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Ch10.
The Mortgage Application
Introduction
This chapter explains the types of information and documentation you need when applying for a mortgage. Most of the information that lenders require is the same for individuals, businesses and nonprofits, but the differences warrant separate discussions. Therefore, the remainder of this chapter is divided into three sections:
Applying as an Individual
Applying as a Business
Applying as a Nonprofit
Banking Terms
(this is a duplicate from previous chapters and has been included for ease of reference)
Key terms to know for this chapter include:
Amortization: The elimination of the mortgage debt through regular payments over a specific length of time. Payments must be large enough to cover both principal and interest.
Debt Ratio: A comparison between your total assets (gross income, cash, equity in property, etc.) and total debts (credit cards, student loans, car loans, etc.).
Deed: Legal document that transfers title of the property to the buyer.
Earnest Money: Funds the buyer deposits with the seller to indicate seriously interest in purchasing the space.
Escrow: An account set up by the lender where funds for the buyer's insurance and property taxes are held until payments are required. The lender typically makes payments for these expenses from this account.
Equity: Represents the difference between what you owe on the property (the mortgage) and what the property is actually worth. For example, if the value of a home purchased for $115,000 increases to $125,000 after five years, but the buyer still owes $75,000 on the mortgage, the difference between the property's value and the mortgage amount owed is $50,000 ($125,000 - $75,000). This equals $50,000 in equity in the property.
Interest Rate: The amount of money you are charged for using the lender's money to purchase the property. Is based on the risk of the loan and prevailing market rates.
Lien: A legal claim against the property, used to secure loans; they must be paid first if the building is sold. For example, the lender puts a lien against the building when you take out a mortgage to purchase it. Other types of liens include property taxes, from the Internal Revenue Service, court-ordered, etc.
Mortgage: A type of loan specifically used to finance the purchase of real estate. Several types are available.
Mortgagee: The bank, credit union or other financial institution that loans money to purchase real estate.
Mortgagor: This borrower who accepts the loan.
Principal: The original amount of money borrowed for the mortgage. Does not include the interest rate.
Term: The length of time the borrower has to pay back the principal with interest. The longest mortgage term for residential properties is typically 30 years.
Title: The legal document that denotes ownership of real estate.
Other terms and their definitions will also appear in the text and will be defined as we go along.
Individual Application
What is the first step in the buying process? Finding out how much space you can afford! Contact a lender to get a pre-qualification assessment, which is usually free. During the process, a loan officer will look at a variety of factors, including your financial situation, to help you evaluate your financing options. Pre-qualification gives you an idea of how much the lender will give you before you start looking; this allows you to target your search and gives you more negotiating power when you are ready to make an offer on a specific property.
During the pre-qualification process, the loan officer will look at and compare the following:
Gross Monthly Income: Your total monthly income before taxes. You must list the source and amount of income, and can include money earned from:
A job.
Selling artwork and performances.
Lecturing fees.
Commission work.
Alimony, child support and maintenance income. (Do not include information about these income sources if you do not want them to be considered as funds available to repay the loan).
Dividends.
Rental income on other properties.
Monthly Debts: Debts you pay each month, including:
Bank, credit union or car loans, student loans, debt consolidation payments.
Credit cards: Lenders will base this amount on your minimum monthly payments per card, or 5% of the outstanding balance.
Co-signed debts.
Alimony, child support, separate maintenance payments (if applicable).
Mortgage payments made for other properties.
Your gross monthly income and debts will then be used to help determine the amount of the loan for which you qualify. Other factors to be considered include:
Property Debt Ratio:
The ratio of your property costs to your income includes:
Mortgage payments.
Property taxes.
Insurance (property and mortgage).
Condominium/association fees, if applicable.
In most cases, this ratio should not exceed 28% of your income for residential properties. For example, if your income is $3,500 per month, then 28% of this would equal $980 ($3,500 x 0.28). This means $980 is the total amount a lending institution will allow you to use to pay the mortgage, property taxes, insurance and condominium/association fees (if applicable).
Because commercial mortgage loans are customized on a case-by-case basis, the requirements for property debt ratio will vary from lender to lender.
Total Debt Ratio: The ratio of your property costs plus any other fixed monthly debt (student loan payments, credit cards, etc.) you must pay. This debt should not exceed 36% of your income for residential properties. Using our previous example, if your income is $3,500 per month, then 36% of additional debt translates into $1,260 ($3,500 x 0.36). Besides the $980 per month the lending institution will allow you to dedicate to paying your property expenses, you are allowed another $1,260 per month to allocate towards non-property related bills such as utilities, credit card payments, student loans, car payments, etc. Again, the total debt ratio allowed will vary from lender to lender for commercial mortgage loans.
Using the above example, the total amount of funds from your income allowed per month for both your property expenses and other bills would be $2,240.
Depending on the type of loan you use, these maximum ratio guidelines may differ. When you pre-qualify for a mortgage, the loan officer will determine your loan amount by using a calculation similar to the one used in the Mortgage Calculation Worksheet. Requirements and calculations might be different for commercial purchases.
You might want to consider getting a co-borrower, such as a family member, if you do not have enough income to qualify for a mortgage loan. However, the lender will typically want to add that person's name to the title, which will make this individual a co-owner of the property. You should only complete the co-borrower section if another person will be jointly obligated for paying the mortgage, or if you will be relying on the income assets of another person (i.e. your spouse) for repayment of the loan.
