What clause in a mortgage allows the holder of a note to increase or decrease the interest rate?

Module 2: Financing Real Estate Transactions

Mortgages

The most common ways homebuyers finance home purchases are with mortgages. A mortgage is a legal encumbrance on property – it is a loan for which property is the collateral. The lender loans money which must be paid back, with interest, over a set period. The lender does not have the right to enter or possess the property so long as the borrower complies with the mortgage agreement’s terms.  

The first benefit of a mortgage is that mortgages are typically available with much lower interest rates than other types of loans. As of this writing, the average mortgage rate for a 30-year fixed mortgage is about 4.5% Contract that with credit card interest rates, which are typically well over 10% and can be as high as 24% or even higher.

Because real estate typically appreciates, on average, at a rate of more than 5% per year,[1] low mortgage rates encourage home ownership since expected appreciation is often more than the mortgage interest paid for the investment. Moreover, except in the case of very expensive homes, mortgage interest qualifies as a Schedule A tax deduction, further encouraging home ownership through this tax break. In all, Americans hold over $14.5 trillion in mortgage debt, and this sum keeps increasing.[1]

While the borrower makes monthly payments to repay the loan, he can use and occupy the land. However, if a borrower violates the terms of a mortgage agreement by defaulting on a payment or using the property in a manner prohibited by the agreement, he risks losing the property through foreclosure and public sale, with the proceeds applied first towards the secured obligation.[2]

Creating a Mortgage-Promissory Note

A borrower executes at least two instruments to create a mortgage: a promissory note and a security agreement.[3]  A promissory note is a written document that guarantees a lender’s right to be repaid the underlying debt. The document contains a written promise to pay a predetermined amount to the lender at a specified date or schedule of dates.[4] A promissory note can be bought and sold,[5] and when the lender transfers it, the debt under the agreement is unaffected. 

The promissory note will have the borrower’s name, the property address, the loan amount, an interest rate (fixed or adjustable), penalties that result from a failure to pay, and a date by which the debt must be repaid.

Most states have usury statutes, which penalize lenders for charging excessively high interest rates. For example, in California, an interest rate cannot exceed 10% per year. A usurious interest rate makes a promissory note unenforceable and should a lender violate a state’s usury laws, the penalties can be severe. In Florida, laws criminalize charging extremely high interest rates and not only will the lender forfeit interest, but a lender could face up to 60 days in prison for charging a usurious interest rate. Lenders are responsible to be aware of the rights and limitations that apply in their states.[6]   

Creating a Mortgage-Security Agreement

While the promissory note is the document that contains the promise to repay the loan, another security instrument is needed to establish a lien on the real property purchased. A security agreement designates the property as collateral for the loan[7] and conveys legal title from a borrower to the lender as security for the mortgage loan.

A security deed is a two-party instrument.  While title to the property remains with the homeowner, the lender is given a security interest, which is a legal interest in the property. Because it is a legal interest in property, it must conform to the formal requirements of the transfers of interests in real estate, including a writing requirement under the Statute of Frauds.

Other Security Interests

Deed of Trust

Another possible financing strategy is to execute a deed of trust. A deed of trust is like a mortgage because it pledges real property to secure a loan. However, unlike a mortgage, where title to the collateral remains in the debtor and creates a lien on the real estate in favor of the creditor, a deed of trust conveys title to a third party known as the "trustee."  The trustee holds the title in trust with the lender designated as the beneficiary. The deed of trust secures repayment of the loan created by the promissory note and guarantees the borrower’s performance by holding the underlying property as collateral. If the borrower defaults on the mortgage, the trustee can sell the land and give the sale proceeds to the lender to offset the borrower's remaining debt.[8]

Regardless of whether the security agreement is a deed of trust or mortgage, it must include the parties’ names, words of conveyance or grant, a legal description of the property, legally-compliant execution and attestation.[9] 

Securing a Loan with Personal Property

A borrower can secure a loan by using personal property with substantial value. For example, a borrower can use items such as jewelry or art work as collateral. Article 9 of the Uniform Commercial Code, a uniform commercial law adopted in every U.S. state, regulates secured transactions.   

Under Article 9, a borrower signs a security agreement conveying a security interest in personal property to the lender and then files a UCC-1 financing statement. A financing statement itself won’t create the lien or security interest, but when properly filed, it gives notice of the security interest created in the security agreement.

The UCC financing agreement will describe the borrower's collateral, describe the obligation it secures, identify what constitutes a default, the rights of the creditor if the borrower defaults, the requirements of the debtor with respect to the care of and insurance maintained on the collateral, and any other obligations in the transaction.

