BASICS OF TRUST DEED/MORTGAGE INVESTING

The purpose of this narrative is to provide some basic information which you should know if you plan to purchase existing promissory notes or fund loans, the repayment of which is secured by deeds of trust or mortgages (hereinafter referred to as Td's and Mort's) recorded against real property. The funding of a loan or the purchase of a promissory note is an investment which involves some risk. Prior to becoming a lender of loans or a purchaser of promissory notes, you should be able to answer the following questions:

1. What is a 'promissory note?' A promissory note is a written promise to pay or repay a certain amount of money at a certain time, or in a certain number of installments, or on demand to a named person. It usually provides for payment of interest, and its payment can be secured by a Td or Mort.

The person receiving the loan proceeds ( borrower, payor, vendee, mortgagor or trustor ) becomes obligated to repay the debt by signing a promissory note to the ( lender, payee, vendor, mortgage or trustee ) which specifies: (1) the amount of the loan (principal, face amount); (2) the interest rate (interest); (3) the amount and frequency of payments (debt service); (4) when the borrower must repay the principal (due date); and (5) the penalties imposed if the borrower fails to timely pay or tender a payment (late charge) or decides to pay a portion or all of the principal prior to the due date (prepayment penalty). The promissory note identifies the borrower and the person who will receive the payments (lender or note holder).

2. How do you obtain a promissory note? You obtain a promissory note by either making a loan or purchasing an existing promissory note. When making a loan may be subject to an interest rate ceiling impose by the state government where the property is located. Charging a rate in excess of this ceiling is referred to as usury.

Most seller carried td's & Mort's are written by the seller and or buyer of the property being sold usually because the seller wants to be the bank and receive payments, income tax favored over a long period of time. Or they could not sell with conventional financing.

In terms of seller carried back financing, any thing, two minds can think of, can and will be put into the writing of a note ( with the above parameters ) used to sell a property. i.e I knew of a situation where seller and buyer agreed to terms of selling a rural house and land on a note td with annual interest only payments and a balloon payment in ten years . The interest payments were one beef per year, yes one 1200 lb. head of cattle per year. A valid note.

3. What secures your investment? Your note is secured by a Td or Mort recorded against the title of the borrower's property (the Property). Unlike deposits in a bank or savings and loan, which are generally insured by a federal agency (such as FDIC) and may usually be withdrawn with limited notice, the promissory note: (1) involves some risk to principal (a typical feature of all investments); (2) establishes a specific and predetermined period of time for the repayment of your investment; and (3) does not benefit from insurance issued by a federal agency.

In a Td or Mort, the borrower (trustor) transfers the Property, in trust, to an independent third party (trustee) who holds conditional title on behalf of the lender or note holder (beneficiary) for the purpose of exercising the following powers: (1) to reconvey the Td or Mort once the borrower satisfies all obligations under the promissory note; or (2) to sell the Property if the borrower defaults (known as a foreclosure). Foreclosure involves the process of selling the Property to a third-party bidder or, in the absence of a sufficient third-party bid, acquiring title to the Property. The foreclosure sale, in most cases, satisfies the debt.

Depending upon the method of foreclosure, the nature of the loan, the circumstances of origination, and the value of the Property, you may or may not be able recover your entire investment. For example, if a third party bids at a non-judicial foreclosure sale an amount equal to or greater than the amount you are owed (including fees, costs, and expenses of the foreclosure), your investment would be fully paid. On the other hand, if you bid the full amount that is owed to you, including all foreclosure fees, costs, and expenses (full credit bid) and there are no third-party bids, you will generally be limited to the Property and its value as the source of repayment of your investment.

If the loan is a non-purchase money mortgage (Td) and the Property's value is insufficient to recover all you are owed, a judicial foreclosure coupled with an action for a deficiency judgment may be the only way to recover your investment; i.e., collect any difference between the amount received at the foreclosure sale and the amount of money the borrower owes you.

Remember, the Property identified in the Td or Mort is what secures your investment.

Essential Elements of Trust Deed or Mortgage Investments:

1. Fair market value and equity in the Property and the security for your loan.

2. Borrower's financial standing and creditworthiness.

3. Escrow process involving the funding of the loan or the purchase of the note.

4. Documents and instruments describing, evidencing, and securing the loan.

5. Loan servicing provisions, authority and compensation, if any.

6. Recovering your investment when the borrower fails to pay.

The information that follows will assist you in considering the elements of a loan transaction which you should understand before funding a loan or purchasing a promissory note.

1. MARKET VALUE AND EQUITY OF THE PROPERTY AND THE SECURITY FOR YOUR LOAN

The fair market value of the Property is critical to your decision to lend your funds or purchase a promissory note because there is a possibility that the only way to recover your investment is through the sale of the Property. Therefore, the market value of the Property should be correctly estimated and the total loan-to-value ratio properly analyzed as illustrated below. This information should be made available to you before you commit your money to the transaction.