Additional Factors
Besides income and debt ratios, the lender will also look at other factors, including:
Employment History: Applicants should meet one or more of the following criteria:
Two years at the same job
Two years in related fields
At least one year in a new field with "logical moves" (or example, you move from teaching art at the high school level to teaching at the college level).
College degree or advanced education for new participants in the workplace. If you have recently completed a graduate degree, each year you spent in school is counted as one year in the workforce. Two years in school = two years of working.
Income:
Determined from pay stubs, W-2s, tax returns or other applicable documentation. Child support or alimony income can apply if you have received it for the past 12 months and it will continue for at least three years into the loan period. You do not need to include alimony, child support or separate maintenance income, if you do not want it to be considered as money available to repay the loan. However, not including this money might affect your loan amount.
Special Calculations:
Lenders will require special calculations and additional information for self-employed borrowers. You might have to provide full tax returns showing all schedules for at least the last two years in order to document your "After Expense" income. Most good loans are "full doc" loans, meaning the lender wants full, complete real documentation of your income before making the loan.
You might also need to provide this information if you are:Self-employed,
- Work on contract,
- Work on commission,
- A retired borrower,
- A military borrower, and/or
- Use interest and dividend income as your main source of income.
Down Payment:
The amount you pay must meet the minimum standards required by the loan product you choose. Typically, the more money you put down towards the purchase, the lower the amount you need to borrow; this can increase your chances of securing a loan. In addition, the lender will look at the source of your down payment. The following are acceptable sources for a down payment:
Funds from savings and checking accounts.
Funds from a down payment assistance program (guidelines vary, depending on the loan).
The equity in your current property.
Secured loans.
Retirement savings plans such as IRAs or 401(k) plans (many plans allow a hardship withdrawal or a loan against your balance; some allow loans specifically for purchasing residential property).
Proceeds from the sale of an asset, such as your art, car, jewelry, etc., are valid. You can sell any item the value of which can be supported by an independent appraisal. You will also be required to provide proof of sale and sale price. A bill of sale is often sufficient evidence.
Income from investments.
Additional sources from family, friends, organizations, etc. allowed by your lender or loan product.
Credit History:
The lender will pull a credit report to help determine your credit risk, and whether or not you can repay the mortgage debt. Credit items for review include:
How much do you owe? Items like credit cards, car loans, student loans, etc. will be considered.
How often do you borrow?
Do you pay your bills on time?
Do you live within your means?
Do you have a history of bad credit or unpaid debts?
If your report shows problems, the lender might ask for a letter of explanation and supporting documentation to prove past debt problems have been settled. Many lenders will work with you to help you get your credit in shape and enable you to qualify for a loan - eventually. For additional information on credit, see Chapter 3: Understanding Credit.
Stability:
How you live and work is important to a lender. Long-term employment and residential tenure reflects commitment to the long run. Lenders are risk-averse, and a mortgage is a long-term commitment. Consistent job-hopping (without logical moves) and serial moving are red flags to lenders that you are a financial risk; they will consider you unstable.
Collateral:
The lender will evaluate the property you intend to purchase (with the help of an appraisal) to determine if the property is valuable enough to support the loan request. The property then becomes your collateral, and is a guarantee to the lender that if you are unable to continue making mortgage payments, they can recoup their investment through the foreclosure then sale of your property.
Additional Considerations:
Depending on the loan you choose, cash and funds not deposited in a financial institution might not be accepted for down payments, closing costs or even as collateral.
Application
By now, you have weighed the pros and cons of ownership vs. leasing, have examined your finances, and have identified the location and type of space you want. It is now time to compile your documents and secure your loan!
At your application appointment, your loan officer will request the following types of information and documentation. Lender requirements may vary; if you are using a homeownership assistance program or other specialty assistance, you might need to provide additional documentation.
Income Items and Verification:
Recent pay stubs from your present employer showing year-to-date earnings and pay period. Typically, you will need to show pay stubs from the last 30 days if you are paid more than once per month, and stubs from the past 60 days if paid monthly.
If you are a recent graduate student, the lender will need proof that you were enrolled full-time in school. Your academic institution should be able to provide a letter.
Name and mailing address of prior employer.
Signed and dated copies of your Federal Tax Returns (include all schedules from at least the last two years).
W-2 forms for the previous two years to match with your Federal Tax Returns.
Rental/Lease Agreements from your current residence.
Copy of Notes Due. These are loans you have made to others, and represent money owed to you.
Bank statements covering the previous two months.
Verification of stocks owned and dividends paid.
Child support, alimony, friend-of-the-court printouts, and/or 12 months of cancelled checks showing payments received.
Awards letters from the Social Security Administration showing any benefits you receive, and/or federal form 1099 to show you receive disability income.
Tax returns addressing income derived from rental property, commissions, interest or sources of income other than a salary.
Sources of Funds for Down Payment:
Original bank statements for the last three months, including savings, checking and investment accounts.
Stock and securities account statements for the last three months.
A HUD settlement statement, if using funds from the sale of a residential property.
Sale of an asset. You must show proof of ownership, sale and funds transferred to you (i.e. a check, money order, etc.). They want to know that your funds are not illegal.
If You Are Self-Employed :
Signed, completed tax returns for the past two years. Include your personal, partnership and corporate returns, and all schedules.
Business Profit and Loss Statements signed by you and your accountant. Must be year-to-date for the current year, if more than three months have passed since the end of the tax year.
