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

Most residential sales depend on borrowed money, so the national exam tests how loan instruments work before it tests any math. A financed purchase creates two separate legal documents. The promissory note is the borrower's personal promise to repay the debt; it states the principal, interest rate, payment schedule, and maturity. The security instrument, either a mortgage or a deed of trust, pledges the property as collateral so the lender can foreclose if the note is not paid. Remember the relationship: the note is the debt, and the mortgage or deed of trust is the lien that secures it.

Mortgages vs. Deeds of Trust

A mortgage involves two parties: the borrower (mortgagor) and the lender (mortgagee). A deed of trust involves three parties: the borrower (trustor), the lender (beneficiary), and a neutral trustee who holds bare legal title until the loan is repaid. The trustee structure usually allows faster non-judicial foreclosure through a power-of-sale clause, while a true mortgage typically requires slower judicial foreclosure in court. Whether a state is a mortgage state or a deed-of-trust state determines which procedure applies.

Lien Theory vs. Title Theory

States take one of two views of who holds title during the loan. In a lien theory state, the borrower holds title and the lender merely holds a lien against the property. In a title theory state, the lender (or trustee) holds legal title until the debt is satisfied, while the borrower keeps equitable title and possession. A few states follow an intermediate theory. The practical exam point: in lien theory states the buyer holds title even while owing the loan.

Key Mortgage Clauses

These clauses appear repeatedly on the exam:

• Acceleration clause — lets the lender demand the entire balance at once after default.
• Due-on-sale (alienation) clause — lets the lender call the loan due if the property is sold or transferred, preventing free loan assumption.
• Defeasance clause — requires the lender to release the lien once the debt is fully paid.
• Prepayment clause/penalty — addresses whether the borrower may pay early and any fee for doing so.
• Subordination clause — allows an existing lien to move to a lower priority behind a new loan.

Amortization and Equity

A fully amortized loan is repaid through level payments that cover both principal and interest, leaving a zero balance at maturity. Early payments are mostly interest because interest accrues on the large outstanding balance; later payments shift toward principal. A term (straight) loan pays interest only, with the full principal due as a balloon payment at the end. As principal is paid down, the borrower's equity grows. Equity equals market value minus the total of all liens against the property.

Worked Example: Interest and Equity

A borrower owes $200,000 on a loan at 6% annual interest. Annual interest = $200,000 x 0.06 = $12,000, so the first month's interest = $12,000 / 12 = $1,000. If the monthly payment is $1,199, then $1,000 goes to interest and $199 reduces principal, leaving a $199,801 balance.

If that home is worth $260,000 and the only lien is the $199,801 mortgage, equity = $260,000 - $199,801 = $60,199. Equity rises as value appreciates and as principal is paid down.

Table: Note vs. Security Instrument

Primary and Secondary Mortgage Markets

The primary mortgage market is where lenders originate loans directly to borrowers, including banks, credit unions, and mortgage companies. The secondary mortgage market is where existing loans are bought and sold by investors such as Fannie Mae, Freddie Mac, and Ginnie Mae. Selling loans into the secondary market replenishes lender cash so they can make new loans, which keeps the overall supply of mortgage money flowing and stabilizes interest rates nationally.

Seller Financing and Land Contracts

Not every sale uses a bank. In seller (owner) financing, the seller acts as the lender and the buyer signs a note and security instrument in the seller's favor. A contract for deed (land contract) is a form of seller financing in which the buyer takes possession and makes installment payments while the seller retains legal title until the balance is paid. The buyer holds only equitable title until then, which makes land contracts riskier for buyers than a standard purchase with a deed delivered at closing.

Common Traps

• The note is not the lien; the mortgage or deed of trust is. Do not confuse them.
• A deed of trust is not a deed conveying ownership to a buyer — it is a security instrument.
• A due-on-sale clause blocks assumption; without it (or with lender consent) a loan may be assumable.
• Lien theory = borrower holds title; title theory = lender/trustee holds title during the loan.
• In a contract for deed, the seller keeps legal title; the buyer holds only equitable title until paid in full.
• The primary market originates loans; the secondary market buys and sells existing loans.