1. Market Value: The sale price, the cost to build, or the value in use to a specific owner does not necessarily represent the fair market value of the Property. A fair market value opinion requires consideration of comparable sales and other market data by a competent professional.

The fair market value conclusion may be presented in the form of an appraisal report by license a real estate appraiser (a licensed real estate appraiser can give you a drive by report that costs about half what an appraisal with interior inspection cost, and if you are buying an existing note the payor has no interest in or helping you with your note purchase) or a BPO. While the note buyer customarily pays for the cost of the appraisal report, which should be reviewed by you in advance of funding the loan or purchasing of the promissory note. You should make every effort to evaluate the appraisal and the appraisal document.

2. Loan-to-Value Ratio: The total loans against the property, including your loan, divided by the fair market value of the property determines the loan-to-value ratio. For example, if a borrower has a first deed of trust or mortgage in the amount of $25,000 and is requesting a second deed of trust or mortgage in the amount of $40,000 and no other liens will be placed against the property, which is valued at $100,000, the loan-to-value ratio is 65% ($25,000 + $40,000 divided by $100,000 = 65%).

The lower the loan-to-value ratio and the greater the borrower's equity, the more incentive for the borrower to protect the equity in the property (i.e., sell or refinance the property if unable to make payments under your promissory note) or for a third-party bidder to purchase the property at a foreclosure sale. If the property is over encumbered (the total loans or other liens exceed a reasonable loan-to-value ratio or exceed the market value), the property will provide little or no security for your investment. A sufficient equity should be maintained in the property to allow for the fees, costs, and expenses that you will incur in foreclosing if that becomes necessary.

NOTE; The borrower's equity is not the same as the protective equity. The borrower's equity is the difference between the market value of the property and the total indebtedness secured by the property. The protective equity is the difference between the fair market value of the property and the total indebtedness of loans senior to your loan, but does not include loans junior to your loan.

The existence of a lien junior to your loan will diminish the borrower's equity, increase the borrower's payments or debt service, and reduce the borrower's ability to refinance. In the event of a default regarding senior loans (liens), beneficiaries who have a right of a lien upon a property of another (lienors) and who are junior are entitled to protect their security interest in the property by paying the borrower's delinquencies on senior liens and/or by commencing their own foreclosure action. Therefore, junior lienors should keep informed of defaults in connection with senior loans (liens).

3. Preliminary Report (PRELIM): Also known as the Preliminary Title Report, is prepared by a title company and is an offer to insure and does not provide conclusive information about the status of all documents and the property until Title company closes the escrow.

Title insurance companies offer different types of coverage. You should ask the title company from whom the report was obtained for an explanation of the different types of coverage available (e.g., Lenders Policy, CLTA and ALTA) and to what extent you are insured.

The current PRELIM should provide the following information regarding the property:

1. The name(s) of the owner(s); Chain of title

2. Legal description, street address (if available), and the assessor's parcel number (APN);

3. Assessor's plat map, which illustrates the configuration, dimensions, and general location of the property;

4. Assessed valuation;

5. Existence and priority of liens and encumbrances:

6. The name of the owner(s) of existing lien(s); i.e., the owner of record of any deed of trust or mortgage (lien) which you may be purchasing;

7. Requests for notices concerning status of the liens, notices of default (NOD), and notices of trustees' sale (NOS)

8. Notice of a lawsuit or bankruptcy affecting the property;

9. Potential off-record interests of a spouse or other party.

In reviewing the current PRELIM for the above information, be alert to various problems which might affect the fair market value and equity of the property and the security for your loan. If any of the following issues are encountered ask the escrow or title officer for a full explanation.

1. The borrower is not the owner, or the borrower is only one of the owners of record, or a person other than the borrower has an unrecorded interest in ( or claim against ) the property and has not executed the loan documents

2. The ownership (estate) is other than fee title ( i.e., a lease hold estate, life estate or other), or there is an exception noted regarding the deed transferring title to the property to a present purported owner of record.

3. The property does not have direct access to a public road, has only easement access, or is unusually configured.

4. There is a substantial difference between assessed and appraised value, or the assessed valuation does not include improvements while the appraisal report includes both land and improvements.

5. There are: (a) taxes, assessments, or association dues unpaid or delinquent; or (b) deeds of trust, judgment liens, IRS tax liens, claims, or bonds which may or may not be discharged from the proceeds of the loan.

6. There is a NOD or NOS which will remain because the lien is not being removed by the proceeds of the loan.

NOTE: A default may indicate that the borrower's capacity and desire to repay the loan is in question and/or that the security for your loan may be impaired unless the notice of default or notice of sale of the senior lien which is to remain is rescinded.

7. There are encumbrances remaining that have not been explained or considered.

8. There are unresolved lawsuits and active bankruptcies.

9. The owner of record of the deed of trust securing the promissory note you are purchasing is other than the person from whom the purchase is being made.

