31.1 Mortgages & Security Devices: Theories, Pre-Foreclosure Rights & Transfers
Key Takeaways
- A mortgage is a security interest that secures an obligation, usually a promissory note; most states follow the lien theory, which leaves title and possession with the borrower until foreclosure, while title-theory states treat the lender as holding legal title.
- Deeds of trust, installment land contracts, and absolute deeds given as security can function as mortgages, and parol evidence can show that a deed that looks absolute was intended only as security.
- In a lien-theory state, a lender has no right to possession before foreclosure but may reach rents through an assignment of rents or a receiver; at common law, a borrower could not prepay unless the loan allowed it, and an acceleration clause lets the lender demand the full balance after default.
- A buyer who takes 'subject to' a mortgage has no personal liability, while a buyer who assumes it becomes primarily liable and the original borrower becomes a surety; an unconsented modification discharges the original borrower completely under traditional suretyship rules but only to the extent of harm under modern rules.
- Due-on-sale clauses are generally enforceable under the Garn-St Germain Act, except for listed residential transfers such as transfers to a spouse or children or into a living trust, and when a lender transfers a loan, the mortgage follows the note.
31.1 Mortgages & Security Devices: Theories, Pre-Foreclosure Rights & Transfers
NCBE's fourth Real Property area covers mortgages and other security devices: types of security devices, security relationships, transfers by the mortgagor and mortgagee, payment and discharge, and foreclosure. This section covers types of security devices, the parties' relationship before foreclosure, and transfers; Section 31.2 covers discharge, foreclosure, and priorities.
Mortgages: Creation, Theories & Alternative Security Devices
A mortgage is an executed security interest in real property designed to secure the performance of an underlying financial obligation, almost always evidenced by a promissory note.
THE REAL PROPERTY FINANCING LOAN
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THE PROMISSORY NOTE THE MORTGAGE
• Personal debt obligation • Security interest in real estate
• Creates in personam liability • Creates in rem security remedy
• Sued upon for deficiency • Enforced through foreclosure sale
1. Title Theory vs. Lien Theory of Mortgages
Jurisdictions are fundamentally divided on the legal nature of a mortgage:
- Lien Theory (Majority Rule): The mortgage creates merely a security lien on the real estate. The mortgagor (borrower) retains both legal and equitable title and the complete right to possession until foreclosure is completed.
- Joint Tenancy Rule: In a lien theory state, the execution of a mortgage by one joint tenant does NOT sever the joint tenancy, because legal title remains intact.
- Title Theory (Minority Rule): The mortgage transfers legal title to the mortgagee (lender) subject to defeasance upon full repayment, leaving the mortgagor with equitable title.
- Joint Tenancy Rule: In a title theory state, courts often hold that a mortgage by one joint tenant severs the joint tenancy, converting it into a tenancy in common because the unity of title is destroyed.
- Intermediate Theory: Mortgagor retains legal title until default occurs, upon which legal title automatically transfers to the mortgagee.
2. Alternative Security Devices
- Deed of Trust: The borrower (trustor) conveys bare legal title to a neutral third-party trustee (e.g., a title company) who holds it in trust for the benefit of the lender (beneficiary). Upon default, the trustee executes a power of sale foreclosure without judicial proceedings.
- Installment Land Contract (Contract for Deed): The buyer agrees to make periodic payments to the seller over time. The seller retains legal title until the final payment is made. Many modern courts and statutes limit forfeiture under these contracts, and some treat them as mortgages that must be foreclosed (see Section 30.1).
- Equitable Mortgage (Absolute Deed as Security): If a borrower conveys an outright, absolute warranty deed to a lender with the contemporaneous oral agreement that the deed is merely collateral for a loan, equity treats the transfer as an equitable mortgage. Parol evidence is admissible to prove the parties' intent (many courts require clear and convincing evidence), and the lender must foreclose rather than simply keep the land.
Transfers of Mortgaged Property
SALE OF PROPERTY WITH EXISTING MORTGAGE
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How does the Buyer take title?
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"SUBJECT TO" MORTGAGE "ASSUMES" MORTGAGE
• Buyer has NO personal liability • Buyer becomes PRIMARILY liable
• Original Mortgagor remains liable • Original Mortgagor SECONDARILY liable
• If default, lender forecloses land; (Surety status)
cannot sue Buyer for deficiency • Material modification without Mortgagor's
consent may DISCHARGE Mortgagor
1. Transfers by the Mortgagor: "Subject To" vs. "Assuming"
When a property owner transfers real estate encumbered by an existing recorded mortgage, the property itself remains subject to the mortgage in the hands of the grantee. However, personal liability depends entirely on the deed language:
- Taking "Subject To": The grantee makes no personal promise to pay the underlying promissory note. If the loan defaults, the lender may foreclose against the real estate, but cannot sue the grantee for a personal deficiency judgment. The original mortgagor remains 100% personally liable on the note.
- "Assuming" the Mortgage: The grantee expressly promises to pay the mortgage debt. The assuming grantee becomes primarily liable for the debt. The original mortgagor becomes secondarily liable as a surety.
2. Discharge of the Original Mortgagor
If the mortgagee and an assuming grantee agree to a material modification of the loan terms (e.g., increasing the interest rate, extending maturity, or releasing collateral) without the original mortgagor's consent, courts apply suretyship principles:
- Traditional rule: A binding material modification or extension completely discharges the original mortgagor, who is a surety.
- Modern rule: Under the Restatement (Third) of Property: Mortgages (§ 5.3) and modern suretyship law, the original mortgagor is discharged only to the extent the change harms it. For example, it may remain liable on the original terms but not for an increased interest rate.