Once she files the financing statement with the appropriate government office, usually the secretary of state, the lender has a security interest in the personal property and if the borrower defaults, the holder can take possession of and to sell the collateral apply the proceeds to the loan.[10] 

While usually not necessary in the case of mortgages, personal property collateral may be necessary where the house is undervalued. For example, assume that the house is worth $300,000 and the lender only wants to lend an amount that’s not more than 80% of the value of the secured property ($240,000), but the borrower wants to borrow the full $300,000. If the borrower agrees to designate an additional $75,000 worth of personal property as collateral for the loan (perhaps a boat or artwork), the $300,000 that the purchaser wants to borrow would now be 80% of the value of the collateral. It should be noted, though, that most banks require the house being financed to be of sufficient value to be the sole collateral.

Guaranty Agreement

When a borrower doesn’t have an extensive credit history or if she poses additional financial risk, a bank may also require a co-signer to support the agreement to reduce the credit risk. Called a guaranty, it gives a lender the right to sue a third party, the guarantor (or co-signor), who signs an agreement to step in to pay back the borrower’s debts if he defaults.[11]

There are two categories of guaranty notes which dictate how and when the third-party guarantor will pay a lender. The first is a "payment guaranty" wherein, as soon as the borrower defaults, the guarantor’s obligation becomes fixed and she must pay the lender directly.

The second category, a "collection guarantee", requires the guarantor to pay the lender only after the lender has pursued legal action against the borrower and has obtained a judgment for the outstanding balance that has been unsatisfied, or the borrower is insolvent, so a judgment ordering the lender to pay isn’t worthwhile.

Whenever there is a guaranty note, the guarantor must consent before changes can be made to it or to the mortgage agreement.  The guarantor’s consent is necessary because modifying or amending the mortgage agreement in any way could substantially impact his rights and liabilities.[12]

Common Contractual Terms in Mortgage Agreements

Promissory notes and security agreements, together, create a mortgage between a bank and a real estate buyer.[13] Lenders differ on the key terms and conditions necessary for these agreements, but certain ones are uniformly included.

A.    Dragnet Clause

A mortgage agreement’s dragnet clause secures all debts that the borrower may owe to the lender at any time. A dragnet clause is so named because it "drags" in all other debt that has been, or could be, incurred between the borrower and the lender.[14]  

A dragnet clause is worded as follows: “the agreement is made and intended to secure all indebtedness now or hereafter owing by the mortgagor to mortgagee." If a borrower takes out a mortgage with a dragnet clause and she returns to the same bank later to take out a personal loan, any money loaned as part of the personal loan will be dragged in to the mortgage’s balance. The clause also applies to late fees and other costs that are due to the bank.

B.    Due on Sale Clause

A property owner who has taken out a mortgage can sell her property even if she still has numerous mortgage payments to make. However, a mortgage agreement can inhibit the free transfer of property if the underlying agreement includes a "due on sale" clause. 

Such a clause will affect both a borrower and a lender if a property owner wants to sell the property without having paid back the entire loan. This clause allows the existing lender to call the entire loan due and payable if the homeowner transfers title to the home without paying the loan in full.

 However, it should be noted that federal law, under the Garn–St. Germain Depository Institutions Act of 1982, disallows the enforcement of due-on-transfer clauses when the transfers are made to certain close relatives.[2]

C.    “Subject to” or “An Assumption of” Mortgage Default Terms

If there is no due on sale clause, mortgages are easily transferrable.  A transferable mortgage, also called an assumable mortgage, is a loan that one party can transfer to another. The lender puts the loan in the transferee's name; the transferee takes responsibility for repayment under same interest rate and other terms the original borrower had.

Though the mortgage can be transferred, its language determines subsequent purchaser's potential liability for the original borrower’s debt. The key words here are “subject to” or “an assumption of.” If the property can be transferred "subject to" a mortgage, the new owner cannot be held personally liable for the underlying debt.  If the subsequent holder of a "subject to" mortgage defaults, the lender can foreclose on the property will be foreclosed but the lander cannot sue him for any remaining amount due on the debt after public sale. Rather, the lender can recover any remaining damages from the original borrower.

On the other hand, if the subsequent holder of “an assumption of” mortgage defaults, she becomes personally responsible for repaying the debt. The lender can foreclose and sell the property and sue both the original borrower and the subsequent purchaser for any amount still owed on the property.

Subsequent Mortgages on the Same Property

A borrower may want to take out a second mortgage on his property.  Unless the first mortgage agreement expressly prohibits him from doing so, he can mortgage his property as many times as he wants. It’s risky for a lender to issue a second mortgage because the second mortgage terminates if the borrower defaults on the first. Every subsequent mortgage is inferior to the prior. 

