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Invest In Mortgages


MORTGAGE INVESTMENT TUTORIAL

By: Kenneth Jay Gain, MAI, SRS, CCIM, CRE, AI-GRS

WHAT ARE MORTGAGES? The term Mortgage is a generic term referring to debt obligations secured by real estate. As you know there are many brands of photo copying machines currently available, yet many of us still refer to the process of making a copy as Xeroxing, due to the fact that Xerox produced the first widely available good quality copy machine. In the same manner, we refer to debt obligations secured by real estate as Mortgages, even though many states, including Alaska, do not use Mortgages. The term Mortgage is an English common law term and was a form of security instrument used for hundreds of years before the formation of our country (if you are a historically curious type, drop by our office and see an actual old English Mortgage, hand written on parchment with a wax seal). Because the laws in the United States of America are based upon English Common Law, most of the original colonies use Mortgages as a way of pledging real estate as security for a loan. For this reason we commonly use the term Mortgages although you may often encounter the following terms that mean essentially the same thing:

• Deeds of Trust
• Trust Deeds
• Paper
• Discounted Paper
• Notes
• Promissory Notes
• Discounted Notes
• Cash Flows
• Discounted Cash Flows
• Debt Instruments
• Receivables
• Seller Carry Backs
• Income Streams
• Real Estate Contracts
• Escrows

As mentioned above, Alaska does not use Mortgages, although we commonly refer to all real estate secured debt instruments as Mortgages. The use of a Mortgage in Alaska would not be illegal, but because they are not defined by Alaska's statutes there is no good reason to use them. Alaska is what is known as a "Deed of Trust State", because our statutes define and provide law governing the use of a Deed of Trust to secure real estate debts and define the methods of foreclosure in the event of default. All Deeds of Trust actually consist of two documents.

The first document is the Promissory Note, which outlines the terms of the debt obligation. A Promissory Note states the amount that is owed, the interest rate that accrues on the unpaid balance, when and where the payments are to be made, and the date from which interest accrues. Other provisions contained in a Note usually are the fact that the Note will be accelerated (the full balance becoming due) in the event of a default and provides for the Payor to be responsible for attorney costs if suit is filed to collect the Note. The Note may also provide for late payment penalties and penalty interest in the event of default. By itself, it is a totally enforceable legal agreement and suit can be brought to collect on a Note without having a Deed of Trust or without regard to a Deed of Trust, even if one exist.

The Deed of Trust is a separate agreement in which the property is pledged as security for the Note. It usually outlines additional obligations of the Payor, such as the requirement to keep the property insured, pay all property taxes before due, and maintain the property in good condition. In addition, it describes the process for foreclosure by the Trustee.

There are three parties to every Deed of Trust. The Trustor is the borrower (the Payor on the Promissory Note) who pledges the property as security for the debt. The Beneficiary is the person (or entity) to whom the money is to be paid (the Payee on the Promissory Note). The final party to the Deed of Trust is the Trustee, which is usually a title company that is granted nominal title for the purposes of foreclosure only (see Default and Foreclosure below), but the Trustor retains all rights of beneficial ownership. The Deed of Trust defines the rights and obligations of all three parties and because these can vary greatly from transaction to transaction, it is an instrument that should be carefully read in detail.

Although the primary use of Deeds of Trust is to secure a debt obligation, Deeds of Trust can also be used to secure other forms of promises or obligations and these types of Deeds of Trust are referred to as Performance Based Deeds of Trust.

You will often see the term First Mortgage or Second Mortgage (likewise for First Deed of Trust and Second Deed of Trust). What this refers to is the priority position of the Mortgage. A First Mortgage is the first one recorded against the property and therefore has first claim on the real estate for settlement of the debt that it secures. A Second Mortgage is in second position and is totally subservient to the obligation secured by the First Mortgage. For this reason a party foreclosing on a Second Mortgage is obligated to satisfy the obligation secured by the First Mortgage. Therefore investment in Second Mortgages is considerably more risky than investment in First Mortgages. Although our firm does invest in Second Mortgages (and occasionally Third Mortgages) we rarely sell anything to Investors other than First Mortgages. The only exception is when the Investor is someone who has invested with us for a substantial period of time, has demonstrated a high risk tolerance, has considerable investment expertise and is known by us to be wealthy.