A current balance sheet showing income vs. expenses.
Payment History:
Cancelled rent or mortgage payment checks for the past 12 months, if not available on your credit report.
Copies of land contracts, if applicable; and
Child support/alimony payments.
Documentation showing payment requirements.
Credit Items :
Name and address of present mortgage holder or land contract holders; and
Name and address of landlord and a 12-month rental payment history. Recent receipts or cancelled check are acceptable.
Verification and Explanation of
Commission income.
Bonus income.
Child support (through court or copy of cancelled checks). If you receive this type of funding and will use it towards your payment, proof of receipt for the last three months will be required. In addition, you must also provide proof that these funds will continue for at least the next three years.
Overtime income.
Separation papers; and
Copy of bankruptcy petition, discharge and written explanations.
Explanation letter for any of the following credit issues:
Slow pay on credit.
Default or foreclosure
Judgment or liens; and
Bankruptcy.
Additional Information, if applicable:
Purchase agreement, including legal property descriptions and any addendum.
Divorce decree.
Copies of original purchase contract, earnest money (checks) and/or escrow papers.
Closing statement from sale of present property
Gift letter from down payment assistance program (letter must contain amount of gift, relationship of donor to you, evidence that no repayment is required and verification of the source of the gift).
Explanation of source of funds for closing.
Construction/permanent loan. Signed construction contract with cost breakdown, builder plans and paid receipts; and
VA Loan. Original certificate of eligibility (if available) and DD214 (Report of Transfer or Discharge).
At the application appointment, your loan officer will collect the documentation needed to process your loan, help you choose a mortgage product, and complete the official loan application. Next, you will receive documents that:
Outline the terms of your loan;
Estimate the closing costs associated with the loan; and
Other documents specific to the lender and/or loan.
Keep these documents handy throughout the remainder of the loan process.
Processing
Based upon the information you provide at your application appointment, during the processing of your loan, the lender will:
Evaluate and verify your assets, income and/or job status;
Review your credit history to determine how well you have paid your debts in the past; and
Order an appraisal on the property to determine if the value is consistent with the negotiated price.
All of this information helps the lender to determine how much money to lend you. Once you have been approved, the lender will send you a Commitment Letter outlining all terms and conditions and items needed for closing. You will be asked to sign and return the agreement showing that you are ready to prepare for the closing of the loan.
Next, the lender will begin preparing the documents for your loan closing. This involves:
Coordinating title work;
Scheduling property appraisals and inspections;
Settlement figures; and
Other closing documents.
During the loan processing, a title company will search the title to ensure that no one else has an ownership claim, lien or second mortgage on the property you are purchasing. The lender will pursue title insurance, which will protect them against loss if an unforeseen claim arises. Consider purchasing this type of insurance to protect your investment.
Before closing, your lender will require you to purchase either homeowner's or hazard insurance on the property. Homeowner's insurance is for residential properties, while a hazard policy is for commercial and industrial buildings. They protect you and the lender against loss if the property is damaged by fire or storm. Many options are available, so check with your lender to ensure your coverage meets their requirements before selecting a policy.
Your lender might also require you to purchase private mortgage insurance (PMI), which protects them against loss if you cannot repay the loan. It is typically required if you put less than 20% down towards the purchase of the property. Because commercial mortgages often require 20% or more down, PMI is needed primarily for residential spaces.
Descriptions of other type of insurance policies are further explained in Chapter 8: Buying Real Estate. Depending on the type of space you have, and how you will use it, examine policies that allow you to cover various needs under a single policy. See Chapter 20: Insurance for more information on insurance issues.
Closing Day
Closing Day on your loan is when you sign the final documents, get the keys to your new space, and become an official property owner. In most cases, the closing is a formal meeting where the buyer and seller, their respective attorneys and real estate agents, and representatives from the lending and title companies complete the sale and financing transaction. Bring your attorney to review the documents before you sign them. At the closing, you will be asked to sign many documents, including:
HUD-1 Settlement Statement: Both buyer and seller sign this statement, which lists the costs and charges to both parties and is required by federal law. You do not need this document if you have a commercial mortgage.
The Note: This is your promise to pay the lender according to the terms specified in the mortgage. It provides the details regarding repayment of the mortgage, including payment dates and penalties for falling behind.
The Mortgage or Deed of Trust: This legal document secures the note and gives the lender a claim against your property if you default on your loan. In other words, the mortgage gives the lender partial ownership until the loan has been paid in full. It outlines the borrower's responsibilities to pay principal, interest, taxes and insurance on schedule, to maintain homeowner's (hazard) insurance on the property at all times, and to keep the space properly maintained. If you violate the terms of this agreement, the lender assumes the right to foreclose on your property, sell it and use the proceeds to pay off the outstanding loan debt, as well as all costs the lender incurred during the foreclosure process. You will receive any leftover funds after all bills to the lender have been paid.
The Deed: This document transfers ownership of the property from the seller to you.
Truth in Lending Disclosure: Summarizes the actual costs associated with the loan you have obtained.
Additional Documents: Depending on the type of loan you have, or the program you are using, you might have to sign additional documents required by state law, the lender or other parties at the closing. Be sure you and your lawyer review all documents before you sign them.
Now that you've signed all the documents and received your keys . . . welcome to the wonderful world of ownership!
