This educational report on promissory notes explains different types of promissory notes used in real estate transactions. It details the structure and legal implications of secured and unsecured notes, including installment notes (interest-included and interest-extra) and straight notes. The text also covers variations like adjustable-rate, graduated-payment, all-inclusive trust deed, and shared appreciation mortgages. Finally, it discusses California usury laws and the process of reconveyance after a debt is paid.

Promissory Note FAQ

What is a promissory note?

A promissory note is a written document that serves as evidence of a debt owed by one person (the borrower) to another (the lender). It outlines the terms of repayment, including the principal amount, interest rate, payment schedule, and due date. For the note to be legally binding, it must be signed by the borrower and given to the lender upon closing the sale.

How are promissory notes categorized?

Promissory notes are primarily categorized by their repayment method:

• Installment notes: Require periodic payments of principal and interest (or interest only) until the principal is fully paid. These payments can be structured with a fixed interest rate or an adjustable rate. Common variations include interest-included notes (where interest is included in the regular payment) and interest-extra notes (where interest is paid separately).
• Straight notes: Require the entire principal and accrued interest to be paid in a single lump sum on the due date. These are typically used for short-term debts.

What is the difference between a secured and unsecured promissory note?

• Secured note: Backed by an asset, such as real estate, which serves as collateral. In real estate transactions, the security instrument is typically a trust deed or mortgage, creating a lien on the property. If the borrower defaults, the lender can foreclose on the property to recover the debt.
• Unsecured note: Not backed by any specific asset. If the borrower defaults, the lender has limited recourse and may need to pursue legal action to recover the debt.

What are some common variations of promissory notes in real estate transactions?

Beyond the basic categories, several variations of promissory notes cater to specific needs:

• Adjustable Rate Mortgage (ARM): Interest rate fluctuates periodically based on a predetermined index, leading to potential changes in the monthly payment amount.
• Graduated Payment Mortgage (GPM): Payments increase incrementally over time, starting lower and gradually rising to fully amortize the loan.
• All-Inclusive Trust Deed (AITD) Note: Used in carryback transactions where the buyer makes payments to the seller, who then covers the existing mortgage payments.
• Shared Appreciation Mortgage (SAM): Buyer pays a lower fixed interest rate in exchange for sharing a portion of the property’s appreciation with the lender upon sale or maturity.

What are the financial aspects of a promissory note?

The promissory note establishes the principal amount, interest rate, and payment schedule. California usury laws limit interest rates on non-exempt real estate loans, and for consumer mortgages, lenders must adhere to the Ability-to-Repay (ATR) rules to ensure borrowers can manage their debt.

What is the role of a trust deed in relation to a promissory note?

A trust deed secures the promissory note by placing a lien on the property. While separate documents, they are considered parts of a single contract. The trust deed ensures the lender’s security interest in the property, allowing for foreclosure in case of default.

What is a reconveyance?

A reconveyance is the process of removing the lender’s lien (created by the trust deed) from the property title once the debt is fully paid. The trustee executes a reconveyance document, returning full ownership to the borrower.

Are there any interest rate limitations on promissory notes in California?

Yes, California usury laws impose limitations on interest rates for non-exempt real estate loans. The maximum allowable rate is either 10% or the discount rate charged by the Federal Reserve Bank of San Francisco plus 5%, whichever is greater. However, seller carryback notes are generally exempt from usury laws because they are considered installment sales rather than loans.

Briefing Doc: Promissory Notes and Trust Deeds in Real Estate Transactions

This briefing doc reviews the key concepts and facts related to promissory notes and trust deeds in real estate transactions, as detailed in Chapter 3 of “Promissory Note.txt”.

Main Themes:

