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

The Note Versus the Security Instrument

Every financed purchase has two separate documents. The promissory note is the borrower's written promise to repay a sum on stated terms, the actual evidence of the debt. The security instrument (a mortgage or a deed of trust) pledges the real property as collateral for that note.

Keep them distinct: the note creates the obligation, while the security instrument lets the lender force a sale if the borrower defaults. A trap question describes the document that "creates the debt" and lists both, the answer is the note.

Hypothecation

Hypothecation means pledging property as security for a loan without surrendering possession. The borrower keeps living in or using the property while it secures repayment. This is why a homeowner with a mortgage still occupies and controls the home.

Mortgage Versus Deed of Trust

The two instruments differ in party count and in how foreclosure works.

Table: Mortgage vs. Deed of Trust

The mortgagor is the borrower who gives the mortgage; the mortgagee is the lender who receives it. In a deed of trust, the borrower is the trustor, the lender is the beneficiary, and a third-party trustee holds bare legal title until payoff or default.

Lien Theory Versus Title Theory

• Lien-theory states (majority): the borrower holds title; the lender holds only a lien.
• Title-theory states: the lender or trustee holds legal title until the debt is paid.
• Intermediary-theory states: title passes to the lender only upon default.

This distinction drives who technically owns the property during the loan and how foreclosure proceeds.

Standard Mortgage Clauses

Exams test these by their trigger.

• Acceleration clause lets the lender demand the entire unpaid balance at once when the borrower defaults. Without it, the lender could only sue for missed payments.
• Alienation clause (due-on-sale) lets the lender call the full balance due when the borrower sells or transfers the property. It prevents an unqualified buyer from simply taking over the loan.
• Defeasance clause requires the lender to release the lien and return clear title once the debt is fully paid.
• Prepayment clause states whether (and at what cost) the borrower may pay the loan off early; a prepayment penalty charges a fee for early payoff.
• Subordination clause allows an existing loan to move to a lower lien priority so a new loan can take first position, common in construction financing.
• Defeasance releases the lien; acceleration is triggered by default; alienation is triggered by a sale. Do not confuse them.

Assumption Versus Subject-To

When a buyer takes over existing financing, two paths exist.

• In a loan assumption, the buyer formally takes on personal liability for the debt, often with lender approval and a release of the seller (novation).
• Taking title "subject to" an existing mortgage means the buyer makes payments but does not assume personal liability; the original borrower stays liable. The due-on-sale clause usually blocks both without lender consent.

Worked Example: Equity

Equity is market value minus debt owed. If a home is worth $400,000 and the remaining loan balance is $250,000, equity equals $400,000 − $250,000 = $150,000. As principal is paid down, equity grows even if value stays flat.

Foreclosure and Default Remedies

When a borrower defaults, the security instrument lets the lender force a sale. Two routes appear on the exam.

• Judicial foreclosure runs through a court, ends in a sheriff's sale, and is the norm in lien-theory states and wherever a mortgage (not a deed of trust) is used. New Jersey is a judicial-foreclosure state.
• Non-judicial foreclosure uses the power-of-sale clause in a deed of trust, letting the trustee sell without a lawsuit.

Redemption and Deficiency

• Equitable right of redemption lets a defaulting borrower pay the full debt plus costs and reclaim the property before the sale.
• Statutory right of redemption, where it exists, allows redemption for a set period 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 transfer of title to the lender to avoid foreclosure; a short sale is a lender-approved sale for less than the balance owed.

Lien Priority and Subordinate Financing

Lien priority generally follows the first-to-record rule: the earliest recorded lien is paid first from sale proceeds. Two exceptions dominate exam questions.

• Property-tax and special-assessment liens take priority over earlier-recorded mortgages regardless of recording date.
• A subordination agreement can voluntarily move a senior lien behind a new loan.

A purchase-money mortgage (PMM) is seller financing taken back by the seller; a junior or second mortgage sits behind the first. A package mortgage includes personal property (appliances), a blanket mortgage covers several parcels with a partial-release clause, and a wraparound lets a new loan encompass an existing one.

Worked Example: Sale Proceeds Distribution

A home sells at a foreclosure sale for $320,000. A recorded property-tax lien of $8,000, a first mortgage of $250,000, and a recorded second mortgage of $40,000 exist. Taxes are paid first ($8,000), then the first mortgage ($250,000), then the second ($40,000), leaving $320,000 − $298,000 = $22,000 of surplus that flows to the former owner. If proceeds had been only $280,000, the second-mortgage holder would receive $280,000 − $258,000 = $22,000 and the remaining $18,000 could become a deficiency.