7.1 Financing Concepts, Notes, Mortgages, and Deeds of Trust

Two instruments, two jobs

Every financed purchase produces two separate documents, and the exam loves to test whether you can tell them apart. The promissory note is the financial instrument: it is the borrower's personal promise to repay a stated sum at a stated interest rate over a stated term. The note alone is unsecured. The security instrument (a mortgage or a deed of trust) ties that promise to the real property, so that if the borrower defaults the lender can force a sale of the collateral.

Think of it as: note = the IOU; mortgage/deed of trust = the leash that connects the IOU to the house. A borrower could sign a note with no security (a signature loan), but a real-estate loan always pairs the two.

Hypothecation

Real-estate borrowers pledge the property as collateral while keeping possession and use of it. This is hypothecation — you secure a debt with property without surrendering possession. The owner lives in the home, rents it, or improves it during the entire loan term even though the lender holds a security interest.

Title theory vs. lien theory

States fall into two camps regarding who holds title during the loan:

In lien-theory states the borrower (mortgagor) keeps title and the lender (mortgagee) holds only a lien against the property. In title-theory states legal title transfers to a trustee or lender until the debt is satisfied. Many states use intermediate theory, blending the two. For the national exam, know the concept rather than which state uses which.

The practical consequence is foreclosure speed. Where the lender or trustee already holds title with a power of sale, default can be resolved without filing a lawsuit (non-judicial). Where the borrower holds title and the lender has only a lien, the lender usually must sue and obtain a court order (judicial) before the property is sold. Test items frequently pair "deed of trust" with "non-judicial / power of sale" and "mortgage" with "judicial foreclosure."

Mortgage vs. deed of trust: the parties

A mortgage is a two-party instrument:

• Mortgagor = the borrower (gives the mortgage).
• Mortgagee = the lender (receives the mortgage).

A tip for the suffix: -or gives, -ee receives. The mortgagor gives the pledge; the mortgagee receives it.

A deed of trust (trust deed) is a three-party instrument:

• Trustor = the borrower.
• Beneficiary = the lender.
• Trustee = a neutral third party who holds bare/naked legal title and can sell the property if the trustor defaults.

Because a trustee already holds title with a power-of-sale clause, a deed of trust usually permits non-judicial foreclosure — faster and cheaper than the court-supervised judicial foreclosure typical of mortgages.

Clauses you must know cold

• Acceleration clause — on default, the lender can declare the entire unpaid balance due immediately (a prerequisite to most foreclosures).
• Alienation (due-on-sale) clause — the full balance becomes due if the owner transfers the property; this blocks an unauthorized loan assumption.
• Defeasance clause — requires the lender to release the lien and return title once the debt is fully paid (triggers a satisfaction or reconveyance).
• Prepayment clause/penalty — addresses whether and how a borrower may pay early; a penalty compensates the lender for lost interest.
• Subordination clause — a lender voluntarily agrees its lien will move to a lower priority behind another loan.
• Subrogation — substitution of one party for another in a claim (common with title insurers).

Watch the trap: an alienation clause stops assumption; a defeasance clause releases the lien at payoff; do not confuse them.

Satisfaction, reconveyance, and assumption

When a mortgage is fully paid, the lender records a satisfaction of mortgage (also called a release) to clear the lien from the record. With a deed of trust, the trustee executes a deed of reconveyance, returning legal title to the trustor. Both flow directly from the defeasance clause and clear the public record so the owner can convey marketable title.

When a buyer takes over a seller's existing financing, two paths exist. In an assumption, the buyer becomes personally liable on the note and, with a release of liability, the seller is freed. Buying subject to the loan means the buyer makes payments but does not assume personal liability; the seller stays on the hook. A due-on-sale (alienation) clause usually blocks both without lender consent.

Priority and recording

Lien priority generally follows recording order: "first in time, first in right." A first mortgage recorded before a second mortgage has senior priority and is paid first from foreclosure proceeds. Property tax and special assessment liens take priority over private liens regardless of recording date — a frequently tested exception. A subordination clause is how a lender voluntarily lets a later loan jump ahead in priority.