To let the public know that the real estate has been secured by a Mortgage, all Mortgages and Deeds of Trust include a legal description of the property and the full document is placed on record in the District Recorder's Office. It is therefore possible for the public to learn the full terms of a Mortgage or Deed of Trust by going to the Recorder's Office and acquiring a copy of the document. While the Mortgage or Deed of Trust will show the initial amount of the debt, the terms of repayment, which are represented by the Promissory Note, are not available for public scrutiny.

Special Note on Terminology: Because the term Mortgage is the generic term in common use throughout the United States to refer to debt obligations secured by real estate, I have chosen to primarily use that term throughout the information contained on this website. However, when discussing certain legal issues that are unique to Alaska, I will refer to the correct legal instrument for Alaska which is a Deed of Trust or a Note and Deed of Trust. Although I plan to use the term Mortgage on this website as the generic term, in other correspondence and advertising material, I often use the generic term "Notes" as referring to both the Promissory Note and the Deed of Trust securing it. You will find it common for professional investors in Mortgages to use the term Notes as the generic description, whereas, members of the public are more familiar with the generic term Mortgages.

INVESTMENT BENEFITS: The primary investment benefit of Mortgages is the ownership of an investment that provides a higher interest rate than is typically available from other interest bearing investments, such as pass book savings accounts, certificates of deposits, money market funds, etc. Of course you must never forget the important relationship between risk and reward (the higher the reward the higher the risk). To reduce risk is why Mortgages are secured by real estate, so that in the event the debt is not paid as agreed, the Investor (Payee on the Promissory Note) can foreclose upon and become the owner of the real estate. As discussed in our introductory section - - "Why Invest in Mortgages", there are a number of ways to invest in government insured and conforming Mortgages that are quite safe and have little risk of principal loss. However, as Robert Kiyosaki discusses in his "Rich Dad - - Poor Dad" series of books, the secret of wealth is to find investments not widely available to the general public and therefore enjoy the opportunity of superior investment returns. Private Mortgages (such as our Direct Loans and Seller Financed Mortgages) provide yields that are often double the yields on the widely available conforming Mortgages. But with intelligent analysis and careful selection, can be invested in with risk that is not substantially greater than conforming Mortgages.

In summary, the principal benefit of investing in Mortgages is the ownership of high interest rate investments that are secured by real estate. At the current time the Mortgage Investments offered by our firm typically yield from 5% to 10%.

INVESTMENT DRAWBACKS: The principal drawback of an investment in a Mortgage is the possibility of default in payment or the loss of the real estate securing the debt by failure to insure the improvements or paying real property taxes. Certain conforming Mortgages are guaranteed by the government (FHA or VA Loans) or by private mortgage insurance companies. While these guarantees significantly reduce risk they also reduce the yield to about half of what can be earned investing in Private Mortgages.

In Private Mortgages, the principal drawback is that they are not guaranteed by any government agency or third party insurer. In the event the borrower does not make payments as agreed, the fall back position is foreclosure on the real estate securing the debt. If the initial loan amount is too high, or the value of the real estate has decreased since the loan was made, it may not be possible to resell the property for enough to cover the debt (thus the importance of Loan to Value and Investment to Value as discussed below). Other drawbacks include risk of loss due to failure to make certain that improvements on the property are insured or to make certain that real property taxes are paid.

SELLER FINANCED MORTGAGES: This type of Private Mortgage is sometimes called Seller Carry Back, Owner Carry Back, Seller Financed Note, or Seller Financed Deed of Trust. All terms mean the same thing and describe a debt obligation secured by real estate where the debt was created by the sale of the real estate. This occurs when the Buyers, rather than acquiring a Mortgage from a bank or other lender and paying the Sellers all cash, have paid the Sellers a down payment and given a Promissory Note for the balance of the purchase price and secured that debt by a Mortgage or Deed of Trust against the property sold.

