Real Estate Financing and Loan Types

Master the complexities of real estate financing with free flashcards and structured practice on loan types, mortgage instruments, and critical financial calculations. This lesson covers conventional and government-backed loans, promissory notes versus deeds of trust, loan-to-value ratios, and the mathematical formulas essential for California Real Estate Salesperson Exam success.

Welcome to Financing Fundamentals 💰

Financing is the lifeblood of real estate transactions—approximately 90% of home purchases involve some form of borrowed money. As a real estate salesperson, you'll need to understand not just the types of loans available, but also how lenders evaluate borrowers, calculate payments, and secure their interests in property. This lesson builds on your knowledge of property ownership and agency relationships by adding the financial layer that makes transactions possible.

Understanding financing is crucial because:

• Buyer qualification depends on loan availability and terms
• Property marketability varies based on financing options
• Transaction timelines are driven by lender requirements
• Your fiduciary duty includes helping clients understand their financing options

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Core Concepts in Real Estate Financing 🏦

Primary vs. Secondary Financing Markets

The primary market is where loans originate—where borrowers meet lenders. The secondary market is where existing loans are bought and sold, providing liquidity to lenders so they can make more loans.

Fannie Mae (FNMA) and Freddie Mac (FHLMC) purchase conventional loans from lenders, package them into mortgage-backed securities, and sell them to investors. This process:

• Returns capital to lenders quickly
• Standardizes underwriting criteria nationwide
• Keeps interest rates competitive
• Establishes conforming loan limits (2024: $766,550 in most California counties, higher in expensive areas)

Ginnie Mae (GNMA) guarantees securities backed by government-insured loans (FHA, VA, USDA), providing additional market stability.

💡 Tip: When a lender says "we need to meet Fannie Mae guidelines," they're referring to standardized underwriting criteria that allow the loan to be sold on the secondary market.

Conventional Loans vs. Government-Backed Loans

Conventional loans are not insured or guaranteed by the federal government. They typically require:

• Higher credit scores (usually 620+ for approval, 740+ for best rates)
• Larger down payments (often 20% to avoid PMI)
• Lower debt-to-income ratios (typically 43% maximum)
• Full documentation of income and assets

Private Mortgage Insurance (PMI) is required on conventional loans when the loan-to-value ratio exceeds 80%. This protects the lender (not the borrower) if the borrower defaults. PMI typically costs 0.5-1.5% of the loan amount annually and can be cancelled once equity reaches 20%.

Loan Type	Down Payment	Credit Score	Special Features
Conventional	3-20%	620-740+	PMI if LTV > 80%
FHA	3.5%	580+	MIP required (upfront + annual)
VA	0%	No minimum	Veterans only, funding fee applies
CalVet	0%	Varies	CA veterans, direct lending program
USDA	0%	640+	Rural properties only

FHA (Federal Housing Administration) loans are insured by the government, allowing lenders to offer:

• Lower down payments (3.5% minimum with 580+ credit score)
• More flexible credit requirements
• Higher debt-to-income ratios (up to 50% with compensating factors)
• Assumable loans (big advantage in rising rate environments)

⚠️ Important: FHA loans require Mortgage Insurance Premium (MIP)—both an upfront premium (1.75% of loan amount) and annual premiums. Unlike conventional PMI, FHA MIP cannot be cancelled on most loans originated after 2013 unless the borrower refinances or pays off the loan.

VA (Department of Veterans Affairs) loans offer exceptional benefits for eligible veterans, active-duty service members, and surviving spouses:

• No down payment required (100% financing)
• No monthly mortgage insurance
• No prepayment penalties
• Competitive interest rates
• Limited closing costs
• Funding fee (2.3% for first-time use with 0% down, can be financed)

CalVet loans are unique California-specific loans where the state purchases the property and sells it to the veteran through a land contract. The state holds legal title until the loan is paid off. Benefits include:

• Low or no down payment
• Competitive fixed rates
• Life and disability insurance included
• Property tax assistance available

Promissory Notes and Security Instruments 📝

In California real estate financing, two critical documents work together:

