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

Two instruments, two jobs

Every financed sale creates two documents, and the exam loves to test which does what. Confusing the debt with the security is one of the most common ways candidates lose easy points in this domain.

• Promissory note — the borrower's written, signed promise to repay a stated sum at a stated rate over a stated term. It IS the debt. Without a note there is nothing to secure. It is a negotiable instrument the lender can sell on the secondary market.
• Security instrument — a mortgage or deed of trust that pledges the property as collateral for that note. If the borrower defaults, this instrument gives the lender the right to force a sale and apply the proceeds to the debt.

Through hypothecation, the borrower pledges the property as security without giving up possession — you live in the house while the lender holds a lien against it. The note is the IOU; the mortgage is the leash. The note also fixes whether the loan is fixed-rate or adjustable, the payment schedule, and any late-charge or default terms.

Mortgage vs. deed of trust

Memory trick: the borrower is the -or who gives the security (mortgagor, trustor); the lender is the -ee who receives it (mortgagee, benefici-ary). Note that under a deed of trust the lender is the beneficiary, not the trustee — the trustee is a neutral third party (often a title company) who can sell the property without a court order.

Whether a state uses mortgages or deeds of trust is set by state law, and many states permit both. The practical exam point is the foreclosure path: judicial foreclosure goes through the courts and is slower but allows broader borrower defenses, while a non-judicial trustee sale follows the power-of-sale clause and moves faster with strict notice rules.

Lien theory vs. title theory

• Lien theory — the borrower keeps legal title; the mortgage is only a lien against the property. The lender must go to court (judicial foreclosure) to enforce.
• Title theory — the lender (or trustee) holds legal title until the debt is satisfied; the borrower keeps equitable title and possession. Faster, often non-judicial.
• Intermediary theory — a hybrid: title passes to the lender only upon default.

When the loan is paid, the borrower's right to clear title comes from the defeasance clause (mortgage) or a deed of reconveyance signed by the trustee (deed of trust). A satisfaction (or release) is recorded to clear the lien from the public record.

The clauses the exam tests

Security instruments contain standard clauses, and the exam asks you to match each clause to the event it governs.

• Acceleration clause — on default, the lender can demand the entire balance at once, not just the missed payment. This is the prerequisite to foreclosure.
• Alienation clause (due-on-sale) — the full balance comes due if the borrower transfers the property. It blocks an unapproved loan assumption and prevents a buyer from taking the seller's low rate.
• Prepayment clause/penalty — addresses whether, and at what cost, the borrower may pay early. Many consumer loans now restrict or ban penalties.
• Defeasance clause — requires the lender to release the lien once the debt is fully paid.
• Subordination clause — a lender agrees its lien will rank behind a later loan, common in construction or land financing.

Lien priority generally runs by recording date under the rule "first in time, first in right." The major exception: property-tax and special-assessment liens jump ahead of all private liens regardless of when recorded, so a tax lien recorded after a mortgage still gets paid first at a sale.

Default, equity of redemption, and deficiency

If a borrower defaults, the equity of redemption lets them reinstate or pay off the debt plus costs before the foreclosure sale to keep the property. Some states also grant a statutory right of redemption for a period after the sale, allowing the former owner to buy the property back from the high bidder.

If the foreclosure sale brings less than the debt owed, the lender may seek a deficiency judgment for the shortfall, where state law allows. A deed in lieu of foreclosure lets the borrower voluntarily hand title to the lender to avoid a forced sale, but it does not wipe out junior liens, so a lender with junior liens behind it may refuse one. A short sale (selling for less than the loan balance, with lender consent) is another default workout the exam may name.

One more vocabulary point that recurs: a subject-to purchase means a buyer takes the property still encumbered by the seller's loan without formally assuming it, so the seller stays personally liable on the note. Compare that with a true assumption (buyer takes over the loan) and seller financing (seller becomes the lender). The exam tests these by describing the facts and asking who is liable on the debt and who holds title — answer from the instrument involved, never from the label the parties used.