Although certain sophisticated Sellers, or financially well off Sellers, will select this method of financing to earn higher interest or avail themselves of installment income tax reporting, by far the majority of Seller Financed Mortgages are created because there is no other attractive financing alternative. This may mean that the Buyers have weak credit and were not able to obtain a loan from a bank or other lender, or that the property is not considered a conforming property that meets the requirement of banks and other lenders. Properties that typically fall in this category are recreational cabins, vacant land, small commercial properties, mobile homes, and lots improved with mobile homes. Most Sellers are fairly unsophisticated and as a result there is usually little underwriting of the terms of the Mortgage and the interest rate and payment terms may not reflect the real risk. As a result, to make investments in Seller Financed Mortgages attractive, it is necessary to purchase them at less than their face value to provide a yield that is attractive to an Investor. (Discounting)

Example: Assume a Seller Financed Mortgage in which a recreational cabin was sold for $100,000 with $10,000 down and the Sellers carrying back a $90,000 Mortgage at 7% interest payable at $697.76 per month (20 year amortization). After investigation, the Investor determined that based upon the Buyer's credit and other risk factors an 8% yield was necessary to make an investment in this Mortgage attractive. After doing the yield calculation, the Investor would determine that he could pay the Sellers $83,421 for this $90,000 Mortgage and receive an 8% return on the investment. Thus the Mortgage has been discounted and that's why Seller Financed Mortgages are sometimes referred to as Discounted Paper, Discounted Notes, Discounted Mortgages, etc..

DIRECT PRIVATE LOANS: Another type of private Mortgage is one in which a direct loan is made to the Borrowers to refinance a property already owned or purchase a property. The most common purpose for such direct loans is for purchase of a property that provides great profit potential after being renovated, or purchase of a piece of land that can be subdivided and sold at a profit. Other instances include situations in which business Borrowers need additional capital for their business and to secure that money take out a Mortgage on property they already own. Because these are direct loans, they are usually thoroughly underwritten with requirements for Borrower's financial statements, income information, full credit reports, and inspection and/or appraisal of the property before making the loan. As a result, the Lender/Investor is well aware of the risk and therefore makes the loan at an interest rate commensurate with that risk.

Example: Again assume the same example as given above under Seller Financing - - a recreational cabin selling for $100,000 with $10,000 down. In the case of a direct loan the Lender/Investor has determined that the risk requires an 11.5% yield and that to reduce risk, he is only willing to make a loan equal to 65% of the value ($65,000 in this case). So this loan proposal would work only if the Borrowers already owned the property with substantial equity and were just looking to raise money for another investment. But if it were a situation involving a purchase, few Buyers would have $35,000 available as a down payment. Therefore, the structure of the sale in this case would probably involve a loan from the Lender/Investor of $65,000 at 11.5% interest, a down payment of $10,000 to the Sellers and the Sellers carrying back a Seller Financed Second Mortgage for the difference of $25,000 ($100,000 -$10,000 -$65,000=$25,000). In this example, the Lender/Investor would also look to the Sellers as a second source of repayment in the event of default, because if the Borrowers failed to make the required payments and the Lender/Investor foreclosed on the property the Sellers would lose the security for their $25,000 Second Mortgage upon foreclosure. Therefore, the Sellers may be willing to step into the Buyers' position and cure the default on the Lender/Investor's First Mortgage and then proceed to foreclose on their Seller Financed Second Mortgage to protect their $25,000 position.

LOAN TO VALUE: In the foregoing examples, for Seller Financed Mortgages and Private Direct Loans, I gave examples of Loan to Value. Loan to Value ("LTV") is merely the ratio between the face amount of the Mortgage and the selling price or value of the property. In the first example for Seller Financed Mortgages, the Mortgage was $90,000 and the selling price was $100,000 and thus the Loan to Value Ratio was 90% ($90,000 / $100,000). In the second example, for Private Direct Loans, the Lender/Investor's Loan to Value Ratio was only 65% ($65,000 / $100,000). But from the Buyers' perspective, the Combined Loan to Value Ratio ("CLTV") was still 90%, because the sum of the First Mortgage and the Second Mortgage was $90,000. Knowing the Loan to Value Ratio of a Mortgage Investment is very important, because it determines how much the Borrower has at risk. A Borrower who stands to lose $50,000 of equity in a foreclosure will try much harder to cure the default than a Borrower who stands to lose only $5,000 of equity in a foreclosure. In the case of a Direct Loan, it is also important to the Lender/Investor because it shows what the property will have to be sold for after foreclosure to recover the amount of the investment in the Mortgage.