1. Promissory Note (Note)

• The promise to repay the debt
• Creates personal liability for the borrower
• Specifies loan amount, interest rate, payment schedule, and maturity date
• Makes the borrower personally liable for the debt
• Is a negotiable instrument (can be sold/transferred)

2. Deed of Trust (Trust Deed)

• The security instrument that pledges the property as collateral
• Creates a lien against the property
• Involves three parties: trustor (borrower), beneficiary (lender), trustee (neutral third party)
• Allows non-judicial foreclosure (faster, no court required)

┌────────────────────────────────────────────────┐
│     DEED OF TRUST THREE-PARTY STRUCTURE        │
└────────────────────────────────────────────────┘

        🏠 TRUSTOR (Borrower)
            │
            │ Conveys bare legal title
            ↓
        📋 TRUSTEE (Neutral party)
            │
            │ Holds title for security
            │
            ↓
        💰 BENEFICIARY (Lender)
            │
            │ If default occurs
            ↓
        🔨 Trustee conducts foreclosure sale

💡 Memory Device - "TBT": Trustor Borrows from Beneficiary through Trustee

California uses deeds of trust, not mortgages, for most real estate loans. The key difference:

Feature	Deed of Trust (CA)	Mortgage (other states)
Parties	3 (trustor, beneficiary, trustee)	2 (mortgagor, mortgagee)
Title held by	Trustee (bare legal title)	Borrower (lender has lien)
Foreclosure	Non-judicial (faster)	Judicial (court process)
Redemption period	None after trustee sale	Varies by state
Deficiency judgment	Generally prohibited on purchase money	Often allowed

Hypothecation is the process of pledging property as security without giving up possession. The borrower retains possession and use of the property while the lender holds a security interest.

Loan-to-Value Ratio (LTV) and Qualifying Ratios 🧮

Loan-to-Value Ratio (LTV) measures risk from the lender's perspective:

LTV = (Loan Amount ÷ Property Value) × 100

Example: A borrower wants to purchase a $500,000 home with a $100,000 down payment:

• Loan amount: $500,000 - $100,000 = $400,000
• LTV: ($400,000 ÷ $500,000) × 100 = 80%

Lower LTV = lower risk for lender = better loan terms. At 80% LTV or below, conventional loans typically don't require PMI.

Combined Loan-to-Value (CLTV) is used when there are multiple loans:

CLTV = [(First Loan + Second Loan) ÷ Property Value] × 100

Example: A borrower has a $400,000 first mortgage and takes out a $50,000 home equity line on a $600,000 property:

• CLTV: [($400,000 + $50,000) ÷ $600,000] × 100 = 75%

Qualifying Ratios determine borrower capacity:

1. Housing Expense Ratio (Front-End Ratio):

Housing Ratio = (PITI ÷ Gross Monthly Income) × 100

Where PITI = Principal + Interest + Taxes + Insurance

Conventional guideline: 28% or less FHA guideline: 31% or less

2. Total Debt Ratio (Back-End Ratio):

Total Debt Ratio = [(PITI + Other Monthly Debts) ÷ Gross Monthly Income] × 100

Conventional guideline: 36-43% or less FHA guideline: 43-50% or less (with compensating factors)

Step	Calculation Component	Example
1	Monthly Principal & Interest	$2,200
2	+ Property Taxes	$450
3	+ Homeowners Insurance	$150
4	+ HOA Fees (if applicable)	$200
5	= Total PITI	$3,000
6	÷ Gross Monthly Income	$10,000
7	= Housing Expense Ratio	30%

Discount Points and Interest Rates 📊

Discount points are prepaid interest paid at closing to reduce the interest rate. Each point:

• Costs 1% of the loan amount
• Typically reduces the interest rate by 0.25% (varies by market)
• Is tax-deductible for purchase loans in the year paid

Example: On a $400,000 loan:

• 1 point = $4,000
• 2 points = $8,000
• If 2 points reduce rate from 7.0% to 6.5%, the borrower saves interest over time but pays more upfront

Break-even analysis determines whether points make financial sense:

Step	Calculation	Result
1	Cost of points	$8,000
2	Monthly payment savings (7.0% vs 6.5%)	$130
3	Break-even months: $8,000 ÷ $130	61.5 months
4	Break-even years	~5.1 years

Conclusion: If the borrower plans to keep the loan for more than 5 years, paying points saves money. If they'll refinance or sell sooner, skip the points.

