Notes and Their Provisions the structure, requirements, and specific clauses governing the promissory note and the corresponding debt obligations.
Here is a summary of the key concepts within this section:
The Promissory Note
The promissory note is a written document serving as evidence of a debt owed by one person to another, typically arising from the loan of funds or the conveyance of property in an installment sale.
• Enforceability: To be enforceable, the note must be signed by the borrower (payor) and delivered to the lender or carryback seller (payee).
• Security: A note can be secured by a security device, such as a trust deed (commonly called a mortgage), which imposes a voluntary lien on the real estate. Although separate documents, the note and the trust deed for the same transaction are considered one contract and must be read together.
• Repayment Types: Notes are categorized by repayment methods:
◦ Installment notes call for periodic payments of principal and interest, or interest only, until the principal is paid off by amortization or a balloon payment. The most common type is the interest-included installment note, which features a constant periodic payment schedule.
◦ Straight notes require the entire principal and accrued interest to be paid in a single lump sum when due.
• Variations: Variations of notes include the Adjustable Rate Mortgage (ARM), Graduated Payment Mortgage (GPM), All-Inclusive Trust Deed (AITD) note, and Shared Appreciation Mortgage (SAM.
• Carryback Notes: Seller carryback notes are classified as credit sales (installment sales) and are generally not subject to usury laws.
Basic Provisions
A note must contain certain provisions to be enforceable, making the terms of repayment “definite and certain”.
• Minimum Elements: These include the amount of principal owed, the interest rate, the repayment schedule, and who is responsible for repayment.
• Consideration and Negotiability: The note requires valid consideration to be enforceable. An unconditional promise to pay is necessary for the note to be negotiable (transferable by assignment). The phrase “or order” extends the borrower’s promise to pay to whomever the payee assigns the note and trust deed.
• Prepayment: The standard note includes an “or more” clause, which typically allows the borrower to prepay a portion or all of the debt unless restricted by other clauses.
• Default and Reinstatement: A default allows the mortgage holder to trigger acceleration, demanding immediate payment of all unpaid amounts. However, the borrower generally retains the right of reinstatement to cure curable defaults noted in the notice of default (NOD) up until five business days before the trustee’s sale.
Special Provisions and Modification
Special provisions may be added to notes to manage risk or comply with regulations.
• Risk Mitigation: Special provisions include prepayment penalties, late charges and grace periods, compounding on default (accrual of interest on delinquent interest), a final/balloon payment notice, a payoff discount option, and reference to a guarantee agreement
• Exculpatory Clause: An exculpatory clause can be added to convert a recourse debt into nonrecourse debt, barring the mortgage holder from obtaining a money judgment against the borrower in the event of a deficiency.
• Modification: Modifying a note is controlled by contract law and requires a written agreement or an executed oral agreement. The new terms are evidenced by a Modification of the Promissory Note form which is attached to the original note as an allonge. Significant modifications to a senior mortgage may require subordination agreements from junior lienholders to maintain the senior lien’s priority.
A novation occurs when the mortgage holder, buyer, and seller agree to shift the mortgage obligation entirely to the buyer, releasing the seller from liability.
Interest Rate and Payment Provisions
The section covers the specifics of variable interest rates and penalties related to the payment schedule.
• Adjustable Rate Mortgages (ARMs): ARMs are a primary variation on the fixed interest rate repayment method.
• Prepayment Penalties Penalties designed to recover losses incurred by the mortgage holder due to early principal payoff. For fixed rate qualified mortgages (QMs), the prepayment penalty period is limited to three years after origination. The provision allowing for the penalty must be included in the note itself.
• Mortgage Lock-in Clauses: A lock-in clause restricts the borrower to making only the regularly scheduled installment payments, thus prohibiting prepayment. In real estate law, this clause functions as a restraint on alienation.
• Late Charges and Grace Periods: A late charge provision specifies an additional charge if a payment is not received when due or within the established grace period. Late charges on loans made or arranged by a broker are typically limited to the greater of 10% of the delinquent payment or $5. Failure to pay a late charge does not constitute a material breach justifying foreclosure if all other installments are current.
• Balloon Payments: A balloon payment is a final lump sum payment greater than twice the amount of any of the six preceding regular scheduled payments. For consumer mortgages with terms exceeding one year and secured by residential property, a 90 to 150-day due date notice provision is required before the balloon payment is due. Failure to provide this notice extends the note’s due date until 90 days after the notice requirement has been fulfilled.
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Analogy: The promissory note and its provisions can be thought of as the DNA of the debt. It contains the fundamental code (principal, interest, and schedule) necessary for existence, while specialized genes (special provisions like prepayment penalties or lock-in clauses) dictate specific behaviors and restrictions tailored to the security environment (the trust deed) and market rules (consumer regulations). Modifying the note is like gene therapy—a precise change (allonge) to ensure the debt functions correctly without destabilizing its relationship with external elements (junior liens, priority).