INVESTMENT TO VALUE RATIO: In the case of a Direct Loan, the Investment to Value Ratio ("ITV") would be the same as the Loan to Value Ratio from the Lender/Investors' perspective. In the example above, for the Direct Loan, the Investor invested $65,000 and holds a Mortgage with a $65,000 face value, so both the LTV and ITV are 65%. However, in the first example, for the Seller Financed Mortgage, the LTV was 90%, but since the Investor only paid $83,421 to purchase that Mortgage, the ITV is 83.4% ($83,421/$100,000). Unlike LTV, ITV will not show how much the Borrower/Owner stands to lose in the event of a foreclosure, but it will show you how much you would have to sell the property for after foreclosure to recover your investment.

LOAN UNDERWRITING: Underwriting is just a technical industry term that describes the process of evaluating a Mortgage Investment. As such, underwriting encompasses the due diligence investigation and the risk analysis to determine the appropriate interest rate and other terms of a Mortgage. Underwriting consist of an evaluation of both the Borrower and the property pledged as collateral.

Evaluation of the Borrower will usually consist of a minimum of obtaining a financial statement from the Borrower, the Borrower's credit report, and a search of public records to obtain information about the Borrower such as ownership of other real estate, outstanding liens, lawsuits, etc.. In the case of existing Seller Financed Mortgages, usually the only information that can be obtained about the Borrowers is their credit report and matters of public record. However, if the Mortgage has been in existence for sometime (seasoning) then an important part of Borrower evaluation is analysis of the payment record on the subject Mortgage.

CONFIRMATION OF VALUE: To make a realistic calculation of the LTV or the ITV, it is first necessary to know the value of the property. There are a number of ways of confirming value, but since some can be fairly expensive, we use a step approach to this process and usually only require the most expensive form of confirmation (an appraisal report) on properties with loans in excess of $200,000.

For Seller Financed Mortgages, involving sale of the property within the last several years, one important confirmation of value is to obtain the closing statement from the sale of the subject property to verify what price was actually paid for the property. If a relatively small loan is involved and evaluation of other sources of information such as comparable sales of similar properties in the immediate area or tax assessments indicate that the price is reasonable, that may be the limit of confirmation of value. On loans a little larger, the confirmation of value process may be further supplemented by a Broker's Letter of Opinion or an appraisal. For existing Seller Financed Mortgages, it is usually not possible for the appraiser to inspect the interior of the property, and therefore the appraisal is based upon a drive-by inspection, in which the appraiser views the exterior of the property, photographs it and based upon information on its size contained in assessment records, uses the full appraisal process to form an opinion of the current value of the property.

A full appraisal of the property would involve both an interior and exterior inspection of the property. In the case of a residential property a full formal appraisal is usually done on a multi-page form that is accepted throughout the United States by virtually all lenders. In the case of a commercial property, the report is usually a narrative report giving a thorough description of the property and the analysis used in arriving at the appraiser's opinion of value.

Appraisers use three approaches to estimate the value of property:

The Cost Approach, is based upon the Market Value of the site (by the Sales Comparison Approach), plus the cost of reconstructing a similar improvement, less depreciation. The Cost Approach is primarily relied upon for newer properties or special use properties where there is not good comparable sales data and/or where an Income Approach may not be appropriate.

The Sales Comparison Approach is used to estimate the value by comparison with sales of similar properties and making adjustments for differences. This approach is the most important approach in the appraisal of residential property, but is somewhat useful in the appraisal of commercial and income properties, for property types where there are a number of sales, such as apartments and warehouses. It is usually the only approach that is applicable for the appraisal of vacant land.