APR (Annual Percentage Rate) is the true cost of borrowing, including:

• Interest rate
• Discount points
• Origination fees
• Mortgage insurance premiums
• Other mandatory costs

The APR is always higher than the interest rate because it includes these additional costs. Federal Truth in Lending Act (TILA) requires lenders to disclose APR.

Amortization and Payment Calculations 🔢

Amortization is the gradual repayment of a loan through regular payments. Each payment includes both principal and interest, with the proportion changing over time:

LOAN AMORTIZATION OVER TIME

  Payment     Early Loan           Mid-Loan            Late Loan
  Amount    
            ┌──────────┐        ┌──────────┐        ┌──────────┐
            │          │        │          │        │          │
            │ Interest │        │ Interest │        │ Interest │
            │          │        │          │        │          │
            │   90%    │        │   50%    │        │   10%    │
            ├──────────┤        ├──────────┤        ├──────────┤
            │Principal │        │Principal │        │Principal │
            │   10%    │        │   50%    │        │   90%    │
            └──────────┘        └──────────┘        └──────────┘

Monthly Payment Formula (Fixed-Rate Mortgage):

While the actual formula is complex, for exam purposes, you should understand:

• Higher interest rate = higher payment
• Longer loan term = lower monthly payment (but more total interest)
• Larger loan amount = higher payment

Example calculations you might encounter:

Calculating monthly principal & interest: Use the $1,000 monthly payment table provided on the exam. If the table shows that at 6.5% for 30 years, the payment per $1,000 of loan is $6.32:

For a $350,000 loan:

• $350,000 ÷ $1,000 = 350 (number of thousands)
• 350 × $6.32 = $2,212 monthly P&I

First month's interest:

First Month Interest = (Loan Amount × Annual Rate) ÷ 12

For a $300,000 loan at 6% annual rate:

• ($300,000 × 0.06) ÷ 12 = $18,000 ÷ 12 = $1,500

First month's principal:

• If monthly P&I payment = $1,799
• First month interest = $1,500
• First month principal = $1,799 - $1,500 = $299

💡 Tip: Early in the loan, most of your payment goes to interest. This is why refinancing or selling early means you've built very little equity through principal reduction.

Adjustable-Rate Mortgages (ARMs) 📈

Unlike fixed-rate mortgages, ARMs have interest rates that change periodically based on an index. Key components:

1. Index: The benchmark rate the loan is tied to

• SOFR (Secured Overnight Financing Rate) - replacing LIBOR
• Treasury Bills (T-bills)
• 11th District Cost of Funds Index (COFI)

2. Margin: The lender's markup added to the index (typically 2-3%)

Fully Indexed Rate = Index + Margin

3. Caps: Limits on rate changes

• Periodic cap: Maximum rate change per adjustment period (e.g., 2% per year)
• Lifetime cap: Maximum rate increase over loan life (e.g., 5-6% above start rate)
• Initial cap: First adjustment limit

Common ARM structure: "5/1 ARM"

• Fixed for 5 years
• Adjusts annually thereafter
• Often written as "5/1 ARM with 2/2/5 caps" meaning:
  • First adjustment: max 2%
  • Subsequent adjustments: max 2% per year
  • Lifetime: max 5% above initial rate

Example: 5/1 ARM starts at 5.5%

• Years 1-5: Rate stays at 5.5%
• Year 6 (first adjustment): Rate could go to 7.5% (5.5% + 2% cap)
• Year 7: If index rose dramatically, rate could go to 9.5% (7.5% + 2% cap)
• Maximum ever: 10.5% (5.5% + 5% lifetime cap)

⚠️ Payment shock can occur when rates adjust upward significantly. Always counsel borrowers to qualify at the fully-indexed rate, not just the teaser rate.

