The promissory note, referred to as the note or financing instrument, is the borrower’s personal promise to repay a debt according to agreed terms. The note exposes all the borrower’s assets to claims by secured creditors. The mortgagor executes one or more promissory notes to total the amount of the debt.
A promissory note executed by a borrower (known as the maker or payor) is a contract complete in itself.
It generally states the:
When signed by the borrowers and other necessary parties, the note becomes a legally enforceable and fully negotiable instrument of debt. When the terms of the note are satisfied, the debt is discharged. If the terms of the note are not met, the lender may choose to sue to collect on the note or to foreclose.
A note need not be tied to a mortgage or a deed of trust. A note used as a debt instrument without any related collateral is called an unsecured note. Unsecured notes are used by banks and other lenders to extend short-term personal loans.
A note is a negotiable instrument like a check or bank draft. The lender who holds the note is referred to as the payee and may transfer the right to receive payment to a third party in one of two ways:
Interest
Interest is a charge for the use of money. Interest may be due at either the end or the beginning of each payment period. Payment made at the beginning of each period is payment in advance. When payments are made at the end of a period, it is known as payment in arrears. Whether interest is charged in arrears or in advance is specified in the note. This distinction is important if the property is sold before the debt is repaid in full. Most mortgages have interest in arrears.
Usury
Charging interest in excess of the maximum rate allowed by law is called usury. To protect consumers from unscrupulous lenders, many states have enacted laws limiting the interest rate that may be charged on loans. In some states, the legal maximum rate is a fixed amount. In others, it is a floating interest rate that is adjusted up or down at specific intervals based on a certain economic standard such as the prime lending rate or the rate of return on government bonds.
Whichever approach is taken, lenders are penalized for making usurious loans. In some states, a lender that makes a usurious loan is permitted to collect the borrowed money but only at the legal rate of interest. In others, a usurious lender may lose the right to collect any interest or may lose the entire amount of the loan in addition to the interest.
In Illinois, there is no legal limit specifically imposed by Illinois on the rate of interest that a lender may charge a borrower when the loan is secured by real estate.
Loan origination fee
The processing of a mortgage application is known as loan origination. When a mortgage loan is originated, a loan origination fee is charged by most lenders to cover the expenses involved in generating the loan. These include the loan officer’s salary, paperwork, and the lender’s other costs of doing business. A loan origination fee is not prepaid interest; rather, it is a charge that must be paid to the lender. While a loan origination fee serves a different purpose from discount points, both increase the lender’s yield. Therefore, the federal government treats the fee like discount points. It is included in the annual percentage rate of Regulation Z, and the IRS lets a buyer deduct the loan origination fee as interest paid up front.
Discount points
A lender may sell a mortgage to investors (discussed later in this chapter). However, the interest rate that a lender charges the borrower for a loan might be less than the yield (true rate of return) an investor demands. To make up the difference, the lender charges the borrower discount points.
The number of points charged depends on two factors:
For the borrowers, one discount point equals 1 percent of the loan amount and is charged as prepaid interest at the closing. For instance, three discount points charged on a $100,000 loan would be $3,000 ($100,000 x 3%, or .03). If a house sells for $100,000 and the borrower seeks an $80,000 loan, each point would be $800. In some cases, however, the points in a new acquisition may be paid in cash at closing rather than being financed as part of the total loan amount.
Prepayment Penalty
The amount of accrued interest is carefully calculated during the origination phase to determine the profitability of each loan. If the borrower repays the loan before the end of the term, the lender collects less than the anticipated interest. For this reason, some mortgage notes contain a prepayment clause. This clause requires that the borrower pay a prepayment penalty against the unearned portion of the interest for any payments made ahead of schedule.
Note: Lenders may not charge prepayment penalties on mortgage loans insured or guaranteed by the federal government or on those loans that have been sold to Fannie Mae or Freddie Mac.
Lenders in Illinois are prohibited from charging a borrower a prepayment penalty on a fixed rate loan secured by residential real estate when the loan’s interest rate is greater than 8 percent per year. However, they can charge a prepayment penalty on an adjustable rate loan.