The third approach is the Income Approach which is based upon analyzing the potential income that can be obtained from renting the property. Next an allowance for vacancy and collection and operating expenses are deducted to calculate Net Operating Income ("NOI"). The NOI is then capitalized into a value estimate based upon rates of return derived from analyzing the sales of other income producing properties. It is the most important approach for investment properties.

The best form of value confirmation is the verified recent sales price of the subject property further confirmed by a formal appraisal. However, because of the cost of appraisals that process is usually feasible only on larger loans. On any loan in excess of $200,000 we always require a full appraisal. For smaller loans we use less formal methods, but will in some cases still require an appraisal if we are unable to get enough confirming information from other sources to make us feel comfortable about the value of the property. Because I am both a State Certified Real Estate Appraiser and a Member of the Appraisal Institute ("MAI") and have access to a considerable amount of comparable sales information, I am often able to get enough reliable information to provide an acceptable confirmation of value on smaller loans without incurring the expense of an appraisal.

CONFIRMATION OF TITLE: Evaluation of the condition of the title involves a process of confirming that the property is actually owned by the Borrower and determining that the subject Mortgage is a valid Mortgage represented by a recorded Deed of Trust and determining the priority of that Deed of Trust. Although a Mortgage may be referred to as a First Mortgage it is not actually a First Mortgage unless it is the first one recorded. Although there may be no senior Mortgages, certain liens and real estate taxes (see more on this topic below) can have priority over a First Mortgage. Therefore to make a reasonable risk evaluation it is important to know what other senior encumbrances are on title. Likewise, if there are junior encumbrances such as Second Mortgages or liens that are inferior to the claim of the subject First Mortgage, these are indications of other parties that may be secondary sources of repayment in the event of a default.

The best confirmation of title for a Mortgage is obtained through purchasing a Mortgagee's Title Insurance Policy. It is our policy to always obtain a Mortgagee's Title Insurance Policy on all Direct Loans and all Seller Financed Loans with balances of $50,000 or greater. On purchases of Seller Financed Mortgages, that we purchase at the closing of the sale, we always get a Mortgagee's Title Insurance Policy because the cost is very nominal. However, for existing Seller Financed Mortgages, with balances of less than $50,000, we may rely upon informal confirmation of title, such as an older title report and/or a review of public records to determine what instruments have been recorded against the subject property. While this type of search of public records can provide an accurate confirmation of the status of title, it provides no insurance in the event of title claims that were not found in this search and provides no protection against forged documents and other items covered by a Mortgagee's Title Insurance Policy. For these reasons, a Mortgagee's Title Insurance Policy is usually a good investment, except in the case of smaller Mortgages in which the cost of the title insurance is disproportionate to the investment.

CREDIT REPORTS: Credit Reports on the Borrower are one of the most important steps in evaluating the Borrower. While equity is the most important factor to protect a Mortgage Investor from loss in the event of default, the likelihood of default can be predicted from a credit report. Credit Reports aren't perfect predictors because there are people who have incurred credit problems beyond their control such as injury or unemployment. However, my experience indicates that they are about 70% accurate, due to the fact that people who have a long habit of not paying their bills on time rarely change.

The important thing to remember about credit reports is that they are a lot like mortality tables. A mortality table can tell how long the average 50 year old will live, but it can't tell you how long you will live. Likewise, credit reports may not be totally accurate for one given individual, but for a large group they are incredibly accurate in predicting the likelihood of default.

More and more lenders are relying upon the so called FICO score developed by the Fair Isaac Company. FICO scores range from approximately 350 points to 875 points and are available from all three national credit bureaus. Each bureau calculates its score based solely on the data within that bureau's credit files. Each bureau also has it's own name for it's version of the FICO score. For Equifax it's a Beacon score, for Transunion it's an Empiria score and for Experian it's called a Fair Isaac score.

Here are the statistics relating to credit scores. If the score is below 600 a lender will have 8 good loans for each bad loan. However, if the score is above 800, the lender will have 1,292 good loans for each bad loan! With these kinds of statistics you can see why lenders rely heavily on credit scores. Both FNMA and FREDDIE MAC have agreed that a FICO score of less than 620 indicates a need for cautious review of the Borrower's credit history in order to identify compensating strengths to offset the low credit score (high income or large equity).

