7.1 Financing Concepts, Notes, Mortgages, and Deeds of Trust
Key Takeaways
- The promissory note is the debt (the promise to repay); the mortgage or deed of trust is the security instrument that pledges the property as collateral.
- A mortgage involves two parties (borrower/mortgagor, lender/mortgagee); a deed of trust involves three (trustor, trustee, beneficiary) and allows faster nonjudicial foreclosure.
- Hypothecation lets the borrower pledge property as security while retaining possession and use.
- A defeasance clause cancels the lien when the debt is paid; an acceleration clause makes the full balance due upon default.
The two documents of every loan
Every financed purchase rests on two separate instruments, and the exam loves to test whether you can tell them apart.
- Promissory note — the borrower's written promise to repay. It is the evidence of the debt and states the amount, interest rate, payment schedule, and maturity. A note can be a negotiable instrument the lender sells on the secondary market.
- Security instrument — pledges the real property as collateral so the lender can foreclose if the note is not paid. This is either a mortgage or a deed of trust.
Think: the note is the IOU; the mortgage/deed of trust is the leash on the house. You can have a note without a mortgage (an unsecured loan), but a mortgage with no underlying note secures nothing.
Hypothecation and title theory
Hypothecation is pledging property as security for a debt without giving up possession. The borrower keeps living in and using the home while the lender holds a lien.
States follow one of three theories:
| Theory | Who holds title during loan | Typical instrument |
|---|---|---|
| Lien theory | Borrower holds title; lender has a lien | Mortgage |
| Title theory | Lender (or trustee) holds legal title | Deed of trust |
| Intermediate | Borrower holds title until default | Either |
The national portion treats these as concepts; specific state classification is a state-law topic.
Mortgage vs. deed of trust
The core distinction is the number of parties and the foreclosure path.
| Feature | Mortgage | Deed of trust |
|---|---|---|
| Parties | 2: mortgagor (borrower), mortgagee (lender) | 3: trustor (borrower), trustee (neutral 3rd party), beneficiary (lender) |
| Title held by | Borrower (lien theory) | Trustee, in trust |
| Foreclosure | Usually judicial (court) | Often nonjudicial (power-of-sale) |
| Speed | Slower | Faster |
Memory hook: mortGAGE = 2 (GA-GE), deed of TRUST = 3 because you TRUST a third party (the trustee). On a power-of-sale foreclosure the trustee sells the property without a lawsuit.
A borrower signs documents that include a promise to repay $300,000 plus a separate document pledging the home as collateral. Which document is the actual evidence of the debt?
Essential clauses
Security instruments contain clauses that show up repeatedly on the exam:
- Acceleration clause — upon default, the lender may declare the entire unpaid balance immediately due. Without it, the lender could only sue for missed payments. This clause is what makes foreclosure of the full debt possible.
- Alienation (due-on-sale) clause — the full balance becomes due if the borrower sells or transfers the property. It prevents an unqualified buyer from simply assuming the loan.
- Defeasance clause — when the debt is fully paid, the lender must release the lien and return title/rights to the borrower.
- Prepayment clause/penalty — may charge a fee for paying off early; restricted on many consumer loans.
- Subordination clause — a lien voluntarily moves to a lower priority position behind a later loan.
Lien priority and discharge
Generally liens rank by recording date — first to record, first in right. Exceptions: property-tax and special-assessment liens take priority over all others, regardless of when recorded.
Worked example: A home has a first mortgage recorded 2019, a second mortgage recorded 2022, and unpaid property taxes from 2024. At a foreclosure sale, property taxes are paid first, then the 2019 first mortgage, then the 2022 second. A junior lienholder wiped out at the senior's foreclosure sale loses its security but can still pursue the borrower on the note.
Satisfaction of mortgage (or deed of reconveyance under a deed of trust) is the recorded document proving the loan is paid and the lien released. Trap: paying off the note does not automatically clear the public record — the release must be recorded, or the old lien clouds title.
Foreclosure paths and related concepts
When a borrower defaults, the lender enforces the security instrument. Two broad routes appear on the exam:
- Judicial foreclosure — the lender files a lawsuit, the court orders a sale, and a sheriff or referee conducts a public auction. Used most often where the instrument is a mortgage.
- Nonjudicial (power-of-sale) foreclosure — the trustee under a deed of trust sells the property after notice, with no court action. This is the faster route and is the main practical reason lenders favor deeds of trust.
Related terms:
- Equitable right of redemption — before the sale, the borrower can pay the full debt plus costs and reclaim the property.
- Statutory right of redemption — in some states, the borrower may redeem for a period after the sale.
- Deficiency judgment — if the sale brings less than the debt, the lender may sue for the shortfall (where allowed).
Alternatives and financing devices
Not every default ends in foreclosure, and not every purchase uses a single new bank loan. The national exam expects familiarity with these devices:
- Deed in lieu of foreclosure — the borrower voluntarily deeds the property to the lender to avoid foreclosure; junior liens are not automatically erased, which is a key drawback for the lender.
- Short sale — the lender agrees to accept sale proceeds that are less than the loan balance.
- Assumption — a buyer takes over the existing loan (subject to any due-on-sale clause); with a novation the original borrower is released from liability.
- Contract for deed (land contract) — the seller finances and keeps legal title until the buyer completes payments; the buyer holds equitable title meanwhile.
- Purchase-money mortgage — seller-carried financing taken back as part of the purchase price.
A property is sold at foreclosure. There is a first mortgage (recorded 2018), a second mortgage (recorded 2021), and delinquent county property taxes (2023). In what order are these claims paid from sale proceeds?