- Release: Traditionally, a release of the assuming grantee also discharges the original mortgagor; modern rules discharge the original mortgagor to the extent the release causes it loss.
- Subrogation: An original mortgagor who pays the debt after the assuming grantee defaults is subrogated to the mortgagee's rights and may enforce the mortgage against the land and seek reimbursement from the grantee.
3. Due-on-Sale Clauses
A due-on-sale clause (acceleration clause) allows the lender to demand immediate, full repayment of the outstanding loan balance if the borrower transfers or sells any interest in the mortgaged property without the lender's prior consent. The federal Garn-St Germain Depository Institutions Act of 1982 makes due-on-sale clauses generally enforceable despite contrary state law. For loans on residential property with fewer than five dwelling units, however, a lender may not enforce the clause because of certain transfers, including:
- a junior lien that does not transfer rights of occupancy;
- a transfer on the death of a joint tenant or tenant by the entirety;
- a transfer to a relative after the borrower's death;
- a lease of three years or less with no option to buy;
- a transfer that makes the borrower's spouse or children owners;
- a transfer to a spouse under a divorce decree or separation agreement; and
- a transfer into an inter vivos trust in which the borrower remains a beneficiary.
4. Transfers by the Mortgagee: The Note and Mortgage Travel Together
A mortgagee can transfer its rights. The promissory note is the primary obligation, and the mortgage is the accessory security. The mortgage automatically follows the note. If the note is validly assigned, the mortgage transfers automatically to the assignee. A transfer of the mortgage without the note generally gives the transferee nothing it can enforce, because only a person entitled to enforce the secured obligation may foreclose the mortgage.
Rights and Duties Before Foreclosure
The Secured Obligation
A mortgage must secure an obligation, but the obligation need not be a negotiable note. It may be the borrower's own debt, a guaranty of someone else's debt, or a promise to make future advances. Purchase-money mortgages and future-advance mortgages raise special priority questions, covered in Section 31.2.
Possession, Rents, and Receivers
- Possession: In lien-theory states, the lender has no right to possession before foreclosure. In title-theory states, the lender technically may take possession at any time but usually agrees to leave the borrower in possession. In intermediate-theory states, the lender's right to possession arises on default.
- Mortgagee in possession: A lender that takes possession must manage the property prudently, apply rents to the debt, and account to the borrower. It may also face liability as the party in control of the property.
- Rents and receivers: Many commercial mortgages include an assignment of rents. After default, a court may appoint a receiver to collect rents and preserve the property, especially when the security is inadequate or the property is being wasted.
- Waste: A borrower who damages the property or fails to pay taxes in a way that impairs the lender's security commits waste, and the lender may seek damages or an injunction.
Acceleration and Prepayment
- Acceleration: An acceleration clause lets the lender declare the entire balance due after a default. Without one, the lender can sue only for missed installments. Some courts refuse to allow acceleration when the default is trivial or the lender's own conduct caused it.
- Prepayment: At common law, a borrower had no right to pay off a loan before maturity unless the loan documents allowed it. Modern loans usually allow prepayment. Prepayment fees are generally enforceable if clearly stated, although federal and state laws restrict them for many residential loans.
Transfers in More Detail
| Question | Buyer Takes "Subject To" | Buyer "Assumes" |
|---|---|---|
| Does the land remain security? | Yes | Yes |
| Is the buyer personally liable? | No | Yes, primarily |
| Is the original borrower still liable? | Yes | Yes, as a surety |
| Can the lender obtain a deficiency judgment against the buyer? | No | Yes |
Transfers by the Mortgagee
- Negotiable notes: A transferee of a negotiable note who qualifies as a holder in due course—taking for value, in good faith, and without notice of defenses—takes free of the borrower's personal defenses, such as fraud in the inducement, but not real defenses, such as forgery or fraud in the execution. The mortgage follows the note.
- Nonnegotiable notes: The transferee of a nonnegotiable obligation takes it subject to the borrower's defenses.
- Payment before notice: Under the Restatement (Third) of Property: Mortgages, a borrower who pays the original lender before receiving notice of the transfer receives credit for the payment. Federal rules also protect residential borrowers who send payments to a prior loan servicer for a short period after servicing is transferred.
A commercial developer purchased an office park encumbered by an existing $1 million institutional mortgage executed by the prior owner to First Bank. The deed conveying the property to the developer contained an express clause stating that the developer 'hereby assumes and agrees to pay the First Bank mortgage.' Two years later, the developer experienced a cash flow crisis and negotiated a loan modification with First Bank. Without notifying or obtaining consent from the prior owner, First Bank and the developer executed a written agreement extending the loan maturity by ten years and increasing the interest rate by 3%. Six months later, the developer defaulted on the modified loan. First Bank foreclosed on the property, which sold at auction for $700,000, leaving an unpaid deficiency of $300,000. First Bank sued the prior owner personally for the $300,000 deficiency. The jurisdiction follows the traditional rule that a material modification made without a surety's consent completely discharges the surety. What is the legal effect of the loan modification on the prior owner's liability?
A homeowner's mortgage on her single-family home allows the lender to demand full payment if the property is transferred without the lender's consent. The homeowner transferred title to the home into a revocable living trust, naming herself as trustee and beneficiary, and continued living in the home. When the lender learned of the transfer, it demanded immediate payment of the full loan balance. May the lender accelerate the loan?
A borrower who needed $50,000 conveyed her farm, worth $400,000, to a lender by a deed that appeared absolute on its face. At the same time, the parties orally agreed that the lender would reconvey the farm when the borrower repaid the $50,000 with interest within two years. The borrower stayed in possession and kept paying the property taxes. When the borrower could not repay on time, the lender claimed to own the farm outright and sued to evict her. What is the borrower's best argument?