While it varies from lender to lender, common terminology in the Mortgage industry is to refer to a score of 651 or greater as A credit; a score from 601 to 650 as B credit; a score of 551 to 600 as C credit; and a score of 525 to 550 as D credit. Persons who have not had sufficient credit to have a FICO score calculated are usually treated for underwriting purposes as having a score of 551.

Anyone with a credit score of less than 600 will find it virtually impossible to obtain a conventional loan. These persons are therefore prime candidates for Private Direct Loans or Seller Financed Mortgages, but because they represent higher credit risk, it is important to offset this factor by higher interest rates and lower LTV's and/or ITV's.

REAL ESTATE TAXES: The government's lien for real property taxes is superior to the rights of a Payee/Mortgagee or Beneficiary of a Deed of Trust. Therefore, if the Owner/Borrower does not pay the taxes, the government could eventually foreclose on the property and sell it for back taxes. This would eliminate the real estate as security for the debt (but would not prevent suit on the Promissory Note). Fortunately there are a number of checks and balances in tax foreclosures and it usually takes several years before the Lender's lien would be destroyed under the policies followed by most tax jurisdictions in Alaska (I have been told that in other states there is not as much protection and the risk for nonpayment of taxes is far greater).

Even though you will probably be notified by the government and have the opportunity to pay the back taxes before losing your position in a tax foreclosure, the failure of the Owner to pay the taxes creates other problems. An Owner who is not paying taxes is usually not doing so because of a cash flow problem and therefore, knowing that he hasn't paid the taxes gives you an early warning of the possibility of default. In addition, if you have to foreclose and the taxes haven't been paid, paying the back taxes will be an additional cost incurred before you can resell the property (again a good reason for low LTV and ITVs).

The best solution to the tax problem is to register with Alaska Realty Tax Service at the time of sale and they will provide you with periodic reports indicating whether taxes have been paid or not. This gives plenty of time to enforce the terms of your Deed of Trust before being faced with a tax foreclosure.

PROPERTY INSURANCE: Next to the risk of default, the biggest risk is the casualty loss on a property that is not covered with insurance. While it seems only common sense that any owner of improved property would have it insured for replacement cost, my experience is that at least 30% of Seller Financed Mortgages are not insured. In other cases, while the property itself may be insured, the Beneficiary of the Deed of Trust has not been named on the policy.

It is extremely important that anytime a Mortgage is created, that is secured by an improved property, that the property be insured for it's full replacement costs and the Lender be named as a Loss Payee on the policy. That way if the policy is canceled the Lender is notified and can take actions to get replacement insurance in the event the owner fails to do so.

It is also important to remember that most insurance policies have a coinsurance clause so that the in the event of partial loss the insurance company will not pay the full amount of the loss unless the owner carries full replacement cost coverage. It is therefore important to make certain that the policy limits are appropriate for the property insured. If it is an income producing property the policy should also cover loss of rents to continue the income stream while the property is repaired or replaced.

DEFAULTS AND FORECLOSURE: The three most common forms of default are failure to insure the property, failure to pay the property taxes, and failure to make the payments in a timely manner. In the event of failure to pay the taxes, the standard Deed of Trust allows the Lender (Beneficiary) to pay those taxes on the Borrower's behalf and add the cost to the balance owed. However, since it is usually about three years before title to the property is put in jeopardy by the failure to pay taxes there is usually plenty of time to act. The best way to keep the amount of taxes from becoming a large obligation, is to enroll in a tax reporting service at the time of sale so that you receive notification in the event that property taxes are not paid.

The standard requirement in Deeds of Trust is that property remain insured at all times with the Lender named as Loss Payee. In the event the Borrowers fail to pay the insurance or don't renew it, the insurance company will notify the Lender. Under the terms of the standard Deed of Trust, the Lender can purchase insurance and add the cost to the balance owed.

