Real Estate Finance Notes 10/28/04

 

Prepayment

 

Most courts that consider the issue say that prepayment penalties are part of the bargain.Since you can lock in the loan entirely with no prepayment at all, then the lesser measure of prepayment with a penalty is included.If a promissory note is silent on prepayment, do you have a right to prepay?There is a common law presumption that the lender doesnít have to accept prepayment.This is the majority rule, but this is a default rule only.

 

Metropolitan Life Insurance Co. v. Promenade Towers Mutual Housing Corp.

 

If the promissory note says that youíre going to pay over a certain period of time, thatís what youíre required to do, and you donít have the right to prepay.There are a few states that by judicial or legislative action have reversed the common law presumption, saying that if the promissory note is silent, you do have the right to prepay.This is only true in Pennsylvania, North Carolina, and Missouri.About 20 states allow prepayment of residential mortgage loans only.Also, the standard Fannie Mae/Freddie Mac promissory note allows for full or partial prepayment without charge.Parties can insert language like this in any promissory note, and it will be enforceable since the common law rule is only the default rule.Whatever the state law is, virtually every residential mortgage uses this form of promissory note or one that is very similar.Any institutional lender will want the option to participate in the secondary mortgage market.That can only be done if the loan is documented with these forms.In practice, the common law rule only has applicability to commercial mortgages.The default rule is tempered by the courts through interpretation: they bend over backwards to find a provision in the mortgage that allows prepayment.If the note has the phrase ďif not sooner paidĒ, they will find that to be enough to overcome the default rule.

 

Lenders have a number of reasons for prepayment fees and lock-ins.Lenders are concerned about changing interest rates.The lender wants to maximize the return on its investment.If interest rates are going down, itís in the lenderís interest to keep the mortgage in existence.It also costs them money to reinvest or to cover loss from a delay in reinventing.The lender may also have costs of initially placing the loan that are amortized over the life of the loan.Usually, those costs are covered by ďpointsĒ: the interest rate will be, for example 5%, but 1-2% will be charged up-front to cover these initial costs.If a loan is locked in or requires an extremely high prepayment fee, does that necessarily mean that the loan wonít be prepaid?Not necessarily.The parties can negotiate out of the original agreement if thatís mutually beneficial.

 

Letís say that interest rates fall and the borrower has the desire to repay a high interest rate loan and get a lower interest rate loan.If the present value of the lenderís loss due to repayment is less than the present value of the borrowerís gain from refinancing, then both parties will benefit from prepayment at some fee.However, this situation doesnít make sense: how can the borrower refinance for less than the lender is willing to reloan?If thatís the case, then there is no gain from exchange.So is the prepayment penalty an unreasonable restraint on alienation?The Restatement argues that it is not because there is the possibility of bargain.The prepayment penalty may be attacked as interest if there is a state usury law that controls.But in most states, such laws have been greatly watered down.If the fee is unconscionably high, the courts will reject it.Also, recall that improper liquidation of damages can be found to be a penalty.This is judged looking from the perspective of when the contract was formed and asking whether the parties reasonably estimated their damages.The Bankruptcy Code says that prepayment penalties will be allowed and will be secured by the mortgage if they are reasonable.

 

Should there be a prepayment penalty when the promissory note contains a due on sale clause?What if the promissory note is silent?Is this a question of interpretation?Is this a default rule that the parties can contract around, or is this a matter of law?The courts approach this as a matter of interpretation and divining the partiesí intent.The question is whether it is even a prepayment.What about cases of fire, casualty, or eminent domain?The insurance company pays.You can argue that in the event of a prepayment, you have to pay the prepayment fee no matter what.But itís more controversial to have the lender say that the borrower canít rebuild even if they want to.

 

Fleet Bank of Massachusetts, N.A. v. One-O-Six Realty, Inc.

 

What about late fees and ďdefault interestĒ?Late fees are seen as liquidated damages.They must be reasonable.They are must more likely to be reasonable if they are based on the missed payment as opposed to the amount of principal outstanding.What was wrong with the late fee in this case?What payment was late?A balloon payment for the entire outstanding principal was late.

 

How do you discharge the mortgage obligation?Knowing what you have to do to get out of the obligation is crucial to being able to enforce it.There is only one mechanism that can be used to assist with paying off a promissory note.If the obligation is not reducible to dollars, then you canít determine how to distribute the proceeds of the foreclosure sale.You canít determine what the mortgagor should do in order to redeem the property from the mortgage.Therefore, the obligation must be measurable in money.

 

To pay $100,000 is a valid mortgage obligation.Thatís an ordinary mortgage obligation.But a promissory note can secure a promise to construct a house.As long as you can tell with some amount of certainty what the house is worth and when itís supposed to be built, itís okay.Note that there is a different standard depending on who you are enforcing the mortgage against.If you are enforcing against a third party, there will be a greater degree of certainty as to what the obligation is than when youíre talking about the understanding between the original two parties.The mortgage obligation could be to obtain rezoning of land.What about the purported obligation to support the mortgagee for life?UhÖI forgot.

 

Merger

 

The purpose of this doctrine is to simplify title.If someone has a life estate and a remainder, they basically have the whole bundle of sticks, and we just say that they have the fee simple.Thatís what the law does.The merger doctrine does not work to modify any substantive rights, but sometimes courts use it this way.If the mortgagor and mortgagee become the same person, for example when the mortgagee buys the property at foreclosure, we might say that the mortgage is gone and the former mortgagee holds a fee simple.But keep in mind the purpose of the doctrine.Sometimes when we say the mortgage is extinguished, we modify the substantive rights of the parties.

 

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