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Practical Examples 🎯

Example 1: FHA vs. Conventional Comparison

Scenario: Maria wants to buy a $450,000 home. She has $25,000 saved. Should she use FHA or conventional financing?

FHA Option:

• Minimum down: 3.5% × $450,000 = $15,750
• Loan amount: $450,000 - $15,750 = $434,250
• Upfront MIP: $434,250 × 1.75% = $7,599 (added to loan)
• Total loan: $434,250 + $7,599 = $441,849
• Annual MIP: $441,849 × 0.85% = $3,756 annually ($313/month)
• LTV: 98.2%

Conventional Option with 5% down:

• Down payment: 5% × $450,000 = $22,500
• Loan amount: $427,500
• PMI: ~$284/month (estimated at 0.8% annually)
• LTV: 95%

Analysis:

• FHA requires less down payment ($15,750 vs $22,500)
• FHA has higher upfront costs ($7,599 upfront MIP)
• Monthly insurance costs are similar ($313 vs $284)
• Key difference: PMI can be cancelled at 80% LTV; FHA MIP typically cannot
• Recommendation: If Maria plans to stay long-term and build equity, conventional may be better long-term despite higher initial down payment requirement

Example 2: Qualifying Ratio Calculation

Scenario: Tom earns $8,000/month gross income. He has a car payment of $450/month and student loans of $300/month. He's looking at a home where PITI would be $2,400/month. Does he qualify for a conventional loan?

Calculations:

Housing Expense Ratio:

• $2,400 ÷ $8,000 = 0.30 = 30%
• Guideline: 28% maximum
• Exceeds guideline by 2% ⚠️

Total Debt Ratio:

• Total monthly debt: $2,400 + $450 + $300 = $3,150
• $3,150 ÷ $8,000 = 0.394 = 39.4%
• Guideline: 36% maximum (some lenders allow 43%)
• Exceeds standard guideline by 3.4% ⚠️

Conclusion: Tom is borderline. Options:

1. Find a less expensive property
2. Increase income (second job, co-borrower)
3. Pay off the car loan or student loans
4. Look for lenders with more flexible guidelines (may require compensating factors like high credit score or large down payment)

Example 3: Discount Points Decision

Scenario: Linda is financing $500,000. Her lender offers:

• Option A: 7.0% rate, no points
• Option B: 6.5% rate, 2 points

She plans to keep the loan for 10 years. Which option is better?

Calculations:

Option A (7.0%, no points):

• Monthly P&I: $3,327 (using payment table: $500,000 ÷ 1,000 × $6.65)
• Upfront cost: $0

Option B (6.5%, 2 points):

• Monthly P&I: $3,160 (using payment table: $500,000 ÷ 1,000 × $6.32)
• Upfront cost: 2% × $500,000 = $10,000
• Monthly savings: $3,327 - $3,160 = $167

Break-even Analysis:

• Months to break even: $10,000 ÷ $167 = 59.9 months ≈ 5 years
• Linda plans to keep loan for 10 years

Total Savings Over 10 Years:

• Monthly savings: $167
• Months: 120 (10 years)
• Total savings: $167 × 120 = $20,040
• Minus cost of points: $20,040 - $10,000 = $10,040 net savings

Recommendation: Option B with points saves Linda over $10,000 because she's keeping the loan longer than the break-even period.

Example 4: ARM Adjustment Scenario

Scenario: Carlos has a 5/1 ARM that started at 4.5% with 2/2/6 caps. After 5 years, the index has risen 3.5%. The margin is 2.5%. What's his new rate?

Calculations:

Fully Indexed Rate:

• Current index: (original + 3.5%)
• Fully indexed: Index + 2.5% margin
• Theoretical new rate: Would be much higher

Apply First Adjustment Cap (2%):

• Maximum increase: 2%
• New rate: 4.5% + 2% = 6.5%

Even though the fully indexed rate might be higher (say 7.5%), the first adjustment cap limits Carlos's rate to 6.5%.

