Real Estate Law 101: Open-End Mortgages

The following article was prepared by Alex Jones, Law Clerk for Kohrman Jackson & Krantz LLP.

What it is?

Generally, an open-end mortgage is one that remains open after it has been delivered to the county recorder, and it permits the lender/mortgagee to make advances on the loan that are secured by the original mortgage, but only to the extent the total indebtedness does not exceed the maximum principal amount identified. An open-end mortgage acts as a lien on the property described in the mortgage.

 

For example, let’s say borrower takes out a loan for $100,000 that the lender secures with a mortgage, and borrower draws down $10,000 in principal under the loan at closing. With an open-end mortgage, the lender may loan the additional $90,000 in principal and continue to secure the full amount of the loan with the original mortgage.

 

Ohio’s Open End-Mortgage Statute

In Ohio, ORC § 5301.232 governs open-end mortgages, and lenders must be certain to comply with the requirements of the statute in order to reap the benefits of an open-end mortgage. Specifically, to comply with the Revised Code, in addition to the parties intending it to be an open-end mortgage, the mortgage must state at the beginning that it is an “open-end” mortgage and indicate the total amount of principal (exclusive of interest) that may be outstanding at any time.

 

Why Lenders Use them

Lenders use open-end mortgages to advance loan funds to borrowers while maintaining a first priority lien and without having to issue a new mortgage after each advance. However, this right is not absolute.  The right is contingent upon whether the lender has the option to advance future loans or the obligation to advance future loans – the distinction matters.

 

When the future loan advances are optional, an intervening third party loan or mechanics lien may take priority over future additional advances. If the original lender/mortgagee makes additional loan advances after having received notice of the subordinate mortgage loan or other lien, and it was not obligated to make the advance, then it loses its first priority lien with respect to those later advances However, when the lender/mortgagee has an obligation to make an additional advance on the mortgage, then its lien on the additional advances will relate back to the time the original mortgage was recorded and will take priority over any intervening third party loan, including a mechanic’s lien.

 

There is flexibility under Ohio law as to the contractual language needed to make an advance obligatory.  A contractual obligation to make an advance arises even if the advance is conditioned upon the occurrence or existence, or the failure to occur or exist, of any event or fact. The Ohio Supreme Court has explained that as long as the language requires the lender/mortgagee to advance a certain and definite sum in a particular manner then it will be deemed obligatory even if no advancement is ever actually made.  Thus, a properly drafted open-end mortgage can ensure a lender maintains its first priority lien.

 

Borrower’s Right to Limit Indebtedness; Notice requirements

A borrower/mortgagor can limit the amount of the indebtedness secured by the original mortgage to the amount then outstanding.  To do so, the borrower must serve a notice to that effect on the lender/mortgagee prior to recording the notice. The notice must reference the volume/page number or the recorder’s file number, and the borrower’s signature  must be notarized. 

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The above information is meant to provide a brief summary regarding open-end mortgages and is not intended to cover every issue that might arise in the context of an open-end mortgage.

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Casualty and Condemnation Provisions in Loan Agreements

Every mortgage loan agreement contains provisions that address casualty and condemnation (i.e., eminent domain) affecting the property.  All such provisions give the lender some degree of control over the proceeds and identifies what happens to the proceeds, and are usually given scant attention. However, these provisions often can be negotiated, at least with respect to how the proceeds are handled for any restoration of the property.

As a borrower, a property owner doesn’t want to be hamstring with red tape if the proceeds are not material, and a lender shouldn’t want that either. However, a lender needs to protect its security interest in the property.  The trick is to determine where to draw the line.

Typically, the loan agreement includes casualty and condemnation provisions that simply provide all proceeds from such events go to the lender, which may be applied to paying down principal on the loan.

Consider the following scenario, a new storm sewer is scheduled for construction along the road where mortgaged property is located. Eminent domain is being utilized to take a tiny sliver of the properties adjacent to the road. The amount of property to be taken has no material impact on the value of the mortgaged property and accounts for maybe 1-2% of the property.  However, if the loan agreement’s condemnation provision does not include a materiality threshold then the borrower will need to notify the lender, pay a few thousand in fees to the lender to cover its legal fees and contend with red tape over the use of the proceeds.

Typical approaches to identifying what condemnation or casualty events are material include a dollar threshold and a percentage of the property that is affected. When such an event does not trigger these thresholds then the borrower will retain all or some level of control over how the insurance or condemnation proceeds are spent.

For example, a restoration threshold will typically be set at around 5% of the outstanding principal balance on the mortgage loan. Therefore, if the proceeds the result from the casualty or condemnation event do not exceed that threshold then the lender is more likely to permit borrower to keep the proceeds.

Additionally, a lender will want to look at how the property is functionally affected by such events. For example, if the land taken by eminent domain is less than 10%, the percentage of leases that remain in full force and effect after a casualty event exceeds 75% or the less than 35% of the improvements were destroyed, then the lender will be more likely to permit the borrower to restore the property and, depending on other criteria, receive the proceeds for restoration.

When negotiating loan agreements, borrowers should give some attention to the casualty and condemnation (eminent domain) provisions, with the goal of obtaining as much flexibility as possible.
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