Welcome to module seven of the Real Estate License Exam Prep course. Today we are covering finance and valuation — mortgages, loan types, down payments, and the appraisal approaches that put a number on a property. This module has the heaviest arithmetic on the exam, so we will keep the math simple and memorizable.

Let us start with the core documents. A mortgage is a voluntary lien on real property securing a loan. The borrower gives the lender a mortgage as security for the money borrowed. In title theory states, the lender holds legal title until the loan is paid; in lien theory states, the borrower keeps title and the mortgage is simply a lien. Most states are lien theory — the borrower is the owner, and the mortgage is the claim. The exam will ask you to sort theory states, so memorize the split.

The promissory note is the borrower's promise to repay the loan — it is evidence of the debt. Here is the essential distinction: the note is the debt, and the mortgage is the security. A borrower signs a promissory note for three hundred thousand dollars, and that note is what creates the obligation. The principal is the amount borrowed, excluding interest — the two hundred fifty thousand dollars the loan started at. The interest rate is the cost of borrowing, expressed as a percentage — fixed rates stay constant, while adjustable rates change at intervals.

Amortization is the gradual repayment of a loan in equal payments covering principal and interest. A fully amortized loan pays off to zero by the end of the term — a thirty-year amortized loan is paid down to nothing at year thirty. The down payment is the buyer's cash paid toward the purchase price, reducing the loan amount. Larger down payments lower monthly payments and often avoid mortgage insurance. A buyer pays twenty percent down — eighty thousand dollars on a four hundred thousand home.

Now the ratio that matters for lenders: loan-to-value, or LTV — the loan amount divided by the property value or appraised value. An eighty-thousand-dollar loan on a one-hundred-thousand-dollar home is an eighty percent LTV. Higher LTV means less equity, which is riskier for the lender. And when the down payment is below twenty percent — meaning LTV above eighty percent — lenders typically require private mortgage insurance, or PMI. PMI protects the lender, not the borrower, and it is usually dropped once the borrower reaches twenty percent equity. Know that: PMI is required above eighty percent LTV and protects the lender.

Let us compare loan types, because the exam expects you to sort them. A fixed-rate mortgage keeps the same interest rate for the full term — predictable payments, the most common choice. An adjustable-rate mortgage, or ARM, has an interest rate that changes periodically based on an index. ARMs have an initial fixed period and caps on how much the rate can change. The classic is a five-one ARM: fixed for five years, then adjusts yearly. These are the two private loan categories.

Then there are the government-backed programs. An FHA loan is insured by the Federal Housing Administration and allows a low down payment — as low as three and a half percent, with more forgiving credit requirements. A VA loan is guaranteed by the Department of Veterans Affairs for eligible veterans and service members — and it may require no down payment at all. A USDA loan is a government-backed loan for eligible rural and suburban homebuyers, also offering zero-down financing in approved areas. And a conventional loan is simply a mortgage not insured or guaranteed by any government agency — it can be conforming, meeting agency standards, or non-conforming, like a jumbo loan above the conforming limit. The exam pattern: match the borrower profile to the program — first-time buyer with small down payment, FHA; veteran, VA; rural buyer, USDA; strong borrower with twenty percent down, conventional.

Two loan-pricing concepts. Points, or discount points, are upfront fees paid to lower the interest rate. One point equals one percent of the loan amount. A borrower pays two points to reduce the rate from six and a half percent to six percent — buying down the rate with upfront cash. And PITI is the full monthly mortgage payment: principal, interest, taxes, and insurance. Lenders use PITI when qualifying borrowers, and the tax and insurance portions are typically paid from an escrow account — the lender collects a slice each month and pays the annual tax bill and insurance premium when they come due. That escrow account protects the lender's collateral by making sure taxes and insurance are never in arrears.

Two more loan provisions. A prepayment penalty is a fee charged when a borrower repays a loan early — some states restrict them on residential loans, so the lender cannot trap the borrower forever. And assumption is taking over an existing mortgage from the seller. Assumption may require lender approval and some loans are non-assumable, but a buyer who assumes the seller's four percent mortgage avoids taking a new, higher-rate loan.