Small Business Application
For small businesses, the road to property ownership can be a bit more difficult than for individuals. Many lenders shy away from start-up businesses, which are viewed as a higher credit risk. Lenders want to know that they will get a return on their investment, and are usually more likely to finance businesses that have a proven track record in the marketplace.
The first step for small businesses that wish to apply for a mortgage is to organize their paperwork and find an affordable mortgage. Neighborhood community banks and other lending institutions often specialize in working with nonprofits or small businesses. Research local banks or credit unions that have a history of funding small businesses. For more information about lending resources, see the resource section of Chapter 8: Buying Real Estate and Chapter 11: Models of Ownership. In contrast to individual purchasing, it is very uncommon to get a loan pre-qualification assessment for a business. Lenders are interested in a variety of elements of your business, but are especially concerned with your monthly income and debts. The lender will examine and compare the following:
Gross Income:
The income companies make before taxes, insurance and other expenses are paid. Businesses can include profits from selling products (artwork, tickets to events, murals, etc.) or services (consulting, commission, contract work, classes), as well as income derived from dividends.
Debts:
When calculating monthly debts, divide bills paid through lump sums or other payment arrangements (i.e. property taxes, insurance premiums, etc.) over a 12-month period in order to accurately assess monthly debt. Include debts paid each month, such as:
Business loans or credit cards,
Mortgages on other properties,
Employees' salaries, and
Insurance premiums to cover space, business or employees.
Additional Factors
Though important, your gross monthly income and debts are not the only factors a lender will consider. Others include:
Business Plan:
This informs the lender of the type of business you have, and its potential financial feasibility. (A brief plan will normally suffice. ) Lenders want to understand how your company makes money, who your clients are, where you are headed, what your goals are, and how do you plan to get there.
Examples of business plans:
Contains several types of business plans: http://www.bplans.com/sample_business_plans.cfm
Year-to-Date Profit and Loss Statement:
This tells the lender how you manage your cash flow, and whether you have any debt management or financial problems. Lenders usually request at least three consecutive years of statements.
Income:
Businesses can include money earned from sales of products or services, as well as income derived from dividends and other sources. Spread lump sum payments received over a 12-month period to accurately assess of your monthly income.
Down Payment:
This must meet the minimum standards required by the particular type of loan you chose. Typically, the more money put towards the purchase, the lower the amount you need to borrow. This can increase your chances of securing a loan. For commercial loans, a down payment of at least 20% or more is required. However, financing through a nonprofit lender often provides greater flexibility in the down payment requirements.
The source of the down payment will be considered as well. The following are acceptable sources:
Funds from business savings and/or checking accounts.
Equity in any property currently owned by the business.
Proceeds from the sale of assets, such as other property. The business can sell any item with a value that can be supported by an independent appraisal. You must provide proof of sale and sale price. A bill of sale is often sufficient evidence.
Income from other investments; and
Money from funders.
Credit History:
As with personal loans, the lender will pull a credit report on your business to determine your organization's credit risk and ability to repay the mortgage. Because many businesses do not have a solid credit history, the lender might request verification from your creditors.
Lenders sometimes require owners and board members of start-up businesses to personally guarantee the loan, which makes them personally responsible for the loan in the event that the business is unable to meet its obligations to pay the mortgage. In this situation, credit risk and financial capabilities serve as the basis for the business' ability to secure the loan, as well as that of other loan guarantors.
Lenders consider the following when determining ability to repay a mortgage:
How much does the business (you/funders) owe other creditors?
How often does the business (you/funders) borrow?
Does the business (you/funders) pay bills on time?
Does the business (you/funders) operate within its means?
Does the business (you/funders) have bad credit and/or unpaid debts?
If problems appear on the organization's credit report, the lender may ask for a letter of explanation and supporting documentation to prove settlement of past debt problems. For additional information on credit, review Chapter 3: Understanding Credit.
Financial Stability:
Financial Stability is one of the biggest factors that lenders consider when lending to small businesses. This includes the ability to pay current debts, infuse money into the business, and grow and/or operate with positive financial results.
If you are borrowing as a business, lenders will review:
Your history with clients;
The variety of clients;
Whether your client list focuses on one or several companies;
How well you have been selling your products and/or services, and growth trends;
Profit margins/losses over the last three years;
Money and assets the company has to cover unexpected expenses, slow sales, and other issues;
The consistency of your cash flow. Have there been problems in the past? If so, how did you handle them?;
Industry track record/reputation;
If major industry players are on your staff that can generate new/additional business.
Collateral:
The lender will evaluate the property you intend to purchase (with the help of an appraisal) to determine if the property is valuable enough to support the loan request. This is called the Loan-to-Value Ratio. Most banks will only lend up to 75% of the cost of what the property would be worth post-construction completion. The loan is based on the estimated value of the property after any rehabilitation or remodeling on the building has occurred.
For example, you purchase a property for $100,000 and put another $250,000 into rehabbing the space. In this situation, the loan value will be 75% of a $350,000 loan ($100,000 + $250,000). However, if you purchase your space with a small business development loan, such as those offered by the U.S. Small Business Development Center or other community-based financial institution, you might be able to increase the loan amount to as much as 90%.
The property then becomes your collateral, and serves as a guarantee to the lender that if you stop making mortgage payments, they will recoup their investment through the sale of the property.
Other items that can be considered collateral include:
Other properties owned by the business; and
The owner or founder of the business, or other individual, may put up a letter of credit stipulating they will personally pay all or a portion of the mortgage in case of default.