The most common form of default is failure to make payments in a timely manner. If the Lender acts quickly and notifies the Borrower of the default when it occurs, most Borrowers begin paying on time. Some people are just careless and only pay the squeaking wheel. On the other hand if the Borrowers do have a true problem such as illness, divorce or loss of employment, by contacting them early the Lender will learn the situation and can perhaps suggest solutions. If the Borrowers are not able to make payments, a Deed in Lieu of Foreclosure can be negotiated. This will save the Lender the cost of foreclosure and can be done in a manner so that the Borrower's credit is not hurt by the action. If the Borrowers' problem is only temporary, payments can be restructured to something they can handle. (My policy is always to ask for an increase in interest anytime restructuring occurs). By acting quickly and dealing with people on a personal basis, it is often possible to resolve a default before it becomes serious.

While defaults are seldom fun, a Lender who has the proper knowledge and who acts quickly can usually keep them from becoming a nightmare.

In the event such negotiations are not successful the Lender has two foreclosure options and one non-foreclosure litigation option. In the order of their most common usage, these options are:

Typical Non-Judicial Foreclosure - In this type of foreclosure the Lender invokes the right to foreclose through a Trustee's Sale, without the necessity for litigation. After a default has occurred for at least 30 days (or more if required by the Deed of Trust) the Lender closes the escrow collection account (if one exists) and then turns the file over to his attorney. The attorney prepares a Beneficiary's Affidavit and a Declaration of Default. This is then delivered to the Trustee who executes a Notice of Default and records it. This Notice of Default is mailed to the defaulting Borrower (Trustor) and any other parties in interest. The Trustee must also post a Notice of Sale in three public places within 5 miles of the sales location and must advertise the Notice of Sale in a newspaper of "general circulation" four times within 30 days prior to sale. Assuming that the default is not cured by payment of all past due payments and foreclosure costs, the property is then sold by the Trustee to the highest bidder. The Lender may enter a non-cash bid equal to the amount owed, including accrued interest, late fees and foreclosure costs. If this is the high bid, title to the property then passes to the Lender. In this type of foreclosure, the Borrower has no right of redemption and the Lender has no right to deficiency judgment in the event that the value of the property has decreased. If all steps are performed on a timely basis, such a foreclosure can be accomplished in about 90 to 120 days and costs typically fall in the range of $3,500 to $5,000.

Judicial Foreclosure - Under this type of foreclosure, a suit is actually filed with the court system and a judge must approve the foreclosure and sale of the property. After the court approves a foreclosure sale, the property is sold to the highest bidder. Again, the Lender may make a non-cash bid at a "fair amount", which term is not precisely defined. After the sale, the Lender petitions the court for an order confirming the sale, subject to the Borrower's one year right of redemption, and asks the court for a judgment against the Borrower for the difference between the amount owed less the sale price of the property. After receipt of the Deficiency Judgment, the Lender is free to pursue normal judgment remedies such as attaching bank deposits, garnishing wages and attaching and forcing the auction of other assets. Due to the chilling effect of the Borrowers having a one year right of redemption, such sales are usually at less than their current market value. As a result, the Lender can usually get a deficiency judgment. This type of foreclosure can often take up to a year to complete, plus an additional year for the right of redemption. I have heard of reported costs in the range of $7,000 to $12,000. This remedy should only be considered if the value of the property is less than the amount owed, and there is belief that the Borrowers have other liquid assets that can be attached.

Suit on Note - With this remedy the Lender does not foreclose on the property, but instead sues on the Note, and after obtaining a judgment may pursue normal judgment remedies, such as attaching bank deposits, garnishing wages, and attaching and forcing the sale of other properties. This type of judicial action usually takes less time, and costs less than a Judicial Foreclosure. It is useful only if the Borrowers have liquid assets that can be found and attached. This course of action is useful when well-to-do Borrowers have abandoned the property and/or have allowed its value to deteriorate through lack of maintenance.

Foreclosure and/or litigation are never fun, and I always recommend an attempt to negotiate, as discussed above. However, if negotiation is not successful, the Lender does have the advantage of choosing from three courses of action, the one that he believes will provide the best financial result. As a note of caution, I point out that I am not an attorney and the above explanations are only summary descriptions of legal options available. None of these three remedies should be attempted without seeking legal advice.