• Promissory Notes as Evidence of Debt: A promissory note is the primary document evidencing a debt owed in a real estate purchase financed through a mortgage or a seller carryback financing arrangement. The note outlines the promise to repay the debt, signed by the buyer (borrower) and delivered to the lender (payee).
• Secured vs. Unsecured Notes: A note can be secured by an asset (collateral), typically the property being purchased. This secured note is then attached to the property title as a lien through a security instrument, most commonly a trust deed (mortgage).
• Types of Notes and Repayment Schedules: Notes are categorized based on their repayment methods:
• Installment Notes: These require periodic payments of principal and interest, either with interest included in the payment or paid separately. Installment notes can amortize over time or include a final balloon payment.
• Straight Notes: The entire principal and accrued interest are paid in a single lump sum at a specified due date.
• Variations in Interest Rates and Payment Schedules: Several variations exist, including:
• Adjustable Rate Mortgages (ARMs): Interest rates fluctuate based on a predetermined index.
• Graduated Payment Mortgages (GPMs): Payments increase periodically until full amortization is achieved.
• All-Inclusive Trust Deed (AITD) Notes: Used in carryback transactions, the buyer’s payments cover both the existing and new loans.
• Shared Appreciation Mortgages (SAMs): The lender receives a portion of the property’s appreciation at a future sale or maturity.
• Legal Considerations:Usury Laws: California law limits interest rates on non-exempt loans. However, seller carryback notes, being installment sales, are exempt from usury laws.
• Reconveyance: Upon full debt repayment, the lender must remove the lien through a reconveyance process, releasing the property title.

Important Ideas and Facts:

• “A promissory note is a document given as evidence of a debt owed by one person to another… To be enforceable, the promissory note needs to be signed by the buyer, also known as the borrower, debtor or payor.”
• “The note and trust deed for the same transaction are considered one contract to be read together.”
• “California’s usury law limits the interest rate on non-exempt real estate loans to the greater of: 10%; or the discount rate charged by the Federal Reserve Bank of San Francisco, plus 5%.”
• “Seller carryback notes are not money loans. Rather, they are installment sales that extend credit for payment of the price on a sale. Thus, they are not covered by usury law.”
• “When a debt secured by a trust deed lien on real estate has been fully paid, the lien is removed from title, a process called a reconveyance.”

Significance:

Understanding the intricacies of promissory notes and trust deeds is crucial for both buyers and sellers in real estate transactions. It ensures transparency, clarifies repayment obligations, and protects the involved parties’ legal and financial interests.

Next Steps:

Further research is recommended to delve deeper into specific note types and their implications for various real estate scenarios. Familiarizing oneself with applicable laws and regulations is also crucial for informed decision-making.

Promissory Notes and Trust Deeds: A Study Guide

Short Answer Quiz

Instructions: Answer the following questions in 2-3 sentences each.

1. What is a promissory note and what are the key elements required for it to be enforceable?
2. Differentiate between a secured and an unsecured note. What security device is typically used for a note secured by real estate?
3. Explain the difference between an installment note and a straight note. Provide an example of when each type might be used.
4. Describe how an interest-included installment note amortizes the principal over time.
5. What is a balloon payment and under what circumstances are they permitted in consumer mortgages?
6. How does an interest-extra installment note differ from an interest-included installment note in terms of payment structure?
7. Explain the concept of negative amortization and provide an example of a mortgage type where it might occur.
8. What is the purpose of an all-inclusive trust deed (AITD) note, and when might it be particularly popular?
9. Describe how a shared appreciation mortgage (SAM) functions, including the concept of a “floor rate” and “contingent interest.”
10. What are the limitations on interest rates for real estate loans in California? Are seller carryback notes subject to these limitations?