Occupancy Costs: Lenders will want to know how much it cost to lease your last/current space. Were you responsible for property taxes, maintenance and building insurance, or were you simply paying the rent? You have a better chance of securing a loan if you have been paying these additional expenses; to many lenders, it's a sign that you have both the financial stability and capability to maintain the costs of operating a building.
Other Factors: Lenders may also have additional questions for you about your project that deal with the feasibility of financing the property. For a more in-depth exploration of these issues, review the Lender's Criteria in the Nonprofit section.
Application
You have weighed the pros and cons of ownership vs. leasing, examined your finances, and researched the desired location of your space. It is now time to secure your loan. At your application appointment, your loan officer will need a good deal of information about your business and its finances.
If you are purchasing through an assistance or specialty program, you might need to provide additional documentation. Be prepared for additional questions and requests for information. It could take several weeks for you to gather all the information the lender needs to make a decision on your loan application.
Types of information and documentation the lender will request :
Income Items and Verification:
Year-To-Date Profit and Loss Statement signed by you and your accountant (self-employed borrowers);
Corporate/Partnership Tax Returns with original signatures;
Partnership Agreements;
Rental/Lease Agreements for space you presently occupy;
Copy of Notes Due. These are loans you have made to others, and represent money owed to you;
At least the last two months of bank statements;
Verification of stocks owned and dividends paid; and
Tax returns from at least the previous three years.
Sources of Funds for Down Payment :
Original bank statements for the last three months from savings, checking and investment accounts;
Stocks and securities account statements for the last three months;
HUD settlement statements, if using funds from the sale of a property; and
Sales of assets, including proof of ownership, proof of sale and proof of funds transfer.
Payment History and Credit Items:
Cancelled rent or mortgage payment checks for the past 12 months, if not available on credit report;
Name and address of present mortgage holder; and
Name and address of landlord and a 12-month rental payment history. Recent receipts or cancelled check are acceptable.
Explanation letter for any of the following credit issues:
Slow pay on credit,
Default or foreclosure,
Judgment or liens, and
Bankruptcy.
Additional Information, if applicable:
Closing statement from sale of present property; and
Construction/Permanent Loan -- a signed construction contract with cost breakdown, builder plans and paid receipts.
Processing
Once you have assembled all the documents needed by the lender, the evaluation process begins. New questions might arise, requiring additional documentation and answers.
Throughout the processing of your loan, the lender will:
Evaluate and verify your business' income and assets;
Review the business' credit history to determine how well you have paid your debts in the past;
Order an appraisal to determine if the value of the property is consistent with what you have agreed to pay; and
Determine the feasibility of the project.
All of this information will help the lender determine how large a mortgage loan to give you. You and the lender will discuss the type of mortgage that best fits your needs and abilities. Once your application has been approved, the lender will send you a Commitment Letter outlining all terms and conditions of the loan and the items you will need for closing. You will be asked to sign and return the agreement showing that you are ready for the closing of the loan.
Next, the lender will begin preparing the documents for your closing. This involves coordinating title work, inspections, settlement figures and other documents.
Whether your business is purchasing a commercial or residential property, the lender will acquire title insurance. This policy protects the lender from loss if an unforeseen claim comes up against the property, such as a secondary mortgage or liens by government agencies. You might also want to purchase this type of insurance to protect your investment. During processing, a title company will search the title to make sure that no one else has a stake in the ownership of the property.
Before your closing, the lender will require you to purchase hazard insurance, which covers you and the lender in the event that a storm or fire damages and/or destroys the property. Many options are available, so make sure your coverage meets the lender's requirements.
Closing Day
Typically, the closing is a formal meeting where the buyer or company/organization representative, seller, real estate agents, and representatives from the lender and title companies meet to complete the sale and financing transaction. Bring your attorney to review the documents before signing them. Documents to be signed include:
The Note: The business' promise to pay the lender according to the terms specified in the mortgage. It spells out all specifics regarding mortgage repayment, including payment dates and penalties for falling behind.
The Mortgage or Deed of Trust: This legal document secures the note and gives the lender a claim against the space if the loan goes into default. In other words, the mortgage gives the lender partial ownership in the property until the loan has been paid in full. It outlines the borrower's responsibilities to pay principal, interest, taxes and insurance on schedule; to maintain homeowner's (hazard) insurance on the property at all times; and to keep the space properly maintained. If the business/organization violates these terms of agreement, the mortgage contract gives the lender the right to foreclose on the property. The lender can legally seize and sell the property, and use the proceeds to pay off outstanding loans and any costs it incurred while pursuing the foreclosure. The business/organization will receive any remaining funds after all bills to the lender and others (i.e. property taxes, mechanic liens, etc.) have been paid.
The Deed: This document transfers ownership of the property from the seller to the business.
Inter-creditor Agreement: This document is needed when multiple lenders co-fund a project. The agreement stipulates the process and procedures to be followed in managing the loan, such as which lender gets paid first in the event of default.
Guaranty: This document is needed if the organization's executive director or board members personally guarantee the loan.
Other Documents: Depending on the type of loan you have, or the program you use, you might have to sign other documents required by state law, the lender or other parties. Read all documents carefully before you sign them.
Now that all the documents have been signed, and the keys have been handed over, welcome to the wonderful world of property ownership!
Non-Profit Application
Applying for a mortgage as a nonprofit can be more complicated than purchasing as an individual or business. Not only must you demonstrate that your organization can financially sustain itself and the new property -- you must also deal with preconceived notions many conventional lenders have about nonprofits.