LOAN SERVICING: Although Mortgages are not management intensive investments, they do require some management efforts. Fortunately, the lion's share of this management effort is the rather joyful process of collecting a payment each month! However, as a recipient of interest, a Lender is required by law to report the interest received to the Internal Revenue Service and if the amount received is greater than $600 must a provide an IRS Form 1098 to the Payor. This means it is incredibly important to keep very accurate records in which each payment is recorded and allocated between principal and interest. While this does not sound too complicated, the fact is that there are a number of ways to compute interest and it is often possible for serious disputes to develop between the Lender and the Payor over the allocation. Therefore, unless you have a major enough participation in Mortgage Investments to justify buying Mortgage servicing software, I strongly recommend third party Mortgage servicing.

Alaska is very fortunate in that it has several banks and several private escrow companies that do most of the Mortgage servicing. In addition to calculating principal and interest and providing the government reports, these escrow companies also hold the reconveyance documents to be delivered to the Payor when the Mortgage has been satisfied. The credibility provided to the Payor by knowing that reconveyance documents are protected by a reputable company and knowing that principal and interest will be calculated correctly, help to encourage on time payments.

The bad news is that the bank escrow departments and escrow service companies, while they do an excellent job of what they do, do not do everything involved in Mortgage servicing. While they will send delinquency notices, they are not responsible for collections and likewise do not enforce the provisions for keeping the property insured or payment of real property taxes. While some will collect reserve payments to be used to pay taxes and insurance, and may even pay those when due, they do not assume the responsibility of reviewing the insurance to make certain that it is properly written with the Lender listed as Loss Payee. Also, in the event of a default, they do not supervise the foreclosure process. Therefore, the Lender always retains certain management obligations to insure the success of the investment.

Because our Company is in the business of servicing our own Mortgage investment portfolio, on Mortgage investments that we sell in which our company or our affiliated company maintains a residual interest, we do provide for Mortgage servicing (this service is not provided on the sale of whole Mortgages, but even in those cases we always remain available to provide advice when requested).

Because we provide full Mortgage servicing for our Preferred Mortgage Interests and Preferred Fractional Interests, the Investor in these Mortgage Investment products can truly be an "Armchair Investor".

TO LEARN MORE ABOUT MORTGAGE INVESTMENT: This short tutorial was written to give only an overview of Mortgage investing. If you want to know more about the topic there are a number of ways to obtain additional information. Since the ultimate security of any Mortgage Investment is the real estate that secures it, any additional knowledge that you acquire concerning real estate law, real estate principles and practices, and real estate valuation will be useful. Fortunately every book store has a multitude of books available on real estate and real estate investing and most universities and community colleges offer courses in real estate investing. To get more specific information related strictly to Mortgage Investments, I recommend the following:

"Note Owners Manual": This is a booklet published by our firm that is targeted toward owners of Seller Financed Mortgages. You can obtain a free copy of it by visiting www.cashnowak.com.

"Owner Will Carry": This book is written for Sellers of property, who plan to take back a Seller Financed Mortgage, and for real estate agents. However, because it's purpose is to teach them how to create safe legal Mortgages, it is also a useful reference source for Mortgage Investors. This excellent book can be previewed and ordered by going to store.papersourceonline.com

"The Number One Real Estate Investment No One Talks About", by Sanford W. Hornwood: This book is about investing in Seller Financed Mortgages but provides information that is useful for all forms of Mortgage Investments. I have seen copies of this book in local bookstores and it is also available from Amazon.com.

"Smart Trust Deed Investment in California", by George Coats: Don't let the title fool you. Although George wrote this book specifically for investing in California, California's laws are similar enough to Alaska's laws concerning Deeds of Trust so that about 98% of everything said in this book is applicable to Alaska. Unfortunately, although this is one of the best books ever written on the topic, it is no longer in print and therefore is very hard to find. I did see one copy offered by a rare book seller on the Amazon.com site, for $170. However, I still have my copy of it and if you would like to come by my office, I would be happy to loan it to you for a couple of weeks.

"Paper Source Newsletter": This is an excellent newsletter and they also have lots of useful information on their website (Click: www.PaperSourceOnline.com).

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