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

The Note and the Security Instrument

Every financed purchase involves two separate documents. The promissory note is the borrower's written promise to repay the debt; it states the principal, interest rate, payment schedule, and maturity date. The note is the actual evidence of the debt.

The security instrument pledges the property as collateral for that debt. It is either a mortgage or a deed of trust. A common exam trap is treating the note and the mortgage as the same thing: the note is the debt, the mortgage merely secures it.

Through hypothecation, the borrower pledges the property as security yet keeps possession and use during the loan term. The lender's interest is recorded but does not displace the owner.

Mortgage vs. Deed of Trust

A mortgage has two parties: the mortgagor (borrower, who gives the mortgage) and the mortgagee (lender, who receives it). A handy memory aid: the party adding the -or gives, the party with -ee receives.

A deed of trust adds a neutral third party. The trustor (borrower) conveys title to a trustee, who holds it for the beneficiary (lender) until the debt is paid.

Table: Security Instrument Comparison

Because the trustee already holds a power of sale, deeds of trust commonly permit faster non-judicial foreclosure, avoiding a full court action.

Lien Theory vs. Title Theory

States split on who holds title during the loan. In a lien-theory state (the majority), the borrower holds title and the lender holds only a lien. In a title-theory state, the lender or trustee holds legal title until the debt is satisfied; the borrower keeps equitable title and possession.

This distinction drives foreclosure procedure: lien-theory states more often require judicial foreclosure, while title-theory and deed-of-trust states more often use non-judicial sale.

Common Clauses

• Acceleration clause - Lets the lender demand the entire unpaid balance at once upon default (it makes foreclosure possible).
• Alienation clause (due-on-sale) - Requires full repayment when the property is sold or transferred, preventing the loan from being assumed without lender consent.
• Defeasance clause - Requires the lender to release the lien and return clear title once the debt is fully paid.
• Prepayment clause/penalty - States whether and how the borrower may pay early; a penalty compensates the lender for lost interest.
• Subordination clause - Lets an existing lien voluntarily move to a lower priority so a new loan can take first position.

Worked Example

A borrower defaults after missing three payments. The lender invokes the acceleration clause, declaring the full $182,000 balance due immediately rather than just the three missed payments. Only after acceleration can the lender pursue foreclosure for the entire balance.

Foreclosure and Redemption

When default cannot be cured, the lender forces a sale. The exam distinguishes two paths:

• Judicial foreclosure - a court action ending in a sheriff's sale; common in lien-theory mortgage states.
• Non-judicial foreclosure - the trustee exercises the power of sale in a deed of trust, selling at public auction without a full lawsuit; faster and common in deed-of-trust states.

Borrowers may have redemption rights:

• Equitable redemption - the right to pay the full debt and reclaim the property before the foreclosure sale.
• Statutory redemption - in some states, a period after the sale to redeem by paying the sale price plus costs.

If the sale brings less than the debt, the lender may seek a deficiency judgment for the shortfall (where state law allows). Alternatives that avoid a forced sale include a deed in lieu of foreclosure (borrower voluntarily conveys title) and a short sale (lender accepts a sale price below the loan balance).

Exam Trap: Equitable redemption is before the sale; statutory redemption (where it exists) is after. Mixing up the timing is a frequent miss.

Purchase-Money and Seller Financing

Not all loans come from a bank. A purchase-money mortgage (PMM) is any loan used to buy the property, and the term also describes seller (owner) financing, where the seller acts as the lender and the buyer pays the seller over time.

A related tool is the land contract (also called a contract for deed or installment land contract): the buyer takes possession and makes payments, but the seller keeps legal title until the final payment, when the deed is delivered. The buyer holds equitable title in the meantime.

Table: Who Holds Title During the Loan

Seller financing can help a buyer who cannot qualify conventionally, but the buyer under a land contract has weaker protection because the seller retains title until payoff. If the buyer defaults late in the term, some states let the seller forfeit the contract and keep prior payments, which is why land-contract buyers are urged to record the contract and seek legal review.