One of the most important papers you will be asked to sign when you go to a house closing -- whether it be for the purchase of a new home or, a refinance settlement -- is a promissory note.
This is your promise to pay back to your mortgage lender, the money you are borrowing.
My legal dictionary defines a promissory note as follows:
A promise in writing, and executed by the maker, to pay a specified amount during a limited time, or on demand, or at sight, to a named person, or on order, or to bearer.
The promissory note is your "IOU." You borrow money from a mortgage lender, and the lender wants to make sure that all of the terms and conditions of your loan are spelled out in a single document. The lender also wants to make sure that there will be no confusion as to these terms and conditions, so that in the future you cannot claim that you did not know what your legal obligations were with respect to your loan.
There are many different kinds of mortgage loans currently on the market:
A fixed 30 year loan -- Here, you make equal monthly payments for 360 months. An amortization table is developed which will compute the exact amount of the monthly payment so that at the end of the 30 years, the loan will be paid off in full.
An Adjustable Rate Loan, also called an ARM -- Here, your interest rate is fixed for a period of years (generally one, three, or five), and thereafter it will adjust on a yearly basis, depending on then existing market conditions and market rates.
Interest only loans -- Under this arrangement, your monthly mortgage payments are based only on the interest which has accrued for the previous month. For example, if you borrow $300,000 at six percent, the monthly payment (interest only) would be $1,500.00. Generally, these loans do not have a long life -- and often can become due within five or ten years from the date of the loan. It is important to understand that despite the fact that you are making monthly payments, your loan balance will not change, unless you add more money to your payment.
Contrast this to a fixed 30 year $300,000 loan at six percent, where the monthly mortgage payment would be $1,798.68 -- or a monthly savings of $298.68.
Balloon Notes -- Under this type of loan, your monthly payments are not sufficient to fully amortize your loan on the due date. Thus, when the loan becomes due, the entire balance "balloons" -- i.e., comes due.
Interest only loans are a form of balloon note.
Regardless of the type of loan you obtain, you will have to sign a number of legal documents, including the HUD-1 settlement statement, a Deed of Trust (discussed last week in this column), and a promissory note.
Read the note carefully. Unlike the Deed of Trust (which can be as large as 15 or more pages), the note is generally a short document. But do not get misled by its brevity; it can give you a knock-out punch if you do not make your payments on a timely basis.
There are some very important sections in every promissory note:
- Be sure you verify that your name and address are correct
- Confirm that the interest rate is what you were promised by your lender. While you should also analyze the Truth in Lending statement which must be given to you at settlement, the Annual Percentage Rate (APR) contained in that statement is not the same as your mortgage interest rate which must be spelled out in the Note. The APR represents the true yield to the lender, computed on all of the fees and costs you will have to pay at settlement.
- When is your first payment due. Typically, interest is paid in arrears, so when you make your March payment, for example, it is paying the interest which has accrued during the month of February. If you were to settle on February 14th, your lender will collect at settlement, interest on a daily basis through the end of the month (15 days), but your first monthly payment will not be until April 1st.
- The note contains the amount of your monthly payment. Make sure that it is correct. However, some lenders will escrow moneys for real estate taxes and insurance, and thus your actual monthly payment will be higher than that which is spelled out in the note. Make sure you know exactly what your real payment will be, before you leave the settlement table.
- Do you have the right to prepay your loan with out a penalty? This is a very important issue, and you should know your rights before you complete the settlement. In fact, this is an issue which you should discuss with your lender well in advance of settlement. If there is a prepayment penalty associated with your loan, you may want to shop around for another lender.
- Is there a period of grace before you are in default? Most commercial lenders will allow you to make your payment up to the 15th of each month before calling you in default. However, interest will accrue on your loan until the payment is received -- and recorded -- on your lender's books, and thus you should try to make your payments as early in the month as possible.
- Is the loan assumable? Can someone buy your property and take over your loan. Most loans contain what is known as a "due on sale" clause. In the Promissory note, the section will be called "transfer of property or a beneficial interest in Borrower".
The due on sale clause simply means that your loan is not assumable, at least not without the written permission of your lender. If you transfer your house to a third party, your lender has the absolute right to call the entire loan due and payable.
There are a number of exceptions to this right of the lender to call the entire loan due. Under the Garn-St. Germain Depository Institutions Act of 1982, a lender has no right to call the loan if, for example:
- The transfer of property occurs as the result of the death of a one of the joint owners of the property.
- A transfer to a relative resulting from the death of a borrower.
- A transfer where the spouse or children of the borrower become an owner of the property.
- A transfer resulting from a decree of a dissolution of marriage, legal separation agreement; or from an incidental property settlement agreement, by which the spouse of the borrower becomes an owner of the property.
- A transfer into an inter vivos trust in which the borrower is and remains, a beneficiary and which does not relate to a transfer of rights of occupancy in the property.
Finally, you should understand that if you do not pay your monthly mortgage payments on time, and become delinquent, your lender has two alternative courses of action. First, they can foreclose on the property, based on the deed of trust which you also signed at settlement. Second, they can sue you in a court of law to collect on the note. Under this scenario, if the lender gets a money judgment from the Court, the lender has a number of collection options:
- Foreclose on your property.
- Attach your bank account or other assets.
- Garnish your wages.
Thus, as you can see, the Promissory Note is an important document. You should read it carefully, and ask questions of the title attorney if you do not fully understand all of the terms of the note.
And make sure that you get a copy of the note (as well as all other settlement documents) when you complete the settlement.