Lenders are careful in taking risks. They want a return on their investment, and usually finance organizations with proven successes. Conventional lenders sometimes shy away from small or fledgling nonprofits, which they view as having a higher credit risk.
Cast a wide net in your search for lenders. Consider neighborhood community banks and other institutions that specialize in working with nonprofits, these lenders often have less stringent guidelines than conventional lending institutions, and might consider your loan if you relocate to their communities. This is a link of lenders who have funded facilities projects for local non-profits: https://wshfc.org/facilities/index.htm. These lenders have experience funding non-profit projects and may prove to be a valuable resource.
Develop a realistic understanding of what your organization can afford, where its operating funds are generated, and how cash flow works within your organization. In addition, be alert when dealing with financial institutions that are unfamiliar with the workings of nonprofit organizations. The lender might suggest a larger loan than your organization can handle.
Lender's Criteria
Strive to understand the criteria lenders will use when considering your project. The three main factors that the lender will evaluate:
Organizational Strength
When reviewing an organization's strength, lenders consider:
Its nonprofit charter, which explains whether or not your organization can receive grants/charitable gifts.
Your 501(c)(3) final determination letter from the IRS. Most lenders prefer borrowers who have been in business for three or more years.
Size of board and staff, and how many volunteers help to achieve your mission.
Who on staff and/or board has expertise in real estate development.
If your staff/board does not have the real estate development capacity, which consultant or real estate development firm you have hired to orchestrate the process for your organization.
The depth of leadership and professional, networking, financial resource management, real estate development, legal, and fund-raising experience among board members and staff.
Who can ensure successful completion of the project and maintain effective operating procedures.
Whether the organization developed real estate projects before, and, if so, how successful they were; their size and scale.
The organization's annual operating budget for the past three years.
The organization's fiscal management. Does it routinely operate with budget surpluses or deficits? Is cash flow strong and steady? Is grant support consistent? Is the organization's net fund balance (i.e., net worth) positive? Does it have operating (and/or capital) reserves to cover unexpected expenses or an unexpected shortfall in earned income and/or charitable support? Does the organization have its own cash equity to invest in the project? Does the organization have a solid track record of paying back loans and other creditors?
The type of collateral the organization can put up for the project. Are there financial pledges (in writing) which can be used as collateral?
Financial Stability
A nonprofit organization's financial stability is of utmost importance to lenders. An organization's debt management, growth, operations and fund-raising success are critical factors. Lenders will review:
Income sources
Whether the organization has diverse funding streams
Consistent organizational growth
Reliance solely on grants, or other income-generating sources such as membership fees, workshops, interest from an endowment, etc. (this is also known as earned income)
Fund-raising track record
Guaranteed financial commitment from funders for the next 3 or more years, and amount
Contingency plans for unexpected loss of major funding sources
The organization's financial "cushion" (or operating reserve) for dealing with unexpected events, slow memberships, etc.
Sustainability
Debt-to-asset ratio
Past cash flow problems
The staff's and board's financial competency (whether individuals from the lending and financial industry are on board, and past management success)
Strength and sophistication of fiscal systems such as accounting software and practices, and internal controls such as how reconciling bank statements and control/monitor spending.
In addition, the lender will review the organization's:
Income:
Nonprofits can include sources such as fundraising, grants, membership fees, programming, and ticket sales. Spread payments received in lump sums (grant money) over a 12-month period to accurately assess your monthly income.
Year-to-Date Profit and Loss Statement:
This tells the lender how the organization manages cash flow, and alerts them to debt management and financial problems. Lenders will require at least three consecutive years' worth of statements.
Credit History:
Trying to ascertain a nonprofit's credit history can be complex for lenders, and is usually determined on a case-by-case basis. Typically, lenders will examine alternative forms of credit to determine your ability to repay the mortgage.
Lenders typically consider:
How much the organization owes other creditors
How often the organization borrows money
Whether the organization pays bills on time
Whether the organization operates within its means
Whether the organization has any bad and/or unpaid debts
If the lender requires the executive director or key board members to guarantee the loan, then a personal credit report will be pulled and their personal financial capabilities reviewed. If the organization has experienced past credit issues, the lender might request a letter of explanation and supporting documentation to prove past problems have been settled and corrected. For additional information on credit, see Chapter 3: Understanding Credit.
Project Feasibility
When reviewing a proposed project's feasibility, lenders consider the following:
Assuming your organization has the capacity to develop the project, or has hired a firm that can, is the project itself feasible? Has the cost of the acquisition, construction and other "soft" costs been estimated by a trained and credible professional? Are those costs realistic?
If the lender is only one layer of the financing structure, can financing and/or grants be secured to cover the entire cost of the project? Can the other sources of financing/funding be documented in writing and verified by the lender directly through independent contact with the identified additional sources?
Does the pro forma or multiple-year operating budget for the project suggest that the building itself (not the organization) can generate revenue to cover all expenses and leave ample income to cover the loan payments? Most lenders prefer that the activities in the building generate 20% or more revenue than necessary to cover loan payments. This is known as a 1.2:1 or 1.2 debt service coverage ratio. Ultimately, lenders want to make sure that the activities that occur in the space, as well as the organization's other income-generating activities (grants, off-site workshops, membership, etc.), can sufficiently cover the costs of the building and the organization's other operating expenses while still leaving a contingency cushion. Most lenders won't support projects that can only generate enough funds to cover the cost of the building.