If you have any questions concerning the PRELIM, ask your title officer for assistance.

2. BORROWER'S FINANCIAL STANDING AND CREDIT WORTHINESS

The borrower's ability to repay the loan involves the 'capacity' and 'desire' to make the loan payments.

The borrower's capacity is measured by: income; job position and stability; and overall financial standing, including assets, liabilities, and net worth, and any profit or losses incurred as the result of any business or investment activity. This information is reflected in the borrower's 'Loan Application,' which may be accompanied by a 'Financial Statement' if the borrower is either self-employed or involved with significant business or investment activity. This information is easy to get if you are the lender. However when buying an existing note you may be able to have the payor provide you with this information though this is not usually the case. The payor of an existing note has no reason to give you the buyer any information what so ever. In most cases you will have to rely on the information you obtain from a current credit report which you will have to pull. The note seller (mortgagee) however can give you permission to pull credit on his payor (as permitted by the Federal Fair Credit Reporting Act, Section 604 (a)(3)(E) amended Sept.30, 1997 and applicable state law)

To verify the borrower's representations about capacity to pay, you may examine with permission:

a) Verification of employment;

b) Income tax records;

c) Verification of cash deposits or other assets;

d) Statements from existing lenders reporting amounts owed (beneficiary or payoff demand statements).

The desire to repay is based on the borrower's past performance in handling credit. To verify the borrower's representations about desire to pay, you may ask to review:

a) A credit report;

b) Reports providing payment history on existing loans, including the number of late Payments (loan status reports);

c) Credit references.

When you get a copy of the note check to make sure that the face amount, interest, payments, number of payments are accurate. Many times buyer and seller have calculated these and they are very wrong

Always get from a note seller, if there is a building on property copy fire insurance with a note seller as loss payee. Most standard form trust deed and mortgages have a clause that payor must have the building insured and if they don't they are in violation of the contract and could have the loan called or at least you could force place insurance which they will have to pay

When considering the borrower's capacity and desire to repay, you should ask whether the borrower has, immediately preceding the request for the loan, borrowed a substantial amount of money. A significant amount of concurrent borrowing may indicate the borrower is experiencing difficulty meeting his or her financial commitments. Extensive borrowing may make it more difficult for the borrower to meet financial commitments.

Before closing and after you have been satisfied with all documents and the prelim, it's a good idea to send payor an estoppel to payor or call payor and verify a note amount, when was the first payment, payment amount, interest rate, has there been any payments other than agreed (I have seen a situation where payor was making double payments to reduce principal balance but note seller never reviled any such information), what he thinks the pay off amount is. Have note seller furnish you with copies of payments made or bank statements showing deposits

3. ESCROW PROCESS INVOLVING THE FUNDING OF THE LOAN OR THE PURCHASE OF THE PROMISSORY NOTE

Your funding of a loan or purchase of a promissory note should be transacted through an 'escrow.' An escrow is opened when money, documents, instruments, and written instructions regarding the transaction (escrow instructions) are conditionally delivered by the principals to a third party (escrow agent or attorney).

The escrow instructions set forth the conditions which must be satisfied or waived before the escrow agent or attorney may disburse your funds to either the borrower or the note holder. These conditions include, but are not limited to: (1) removal of certain liens; (2) payment of delinquent taxes; (3) execution and delivery of the promissory note and deed of trust or execution and delivery of the assignment or endorsement of the promissory note and assignment of deed of trust (if you are purchasing an existing promissory note); (4) selection of title insurance coverage; and (5) recording of the deed of trust or assignment of deed of trust concurrently with the delivery of funds pursuant to the escrow instructions.

The information in the escrow instructions should be consistent with your understanding of the loan transaction. Compare the promissory note and deed of trust with what you were told at the time you agreed to make the investment. Before you approve of the escrow instructions and loan documents, make sure you have received an explanation and you have understood that which you have been told.

Both the promissory note and deed of trust should state the name of the borrower and you as the lender and note holder or the assignee or endorsee of the note holder. You should not deliver your funds to either the escrow agent or attorney unless your instructions identify a specific promissory note and deed of trust (or interest therein).

The escrow instructions should require the promissory note and deed of trust be delivered to you or an independent custodian on your behalf at the close of escrow. If you are purchasing an existing promissory note, the following should be delivered to you or and independent custodian on your behalf at the close of escrow:

- deed of trust or mortgage ( THE ORIGINAL)

- assignment of the deed of trust or mortgage

- promissory note (THE ORIGINAL)

- assignment or endorsement of the promissory note

- title insurance policy or endorsement of the existing title policy.

- copy of fire insurance ( if a building)

Escrow 'closes' when all the conditions of the escrow instructions have been waived or satisfied, the instruments have been recorded, and the funds have been disbursed. You must receive a closing statement ( HUD-1) describing to whom and how the funds and the documents were disbursed.