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

Two Documents, Two Jobs

Almost every financed sale produces two separate instruments, and the exam loves to test whether you can keep them straight.

• The promissory note is the borrower's personal promise to repay. It states the amount, interest rate, payment schedule, and maturity. It is the evidence of the debt and is negotiable (it can be sold to another lender).
• The security instrument pledges the real property as collateral so the lender can foreclose if the note is not paid. It is the evidence of the lien.

A helpful mnemonic: the note is the what you owe; the mortgage or deed of trust is the what you lose if you do not pay. Sign one without the other and the lender has either an unsecured promise or a lien backing no debt.

Mortgage vs. Deed of Trust

States use one of two security instruments. Know the party names cold.

The trustee holds naked legal title and reconveys it to the borrower at payoff, or sells the property at a trustee's sale on default. Watch the suffix trap: the mortGAGOR (with an O) is the borrOwer.

Lien Theory vs. Title Theory

Who owns the property during the loan?

• Lien-theory states: the borrower keeps title; the lender merely has a lien. Most states follow this.
• Title-theory states: the lender (or trustee) holds legal title until the debt is satisfied; the borrower keeps equitable title and possession.
• A few intermediate-theory states sit in between.

The practical exam point: in title-theory states the lender's path to the collateral on default is faster because it does not have to wrest title away. Either way, the borrower in possession enjoys the property and pays taxes and insurance.

Key Mortgage Clauses

These clauses appear constantly on financing questions:

• Acceleration clause — on default the lender can demand the entire unpaid balance at once, a prerequisite to foreclosure.
• Alienation (due-on-sale) clause — the full balance is due if the borrower transfers the property; this blocks an unauthorized assumption.
• Defeasance clause — requires the lender to release the lien once the debt is fully paid.
• Prepayment clause/penalty — governs whether the borrower may pay early and any fee for doing so.
• Subordination clause — a lien voluntarily steps to a lower priority behind a future loan.

Distinguish acceleration (speeds up what is owed) from alienation (triggered by a sale).

Foreclosure, Equity of Redemption, and Deficiency

When a borrower stops paying, the lender accelerates and forecloses. Two redemption rights may apply:

• Equitable right of redemption — the borrower pays the full debt before the sale to reclaim the property. Available in every state.
• Statutory right of redemption — in some states, the borrower may redeem for a set period after the sale.

If the foreclosure sale brings less than the debt, the lender may seek a deficiency judgment for the shortfall (where state law allows). A deed in lieu of foreclosure lets the borrower hand over title voluntarily to avoid the process, though junior liens survive it.

Hypothecation, Lien Priority, and Junior Loans

When a borrower pledges property as security yet keeps possession and use, that is hypothecation — the heart of every mortgage loan. The borrower lives in the home while the lender holds a claim against it.

Priority among liens generally follows the rule "first to record, first in right." A first mortgage recorded before a second mortgage is paid first from foreclosure proceeds. Property-tax liens, however, jump ahead of mortgages regardless of date.

• Purchase-money mortgage — seller or third party finances part of the buyer's purchase.
• Package mortgage — secures real property plus personal property (e.g., appliances).
• Blanket mortgage — covers multiple parcels with a partial-release clause as lots sell.
• Wraparound mortgage — a new larger loan that wraps around an existing one.

Watch the subordination trap: a lender that recorded first can voluntarily agree to step behind a later loan, changing the normal priority order.

Assumption vs. "subject to," the secondary market, and loan servicing

When a buyer takes over an existing loan, the exam distinguishes two paths. In an assumption, the buyer formally takes on the loan and becomes personally liable; with lender approval and a novation, the original borrower is released. In a "subject to" purchase, the buyer makes payments but does not assume personal liability and the seller remains on the hook — and the lender's alienation (due-on-sale) clause usually lets the lender call the entire balance due on such a transfer.

Worked trap: a buyer takes title "subject to" an existing mortgage; the seller remains liable, the buyer is not, and the lender may accelerate under the due-on-sale clause.

Financing also has a primary and a secondary market. The primary market is where borrowers get loans from lenders. The secondary market is where those loans are bought and sold — Fannie Mae and Freddie Mac purchase conforming loans, while Ginnie Mae guarantees securities backed by FHA and VA loans. Selling loans replenishes lender capital so they can originate more. This is why a note is negotiable and why your loan servicer may change after closing.

A few more tested terms: a satisfaction (release) of mortgage or deed of reconveyance clears the lien once the debt is paid (defeasance in action). An estoppel certificate confirms the exact remaining balance, protecting an assuming buyer from a borrower's later false claims. The mortgage servicer collects payments, manages the escrow/impound account for taxes and insurance, and handles default — and is required to notify the borrower in writing when servicing is transferred. Distinguishing assumption (liability transfers), subject-to (it does not), and the role of the secondary market is reliably worth several points.