Now the dark side of finance: what happens when the loan fails. Foreclosure is the legal process by which a lender takes the property after the borrower defaults. Foreclosure ends the borrower's equity interest — the bank forecloses after missed payments and the property is sold to satisfy the debt. Two alternatives soften the blow. A deed in lieu of foreclosure is a voluntary transfer of title to the lender to avoid foreclosure — often negotiated to avoid the cost and the public record. And a short sale is a sale for less than the mortgage balance, agreed to by the lender — the bank approves the short payoff because it loses less than it would in a foreclosure. A short sale at two hundred eighty thousand on a three hundred twenty thousand loan means the lender forgives the forty-thousand-dollar gap.

That closes the lending side. Now valuation and appraisal. The most important value to distinguish is market value — the price a willing, informed buyer and seller would agree to in an open market. Market value assumes no duress, full knowledge, and reasonable time. Contrast it with appraised value, the professional appraiser's opinion of value on a given date, which lenders use to size loans. And assessed value is the value a government assigns for property tax purposes — usually a fraction of market value, determined by the assessment ratio. Three different values, three different purposes: market value is the transaction price, appraised value is the lender's check, assessed value is the tax base.

There are three appraisal approaches, and each fits its property type. The sales comparison approach values a property by comparing it to similar recently sold properties, with adjustments for differences — the appraiser adjusts a comp for a larger garage to value the subject. This is the most common method for residential appraisal. The cost approach calculates land value plus reproduction cost minus depreciation — best for new construction and special-purpose properties like churches and schools, where there are no comparable sales. The income approach converts expected income into value through capitalization — value equals net operating income divided by the capitalization rate. A commercial property with sixty thousand dollars of net operating income at a six percent cap rate values at one million dollars.

Let us define the income numbers precisely. Net operating income, or NOI, is the effective gross income minus operating expenses, before debt service and taxes. Crucially, NOI excludes mortgage payments — it is operating expenses only. Eighty-five thousand rent minus twenty-five thousand operating costs equals sixty thousand NOI. The capitalization rate, or cap rate, is the rate of return on income property — NOI divided by value. Higher cap rates mean higher risk and higher return; a property with sixty thousand NOI and a one-million-dollar value has a six percent cap rate. And a quick ratio is the gross rent multiplier, or GRM — price divided by gross monthly rent. A two-hundred-forty-thousand-dollar property renting for two thousand a month has a GRM of one hundred twenty. GRM is the fast-and-dirty version, while cap rate and NOI are the professional versions.

Two more appraisal concepts. Depreciation is an accounting deduction for the wearing out of improvements over time — and the critical rule: land does not depreciate; improvements do. A rental property's building depreciates over twenty-seven and a half years for tax purposes, while the land underneath never does. Highest and best use is the legally permitted, physically possible, financially feasible use that yields the highest value — a corner lot's highest and best use might be a small retail building rather than a house. And comparables, or comps, are recently sold similar properties used to estimate value — you always adjust comps for differences in size, condition, and features.

Let us recap the numbers one more time because they are exam bank. LTV is loan divided by value; PMI kicks in above eighty percent LTV. Amortization spreads principal and interest into equal payments. FHA, VA, and USDA are government-backed; conventional is not. Points are one percent of the loan, paid upfront to lower the rate. PITI is principal, interest, taxes, and insurance. Market value, appraised value, and assessed value are three different figures. The three approaches are sales comparison for homes, cost for new or special-purpose buildings, and income for investment property — NOI divided by cap rate, with GRM as the quick ratio. And depreciation applies to improvements, never to land.

Finance and valuation are where the arithmetic points live, so the study sheet for module seven has the formulas written out — download it and practice the numbers. Next up, module eight: fair housing, leasing, and your final review, where we end with the complete test-day strategy. The full guide with every finance and valuation term is in the description. See you in module eight.