is principal — the principal slice grew and the interest slice shrank, even though the total payment stayed the same.

That is amortization in action: a level payment whose mix shifts steadily from mostly interest toward mostly principal, reaching a zero balance at the end of the term. The exam does not usually ask you to build a full schedule — it asks you to know the direction of the shift (interest down, principal up) and to compute the first month's interest exactly as above.

Key figures — Chapter 10

- Note = promise to repay; mortgage = pledge of collateral. Mortgagor = borrower; mortgagee = lender. NY = lien theory. - Clauses: acceleration (whole balance due), due-on-sale (blocks assumption), prepayment penalty, defeasance (release on payoff), escrow (taxes + insurance). - Amortized loan: interest share falls, principal share rises over time. - LTV = loan ÷ value. PMI required on conventional loans below 20% down (LTV > 80%). - 1 point = 1% of the loan. - Secondary market (Fannie Mae, Freddie Mac) buys loans to keep money liquid; does not lend to consumers.

Common traps — Chapter 10

• Mortgagor vs. mortgagee — the -or is the borrower. Reverse it and you miss a family of questions.
• PMI protects the lender, not the borrower, and it is a conventional-loan feature keyed to the 20% down / 80% LTV line.
• Fannie/Freddie do not make loans to buyers — they operate in the secondary market.
• Acceleration vs. due-on-sale — acceleration triggers on default; due-on-sale triggers on transfer.
• In an amortized loan the payment is level, but its mix shifts — more principal each month, not more interest.

Check yourself — Chapter 10

1. In a mortgage, what is the borrower called?
2. A $400,000 loan at 6% — what is the first month's interest?
3. Below what down payment is PMI generally required on a conventional loan?
4. Which clause lets a lender demand the whole balance upon default?
5. What do Fannie Mae and Freddie Mac do in the mortgage system?

Answers: 1. The mortgagor. 2. 400,000 × 0.06 ÷ 12 = $2,000. 3. Under 20% down (LTV over 80%). 4. The acceleration clause. 5. They buy loans in the secondary market, keeping mortgage money liquid (they do not lend to consumers).