If rates continue rising:

• Year 6 rate: 6.5%
• Year 7 max rate: 6.5% + 2% = 8.5%
• Lifetime max rate: 4.5% + 6% = 10.5%

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Common Mistakes and How to Avoid Them ⚠️

Mistake 1: Confusing Loan Types and Requirements

❌ Wrong: "FHA loans don't require mortgage insurance if you put 20% down."

✅ Right: FHA loans require both upfront and annual mortgage insurance premiums regardless of down payment amount. The conventional loan PMI can be avoided with 20% down.

How to remember: FHA = Federal Helps Affordability but requires MIP as the cost for lower down payments and flexible credit.

Mistake 2: Misunderstanding the Deed of Trust Parties

❌ Wrong: "The trustee is the lender who makes the loan."

✅ Right: The trustee is a neutral third party (often a title company) who holds bare legal title. The beneficiary is the lender.

Memory device: The trustee is trusted by both parties to be neutral—they're not involved in lending.

Mistake 3: Calculating LTV Incorrectly

❌ Wrong: "The property appraised for $500,000 but sold for $480,000. The loan is $400,000, so LTV = $400,000 ÷ $500,000 = 80%."

✅ Right: LTV uses the lower of appraised value or purchase price. LTV = $400,000 ÷ $480,000 = 83.3%

Lenders always use the more conservative figure to protect their interest.

Mistake 4: Forgetting the Entire PITI in Qualifying Ratios

❌ Wrong: Calculating housing ratio using only principal and interest payments.

✅ Right: Include all four components: Principal, Interest, Taxes, Insurance (and HOA fees if applicable).

Checklist for PITI:

• ✓ Principal & Interest payment
• ✓ Property taxes (annual ÷ 12)
• ✓ Homeowners insurance (annual ÷ 12)
• ✓ PMI/MIP (if applicable)
• ✓ HOA dues (if applicable)

Mistake 5: Confusing Points with Origination Fees

❌ Wrong: "Discount points and origination fees are the same thing."

✅ Right:

• Discount points = prepaid interest to reduce rate (tax deductible on purchase)
• Origination fees = lender's processing fees (may be tax deductible, spread over loan life)

Both are expressed as percentage of loan amount, but serve different purposes.

Mistake 6: Not Understanding Non-Judicial Foreclosure Implications

❌ Wrong: "After foreclosure in California, the borrower can redeem the property by paying what they owe."

✅ Right: California's deed of trust allows non-judicial foreclosure with no redemption period after the trustee sale. Once sold, the property is gone.

Important exception: Judicial foreclosure (rare in CA) does provide a redemption period.

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Key Takeaways 🎯

Remember for the Exam:

1. California uses deeds of trust, not mortgages → allows faster non-judicial foreclosure
2. PMI protects the lender, not the borrower, and can be cancelled at 80% LTV on conventional loans
3. FHA MIP includes upfront (1.75%) and annual premiums, cannot be cancelled on most loans
4. Always use the lower of appraised value or purchase price for LTV calculations
5. Discount points are prepaid interest (1% of loan = 1 point, typically reduces rate 0.25%)
6. PITI must include ALL four components when calculating qualifying ratios
7. Hypothecation = pledging property as security while keeping possession
8. Secondary market purchases loans from originators, creating liquidity and standardization

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📚 Further Study

For deeper understanding of real estate financing:

1. California Department of Real Estate - https://www.dre.ca.gov - Official exam content outline and reference materials
2. Consumer Financial Protection Bureau (CFPB) - https://www.consumerfinance.gov/owning-a-home - Comprehensive loan comparison tools and mortgage calculators
3. Federal Housing Finance Agency - https://www.fhfa.gov - Information on Fannie Mae, Freddie Mac, and conforming loan limits

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Next Steps: Now that you understand financing fundamentals, you're ready to explore transfer of property, including deeds, title insurance, and the escrow process. These elements work together with financing to complete real estate transactions in California.