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

Financing concepts

Real estate financing rests on two separate documents. The promissory note is the borrower's personal promise to repay a stated sum at a stated rate. It is the actual debt and is a negotiable instrument the lender can sell. The security instrument pledges the real property as collateral for that note. On the exam the single most common trap is confusing the two: the note creates the obligation; the mortgage or deed of trust merely secures it.

Hypothecation is the act of pledging property as security for a loan without giving up possession. The borrower keeps living in and using the home while the lender holds a claim against it. This is why a homeowner can occupy a mortgaged property for thirty years.

Mortgage vs. deed of trust

Memory aid: the borrower gives the security, so the borrower is the -or (mortgagor, trustor). The lender receives it, so the lender is the -ee (mortgagee, beneficiary).

Lien theory vs. title theory

In lien-theory states the borrower holds legal title and the lender holds only a lien. In title-theory states the lender (or trustee) holds legal title until the debt is satisfied, and the borrower retains equitable title plus the right of possession. Intermediate-theory states blend the two. The practical effect is mostly procedural: title-theory and deed-of-trust states tend to allow faster, non-judicial foreclosure.

Standard clauses

• Acceleration clause — on default, the lender may demand the entire balance now, not just the missed payment. This must fire before foreclosure.
• Alienation (due-on-sale) clause — the full balance comes due if the borrower transfers the property; it blocks a buyer from freely assuming the loan.
• Defeasance clause — when the debt is fully paid, the lender must release the lien (via a satisfaction or reconveyance deed).
• Prepayment penalty clause — a fee for paying the loan off early; restricted on many consumer loans.
• Subordination clause — a lien voluntarily agrees to take a lower priority than a later lien.

Foreclosure and related concepts

Equitable right of redemption lets a defaulting borrower pay everything owed (principal, interest, costs) before the sale to keep the property. Some states add a statutory right of redemption that extends after the sale. A deficiency judgment lets the lender pursue the borrower personally when the sale proceeds fall short of the debt. A deed in lieu of foreclosure is a voluntary surrender that avoids the foreclosure process but does not erase junior liens.

Judicial foreclosure runs through the courts and is the default where a mortgage is used; the property is sold at a court-ordered public auction (a sheriff's sale). Non-judicial foreclosure uses the power-of-sale clause in a deed of trust, letting the trustee sell without a lawsuit, which is faster and cheaper for the lender. The exam often pairs these: deed of trust + power of sale + trustee = non-judicial; mortgage = judicial.

Lien priority

Liens generally rank by the date they are recorded - "first in time, first in right." The major exception is property tax and special-assessment liens, which take priority over all other liens regardless of recording date. A purchase-money mortgage (seller financing where the seller takes back a note) can also carry special priority. A subordination clause is how a lender voluntarily steps behind a later lien - common when a construction loan agrees to sit behind permanent financing.

Other instruments

A land contract (contract for deed / installment contract) lets the buyer take possession and make payments while the seller retains legal title until the final payment - useful when buyers cannot qualify for conventional financing. A wraparound mortgage layers a new loan on top of an existing one that stays in place. A package mortgage includes personal property (appliances) with the realty, and a blanket mortgage covers multiple parcels with a partial release clause freeing lots as they sell.

Amortization, points, and an assumption-vs-subject-to drill

A standard mortgage is fully amortized: each level payment covers the period's interest first, with the remainder reducing principal, so early payments are mostly interest and later payments mostly principal. A partially amortized loan leaves a balloon balance due at the end. Discount points lower the interest rate — 1 point = 1% of the loan amount, paid up front to buy down the rate.

Worked points example: On a $250,000 loan, 2 discount points cost 2% × $250,000 = $5,000. If each point lowers the rate by 0.25%, two points cut the note rate by 0.50%. The buyer weighs the $5,000 cost against the monthly savings to decide whether the buy-down pays off before they sell or refinance.

Assumption vs. "subject to" drill: When a buyer assumes a loan, the buyer becomes personally liable; if the lender also grants a novation, the original borrower is fully released. When a buyer takes title "subject to" the existing loan, the buyer makes payments but does not become personally liable, and the original borrower remains on the hook. Both are blocked by an alienation (due-on-sale) clause, which lets the lender call the full balance on transfer. The exam pairs these: assume = buyer liable; subject to = original borrower stays liable; due-on-sale = lender can stop either by demanding payoff.