Short Answer Quiz Answer Key

1. A promissory note is a written document that serves as evidence of a debt owed by one party (borrower) to another (lender). For a promissory note to be enforceable, it must be signed by the borrower and delivered to the lender.
2. A secured note is backed by an asset (collateral) that can be seized by the lender if the borrower defaults, while an unsecured note lacks this backing. A trust deed, commonly referred to as a mortgage, is the typical security device used for a note secured by real estate.
3. An installment note requires periodic payments of principal and interest over time, while a straight note demands the full principal and accrued interest in a single lump sum payment at maturity. Installment notes are common for long-term mortgages, while straight notes are often used for short-term loans like bridge loans.
4. An interest-included installment note features a fixed monthly payment. Initially, a larger portion of the payment covers interest, with a smaller portion going toward principal reduction. As the principal balance decreases over time, the interest portion shrinks, and the principal portion grows, ultimately leading to full amortization.
5. A balloon payment is a large lump sum payment due at the end of a loan term, encompassing the remaining unpaid principal balance. In consumer mortgages, balloon payments are generally only allowed under specific regulations, such as the “ability-to-repay” (ATR) rules or for certain qualified mortgages (QMs) offered by small creditors.
6. In an interest-extra installment note, the principal is repaid in constant periodic installments, but interest accrues separately and is typically paid alongside each principal installment. Unlike interest-included notes, where the total payment remains constant, interest-extra notes have declining payments as the interest portion decreases with each principal reduction.
7. Negative amortization occurs when the monthly mortgage payment is insufficient to cover the accruing interest, resulting in the unpaid interest being added to the principal balance, effectively increasing the loan amount. This can happen with certain mortgage types like graduated payment mortgages (GPMs) where initial payments are intentionally set lower than the accruing interest.
8. An all-inclusive trust deed (AITD) note, also known as a wraparound mortgage, involves the buyer making payments to the seller, who then uses those funds to cover payments on an existing underlying mortgage. AITDs can be attractive in periods of high interest rates or tight credit as they allow sellers to offer financing at potentially more favorable terms.
9. A shared appreciation mortgage (SAM) features a lower fixed interest rate (“floor rate”) in exchange for the lender receiving a share of the property’s appreciation (“contingent interest”) when it is sold or the mortgage matures. This structure allows buyers to access more affordable financing, while sellers benefit from potential future gains in property value.
10. In California, the maximum allowable interest rate for non-exempt real estate loans is generally the greater of 10% or the Federal Reserve Bank of San Francisco’s discount rate plus 5%. However, seller carryback notes are considered installment sales rather than loans and are exempt from these usury limitations.

Essay Questions

1. Compare and contrast the features, advantages, and disadvantages of interest-included and interest-extra installment notes. Consider the perspective of both the borrower and the lender.
2. Analyze the different types of promissory note variations (ARM, GPM, AITD, and SAM), discussing their unique characteristics and the circumstances under which each might be preferred by either the borrower or the lender.
3. Explain the concept of a trust deed and its relationship to a promissory note in a real estate transaction. Describe the process of reconveyance and the potential consequences if a lender fails to properly reconvey a trust deed.
4. Discuss the legal and ethical considerations related to usury laws in California. Explain how these laws apply to different types of real estate financing arrangements, including traditional mortgages and seller carryback financing.
5. Evaluate the potential risks and benefits of using seller carryback financing in a real estate transaction. Consider factors such as prevailing market conditions, buyer and seller motivations, and the legal framework governing such arrangements.

Glossary of Key Terms

TermDefinitionPromissory NoteA written legal document that serves as evidence of a debt and outlines the terms of repayment, including the principal amount, interest rate, payment schedule, and maturity date.Secured NoteA promissory note backed by an asset (collateral) that the lender can seize if the borrower defaults on the loan.Unsecured NoteA promissory note that lacks any collateral backing.Trust DeedA legal instrument that grants a lender a security interest in real estate as collateral for a loan. Often referred to as a mortgage.Installment NoteA promissory note requiring periodic payments of principal and interest over a set term until the loan is fully repaid.Straight NoteA promissory note requiring the full principal and accrued interest to be paid in a single lump sum payment at maturity.AmortizationThe process of gradually reducing a loan balance through regular payments that cover both principal and interest.Balloon PaymentA large lump sum payment due at the end of a loan term, representing the remaining unpaid principal balance.Interest-Included NoteAn installment note where the periodic payment includes both principal and interest components, with the interest portion decreasing and the principal portion increasing over time.Interest-Extra NoteAn installment note where the principal is repaid in constant periodic installments, and interest accrues separately and is paid alongside each principal installment.Negative AmortizationA situation where the monthly payment is insufficient to cover the accruing interest, resulting in the unpaid interest being added to the principal balance.Adjustable Rate Mortgage (ARM)A mortgage where the interest rate fluctuates periodically based on changes in a specified index, resulting in potentially variable monthly payments.Graduated Payment Mortgage (GPM)A mortgage with a structured payment schedule where initial payments are lower and gradually increase over time, potentially leading to negative amortization in the early years.All-Inclusive Trust Deed (AITD)A financing arrangement where the buyer makes payments to the seller, who then uses those funds to cover payments on an existing underlying mortgage. Also known as a wraparound mortgage.Shared Appreciation Mortgage (SAM)A mortgage where the lender receives a share of the property’s appreciation in addition to interest payments, typically in exchange for a lower initial interest rate.Usury LawsLaws that establish limits on the maximum interest rate that lenders can charge on loans.ReconveyanceThe process of removing a lender’s security interest (trust deed) from a property’s title after the loan has been fully repaid.