Does your organization have an overall business plan and/or operating plan that demonstrates strong financial components, market demand and the appropriate marketing strategy and management team?
Is the project development team capable and experienced? Does your organization have:
- An experienced project manager?
- A real estate development consultant or firm, if necessary?
- A qualified, experienced, licensed and bonded general contractor or builder?
- Qualified, experienced (especially with the type of project), licensed and insured architects?
- A qualified, experienced and licensed real estate attorney?
- An experienced and effective property management firm, if necessary? And
- Appropriate technical assistance providers, if necessary? An artist work condominium would benefit, for example, from being a member of the Association of Condominium, Townhouse and Homeowner Associations: an organization that works with Boards of Directors and unit owners on various methods of operating and managing an association.
For projects that require public sector grants, low-cost loans or zoning changes, does your organization already have the support of your local political and/or community leadership?
The lender will also consider the organizations:
Down Payment:
The amount of down payment must meet the minimum standards required by the loan. If you are using a conventional loan for your purchase, a down payment of at least 20% or more may be required. If your organization is financing through a nonprofit lender, there might be more flexibility in the down payment requirements. In addition, the source of the down payment will be considered.
The following are acceptable sources for your down payment:
Funds from the organization's savings and checking accounts,
The equity in any property currently owned by the business/organization,
Income from investments, and
Grants and fundraising.
Collateral:
The lender will evaluate the property you intend to purchase (with the help of an appraisal) to determine if the property is valuable enough to support the loan request. This is called the Loan-to-Value Ratio. If you plan to rehab or remodel the property, most banks will lend up to 70% of the value of the property, including any value added due to rehabilitation or remodeling.
For example, you purchase a property for $100,000 and put another $250,000 into the rehab and remodeling of the space. In this situation, the loan value will be 70% of a $350,000 loan. Nonprofit Community Development Financial Institutions (CDFI) such as the Chicago Community Loan Fund or Illinois Facility Fund may increase the loan to as high as 90%, and sometimes 100%.
The property then becomes your collateral, and is a guarantee to the lender that, if you are unable to continue making the mortgage payments, they will be able to recoup their investment through the sale of the property. Other items that can be considered collateral include:
Other properties owned by the organization;
A letter of credit in which another foundation or organization guarantees that they will pay all or a portion of the mortgage in case of default; and/or
Financial pledges (in writing).
Occupancy Costs:
Lenders will want to know:
How much it cost to lease your last space;
If you were you responsible for property taxes, maintenance and insuring the building, or simply paying rent. You have a better chance of securing a loan if you have already been paying these expenses. To many lenders, it shows you have both the financial stability and capability to maintain the costs of operating a building.
Loan Intake
Obtaining a mortgage for a not-for-profit is a multi-tiered process. The first steps may involve a telephone or face-to-face interview with the lender known as "The Intake." During the intake the lender will ask you questions about your organization to determine whether or not they can take on your project. Keep in mind that this initial intake process does not guarantee a loan and is simply an information-gathering exercise. This is not an approval, nor a formal application.
Some of the questions the lender may ask include:
How much money are you seeking and when do you need it?
What type of loan are you interested in and under what repayment term (length) are you looking for?
How do you plan on repaying the loan?
What collateral do you have to secure the loan?
What is the environmental status of the property?
If there are environmental problems, can you afford the clean-up if it is necessary?
Are planning to use green supplies when rehabbing?
Do you have the support from community leaders?
How is the financial health of your organization? How do you manage your money and do you consistently pay your bills on time?
Who is on your Board of Directors?
Do you have architectural renderings of the property, if applicable?
If your answers to these questions and your documentation demonstrate that your organization has the capacity to undertake the project, the lender will ask you to submit an official application with supporting documentation. Keep in mind that your space project may not fit the parameters of all lenders, so be prepared to shop around. Some lenders may even point you to other organizations or lenders that can specifically finance your space if they cannot.
Application
Once you complete the intake process, and the lender has expressed interest in your space project, the next step is to submit an application and supporting documentation. Below is a list of the documentation you will need. If you are using any type of assistance or specialty lender (i.e. nonprofit funder, government, etc.), you might also need to provide additional information.
Organization Information
Mission statement;
Summary of the organization's activities (programming, membership services, community activities, etc.);
Summary of organization's goals over the next five years (financial, programming, etc.);
Explanation of how this project impacts goals;
Number of employees, board members and volunteers (may ask for demographic breakdown);
Organizational chart;
Job descriptions of key personnel;
List of all advisors and their roles;
List of board members, including bios;
Reports on the organization, such as news articles;
Organizational brochure, pamphlets and other literature;
Description of current facilities;
501(c)(3) documentation (the IRS Determination Letter); and
Articles of Incorporation.
Project Information
Summary of the organization's real estate buying and/or development experience, including the type of property the organization has owned.
Development Team. Who will work on the space project, and what is their experience in real estate buying and/or real estate development? Consists of consultants, staff and board members specifically responsible for overseeing the project.
A detailed list of all partners involved in the project, including other organizations, businesses and government agencies.
Environmental report on the current environmental condition of the site. Click here for more information.
Appraised value of the property.
What is the tax status of the property? Are back taxes owed? Is property taxed at residential, commercial or industrial rates?
Is the property zoned for your intended use? If not, have you started the rezoning process?
Why is the proposed property appropriate for your use and activities?