To mitigate this risk, the issuer of a second mortgage often requests estoppel certificates requiring the first mortgage holder to give notice of an impending default and give the second mortgage holder an opportunity to cure and prevent foreclosure.[15]

Foreclosure

If a borrower fails make mortgage payments in a timely manner, the lender has several options. Foreclosure is the most widely-recognized consequence for failing to pay a mortgage when due. However, foreclosure is an extreme remedy for default and a defaulting borrower has contractual and due process rights before a lender can begin foreclosure.[16]

In a foreclosure sale, a mortgage holder will sell the real estate used to secure the loan and use the proceeds to satisfy the mortgage debt.  If a foreclosure sale results in a sale price more than the mortgage debt remaining, the borrower is entitled to the additional amount. 

A valid foreclosure sale extinguishes all the borrower’s ownership rights and divests all junior encumbrances on the property, meaning all subsequent mortgages, easements, liens, created after the date of the mortgage in default are terminated at the time of the sale. A federal tax lien, however, cannot be divested through foreclosure unless the mortgage holder gives the Internal Revenue Service at least 25 days’ notice of the sale.

Borrowers default for a variety of reasons.  Most of the time, borrowers default by failing to make the payments required under the agreement, but default can result from a violation of any condition in the mortgage. For example, failing to pay taxes on a property can result in default, as could failing to insure the property, failing to keep the property in good repair, or in some cases, transferring the property without the lender's permission.

Depending on where the property is, a foreclosure can be either court-ordered or accomplished through contractual power of sale. A court-ordered, or judicial, foreclosure requires the lender to file a lawsuit against the borrower in default. 

Judicial action is the sole foreclosure method in some states. A typical judicial foreclosure involves a lengthy series of steps: the filing of a foreclosure complaint and notice, the service of process on all parties whose interests are affected by a judicial proceeding, a hearing before a judge or a master in chancery who reports to the court, the entry of a decree or judgment, a notice of sale, a public foreclosure sale conducted by a sheriff, and the post-sale adjudication as to the disposition of the foreclosure proceeds.[17] The borrower can avoid foreclosure by refinancing the debt and becoming current on payments, so while a judicial foreclosure is time consuming, it affords substantial due process and opportunities for remediation[18]

In jurisdictions that do not practice judicial foreclosure, the mortgage holder has a contractual power to foreclose and sell mortgaged property. While a court won’t review this sale, states impose strict standards on non-judicial foreclosures. For example, in Arkansas, the mortgage holder must file a notice of default with the county records office and must sell the property for no less than two thirds of the appraised value.[19]

Federal and State Limits on Foreclosure 

A borrower has the right of redemption, which means that he can recover the property before the foreclosure is completed by paying off the mortgage at any time prior to foreclosure.

Several states have enacted laws permitting a mortgage borrower to recover it even after a foreclosure sale. This post-foreclosure redemption can only be exercised for a limited amount of time though, and laws vary by state. Following the mortgage crisis of 2008-2009, many states passed laws limiting the rights of lenders to foreclose on residential property. These laws often impose waiting periods of up to 120 days before a lender can foreclose on a property. Some states require mortgage lenders to negotiate with borrowers in default in good faith to modify the terms of the loan and prevent foreclosure. [20]

On the federal level, the Homeowner Affordability and Stability Plan provides a borrower who is behind on mortgage payments access to low-cost mortgage refinancing options. This law has assisted millions of American homeowners threatened with foreclosure by making lenders responsible for lowering total monthly payments to a proportion of the borrower’s income and requiring banks to modify loans to help a borrower remain current on payments.[21]

[7] Renuart, E., Uneasy Intersections: The Right to Foreclose and the U.C.C., 48 Wake Forest L. Rev. 1205, 1212 (2013).

[9] Hinkel, D., Essentials Of Practical Real Estate Law 189 (6th ed. 2016).

[12] Hinkel, D., Essentials Of Practical Real Estate Law 188 (6th ed. 2016).

[15]Hinkel, D., Essentials Of Practical Real Estate Law 194 (6th ed. 2016).

[16] Renuart, E., Uneasy Intersections: The Right to Foreclose and the U.C.C., 48 Wake Forest L. Rev. 1205, 1212 (2013).

[18] Hinkel, D., Essentials Of Practical Real Estate Law 198 (6th ed. 2016).

Which clause allows lenders to increase interest rates?

What is the acceleration clause in a mortgage?

What does an acceleration clause accomplish when it is included in a mortgage note?

What clauses are included in a mortgage?