7.1 Financing Concepts, Notes, Mortgages, and Deeds of Trust
Key Takeaways
- The promissory note is the debt; the mortgage or deed of trust is the security that allows foreclosure.
- A mortgage has two parties; a deed of trust adds a neutral trustee with power-of-sale (nonjudicial) authority.
- Parties giving an instrument end in -or (mortgagor, trustor); receiving parties end in -ee (mortgagee, beneficiary).
- Lien priority is generally first-to-record, but property tax liens and subordination agreements override that order.
- Equitable redemption occurs before the sale; statutory redemption (where allowed) occurs after the sale.
How Real Estate Loans Are Built
Almost every residential sale is financed, so the exam expects you to know the instruments that create and secure debt. Two documents do separate jobs. The promissory note is the borrower's personal promise to repay; it states the principal, interest rate, payment schedule, and maturity. The security instrument (a mortgage or a deed of trust) pledges the property as collateral so the lender can foreclose if the note is not paid. Memorize this split: the note is the debt, the security instrument is the leverage.
Hypothecation and the Two Theories
Pledging property as collateral while keeping possession is called hypothecation. States follow one of two legal theories. In title theory states, the lender (mortgagee) holds legal title until the loan is paid. In lien theory states, the borrower (mortgagor) keeps title and the lender holds only a lien. A few states use an intermediate theory. The practical exam point: in lien-theory states foreclosure is generally judicial; in deed-of-trust states a nonjudicial trustee's sale is common and faster.
Mortgage vs. Deed of Trust
A mortgage has two parties: the borrower (mortgagor, who gives the mortgage) and the lender (mortgagee, who receives it). A deed of trust has three parties: the borrower (trustor), the lender (beneficiary), and a neutral trustee who holds bare legal title and can sell the property nonjudicially under a power of sale clause. Watch the suffix trap: the party giving the instrument ends in -or (mortgagor, trustor); the party receiving benefit ends in -ee (mortgagee, beneficiary).
Key note and security clauses tested heavily:
| Clause | What it does |
|---|---|
| Acceleration | Lets the lender demand the full balance upon default |
| Alienation (due-on-sale) | Loan must be paid off if the property is sold/transferred |
| Defeasance | Cancels the lien and returns title once the debt is paid |
| Prepayment penalty | Charges a fee for paying the loan off early |
| Subordination | Voluntarily lowers a lien's priority to another loan |
| Power of sale | Allows nonjudicial foreclosure (deed of trust) |
Title theory, lien theory, and who holds title during the loan
States follow one of two theories, and the exam expects you to know the practical difference.
| Theory | Who holds title during the loan | Typical foreclosure |
|---|---|---|
| Lien theory | Borrower holds title; lender has a lien | Judicial |
| Title theory | Lender (or trustee) holds legal title until paid | Non-judicial via trustee |
| Intermediate | Hybrid; title shifts on default | Varies |
A deed of trust adds a third party, the trustee, who holds title for the lender (beneficiary) and can sell the property through a power-of-sale clause without going to court — faster than judicial foreclosure on a mortgage.
The two redemption rights
- Equitable right of redemption: the borrower may cure the default and reclaim the property before the foreclosure sale by paying the debt plus costs. Every state recognizes it.
- Statutory right of redemption: in some states the borrower may redeem after the sale within a set statutory period. Not all states grant it.
Trap: "Before the sale" = equitable; "after the sale" = statutory. Mixing the two is the standard distractor.
Worked acceleration and deficiency scenario
A borrower owes $260,000 and defaults. The note's acceleration clause lets the lender demand the entire balance at once, not just the missed payments. The property sells at foreclosure for $230,000. The $30,000 shortfall is a deficiency; where allowed, the lender may seek a deficiency judgment for it. A due-on-sale (alienation) clause is different — it lets the lender call the loan if the borrower transfers the property, blocking an unauthorized assumption. Separating acceleration (triggered by default) from due-on-sale (triggered by transfer) is a frequent exam point.
A buyer assumes a seller's existing loan without the lender's consent, and the lender demands full repayment. Which clause did the lender enforce?
Lien Priority and Recording
Foreclosure proceeds distribute money in order of lien priority. The general rule is first to record, first in right ("first in time, first in line"), but two exceptions dominate exam questions. Property tax and special assessment liens always take first priority regardless of recording date. And a subordination agreement can voluntarily move a junior lien ahead of a senior one. A purchase-money mortgage taken back by a seller can also have special priority depending on jurisdiction. Recording in the public record gives constructive notice and protects priority.
Equitable Right vs. Statutory Right of Redemption
Borrowers in default get a chance to save the property. The equitable right of redemption lets the borrower pay the full debt plus costs before the foreclosure sale to reclaim title. Some states also grant a statutory right of redemption, allowing redemption for a set period after the sale. When a sale brings less than the debt, the lender may seek a deficiency judgment for the shortfall, though some states restrict this. A deed in lieu of foreclosure lets the borrower hand over title to avoid foreclosure, but it does not erase junior liens.
Foreclosure Methods and Related Documents
Fedeals classify foreclosure as judicial or nonjudicial. Judicial foreclosure runs through a court, ends in a court-ordered sale, and is the standard route under a mortgage in lien-theory states. Nonjudicial foreclosure relies on the power of sale clause in a deed of trust: the trustee sells the property at public auction without a lawsuit, which is faster and cheaper. A lis pendens is a recorded notice that litigation affecting title is pending, warning prospective buyers. After a successful payoff, a satisfaction of mortgage (or deed of reconveyance for a deed of trust) is recorded to clear the lien.
Special Financing Instruments
The exam also tests creative financing. A purchase-money mortgage is seller financing where the seller takes back a note for part of the price. A wraparound mortgage layers a new loan over an existing one the seller keeps paying. A package mortgage includes personal property (appliances) along with real estate; a blanket mortgage covers multiple parcels and typically has a partial release clause freeing lots as they sell. A construction loan advances funds in stages and is short-term. Recognizing these by their defining feature, not their interest rate, is what earns points.
Which lien generally takes priority over a previously recorded first mortgage?