Do you have another property in mind, if you cannot obtain this one?
What will be the impact of your organization on the community?
Who is your contractor and/or builder?
How did you select this person and/or company?
Does this person and/or company have experience working with projects similar to your own?
Financial Information
Financial spreadsheets;
What is your proposed budget for this project?
Have you approached other lenders? If so, is their loan commitment contingent on your securing additional financing?
What sources will you use to pay back the loan?
Letters from funders stating how much you have been awarded, and for how long. Should include large gifts from government, private foundations and individuals.
Profit and Loss Statement signed by you and your accountant, covering the last three years
Rental/lease agreements for space you occupy now
Bank statements including savings, checking and investment accounts for the last three years
Tax returns for the last three years
Original stocks and securities account statements for the last three months
Name and address of present mortgage holder
Name and address of landlord
12 months or more rental payment history. Recent receipts or cancelled checks are acceptable
Contact information of your current lenders, as well as the amount you owe
Audits
Collateral
List of items that can be pledged as collateral,
Credit and financial references, and Pledges (in writing).
References
Character references, and
Credit and financial references.
Explanation letter for any of the following credit issues
Slow pay on credit,
Default or foreclosure,
Judgment or liens, and
Bankruptcy.
Additional Information, if applicable
Closing statement from sale of present property; and
Construction and Permanent Loans will need a signed construction contract with cost breakdown, builder plans and paid receipts.
Processing
You have submitted your application and supporting documents. As the lender processes your loan application, be prepared for several rounds of questions and answers as the lender works toward developing a clearer picture of the project and your ability to pay back a mortgage loan. The lender will evaluate and verify the information in your application and supporting documentation, so be as thorough as possible from the start.
If you are working with a nonprofit lender the evaluation process will take several weeks -- or even months. Approval of your project through these organizations typically involves review and approval by a committee.
At the conclusion of the application review process, the lender might:
Need additional information;
Deny your application. So, keep looking elsewhere;
Refer you to another lender that can finance your project;
Agree to finance your project on the condition that you obtain additional education on property ownership as a nonprofit. This is similar to homeownership assistance programs, which sometimes require participants to complete homebuyer courses in order to qualify for a loan.
Agree to finance your project.
If the lender agrees to finance your project, you will typically receive a formal approval commitment letter containing information about the loan, including:
Amount of the loan,
Purpose of the loan,
Interest rate and payment plan,
Term of the loan,
Outline of the conditions and documentation needed prior to closing,
Organizational documents,
Financial statements,
Amount of your down payment,
Proof of insurance, and that it meets the lender's requirements,
Survey (if needed),
Appraisal report,
Proof of tax-exempt status,
The conditions under which the contract and funding can be terminated, and
Additional information specific to the lender and/or loan.
If your agreement letter indicates you must meet specific conditions before accepting the loan, gather the necessary documents and information. Don't be surprised if this process takes a few extra weeks. Once you turn in the required information and documentation, the closing process will begin.
The lender will normally obtain title insurance. This policy protects the lender from loss if an unforeseen claim arises against the property, such as a secondary mortgage or government lien. Consider purchasing this type of insurance to protect the organization's investment. During the loan processing period, a title company will search the title to the property to ensure that no one else has an ownership claim.
Before your closing, the lender will require you to purchase hazard insurance, which covers you and the lender in the event that a storm or fire damages and/or destroys the property. Many options are available, so check with your lender to make sure your coverage meets their requirements as well.
For more information about insurance, see the Mortgage Insurance section in Chapter 8: Buying Real Estate. Depending on the type of space you have, and the activities that will occur in it, you should also examine the different types of policies available in Chapter 20: Insurance.
Closing Day
In most cases, the closing is a formal meeting where the buyer, seller, their respective attorneys and real estate agents, and representatives from the lending and the title companies complete the sale and financing transaction. It is critical that your organization's attorney is in attendance to review all documents before you sign them.
Documents to be signed at the closing include:
Loan Agreement: This document outlines the loan provisions and requirements, such as warranties, contractual agreements for financial updates, agreements not to rehab the property without the lender's consent, etc.
The Note: This document is the organization's promise to pay the lender according to the terms specified in the mortgage, including payment dates and penalties for falling behind in repayment.
The Mortgage or Deed of Trust: This legal document secures the note and gives the lender a claim against the property if the loan goes into default. In other words, the mortgage gives the lender partial ownership in the property until the loan has been paid in full. It outlines the borrower's responsibilities to pay principal, interest, taxes and insurance on schedule; to maintain hazard insurance on the property at all times; and to keep the space properly maintained. If the organization violates these terms of agreement, the mortgage contract gives the lender the right to foreclose on the property. The lender can legally seize and sell the property, and use the proceeds to pay off outstanding loans and other costs the lender incurred while pursuing the foreclosure.
The Deed: This document transfers ownership of the property from the seller to the organization.
Inter-creditor Agreement: This document is needed when multiple lenders co-fund a project. The Agreement stipulates the process and procedures to be followed in managing the loan, such as which lender gets paid first in the event of default.
Guaranty: This document is needed if the organization's executive director or board members personally guaranteed the loan.
Other Documents: Depending on the type of loan you have, or the program you are using, you might have to sign other documents required by state law, the lender, or other parties at the closing. Be sure you and your attorney read all documents carefully before you sign them.
Now that all the documents have been signed, and the keys have been handed over, welcome to the wonderful world of property ownership!