7.1 Financing Concepts, Notes, Mortgages, and Deeds of Trust
Key Takeaways
- The promissory note is the debt (the promise to repay); the mortgage or deed of trust is the security instrument that pledges the property as collateral.
- A mortgage involves two parties (mortgagor/borrower, mortgagee/lender); a deed of trust involves three parties and adds a trustee who can foreclose nonjudicially.
- Hypothecation lets the borrower keep possession and use of the property while it secures the loan.
- Key clauses—acceleration, alienation (due-on-sale), defeasance, prepayment, and subordination—change borrower and lender rights and are heavily tested.
- Lien theory, title theory, and intermediary theory states differ on who holds title during the loan term.
The two-document structure
Nearly every financed sale uses two instruments. New licensees lose points by collapsing them into one.
- Promissory note — the borrower's written promise to repay. It is the actual debt. It states the principal, interest rate, payment amount, term, and default terms. It is a negotiable instrument the lender can sell.
- Security instrument — pledges the property as collateral for the note. It is either a mortgage or a deed of trust. It is recorded; the note usually is not.
Think of it this way: the note says "I owe you the money." The security instrument says "and if I don't pay, you can take the house."
Hypothecation
Hypothecation is pledging property as security for a loan while keeping possession and use of it. The borrower lives in the home throughout the loan; the lender holds only a lien or contingent title interest, not the keys. This is why a financed buyer can occupy immediately.
Mortgage vs. deed of trust
| Feature | Mortgage | Deed of Trust |
|---|---|---|
| Parties | 2: mortgagor (borrower), mortgagee (lender) | 3: trustor (borrower), beneficiary (lender), trustee (neutral third party) |
| Who holds the security interest | Lender | Trustee holds bare/naked legal title for the lender |
| Typical foreclosure | Judicial (court) | Nonjudicial via power-of-sale clause (faster) |
| Reconveyance on payoff | Satisfaction/release recorded | Trustee issues a deed of reconveyance |
Memory aid: mortg-AGOR = borrower (the one giving the mortgage), mortg-AGEE = lender (the one receiving it). The borrower gives the pledge to the lender.
Title, lien, and intermediary theory
Who holds title during the loan depends on the state.
- Lien theory — the borrower holds title; the lender holds only a lien. Foreclosure is usually judicial. The borrower keeps title and possession.
- Title theory — the lender (or trustee) holds legal title until the debt is paid; the borrower holds equitable title and possession.
- Intermediary theory — a hybrid: borrower holds title, but title shifts to the lender on default.
On the exam, if a question says "the lender holds a lien only," you are in a lien-theory frame; "the trustee holds naked legal title" signals title/deed-of-trust frame.
Key clauses (high-frequency tested)
| Clause | What it does | Who it favors |
|---|---|---|
| Acceleration | On default, makes the entire balance due at once | Lender |
| Alienation (due-on-sale) | Loan must be paid in full if the property is sold/transferred; blocks assumption | Lender |
| Defeasance | Requires lender to release the lien when the debt is paid | Borrower |
| Prepayment | Allows early payoff; a prepayment penalty charges a fee for it | Varies |
| Subordination | A lender agrees its lien takes lower priority | The other lienholder |
| Release (partial) | Frees specific parcels from a blanket lien as they sell | Borrower/developer |
Trap: Acceleration must usually be triggered before foreclosure—it is what allows the lender to demand the whole balance, not just the missed payment. Trap: An alienation clause is what prevents a new buyer from simply assuming the existing loan; without it, loans may be assumable. Do not confuse acceleration (about default) with alienation (about sale).
Foreclosure and the borrower's safety valves
When a borrower defaults and the lender accelerates, the property may be sold to satisfy the debt. The exam separates the two pathways and the borrower's rights.
| Concept | Meaning |
|---|---|
| Judicial foreclosure | Court-supervised sale; standard in lien-theory/mortgage states |
| Nonjudicial foreclosure | Power-of-sale by the trustee; faster, common with deeds of trust |
| Equitable right of redemption | Borrower pays the full debt before the sale to keep the property |
| Statutory right of redemption | In some states, borrower redeems after the sale within a set period |
| Deficiency judgment | Lender sues for the shortfall when the sale brings less than the debt |
| Deed in lieu of foreclosure | Borrower voluntarily deeds the property to the lender to avoid foreclosure |
Worked example: A home with a $260,000 loan balance is foreclosed and sells at auction for $230,000. The lender recovers $230,000 and, where allowed, may pursue a deficiency judgment for the remaining $30,000. A short sale would have addressed the same gap before foreclosure, with lender consent to accept less than the full payoff.
Junior vs. senior liens and purchase-money loans
A senior (first) mortgage is recorded first and is paid first from sale proceeds; a junior (second) mortgage or home-equity line is subordinate. A purchase-money mortgage is financing used to buy the property (sometimes seller-financing), and a package, blanket, or construction loan covers, respectively, personal property plus realty, multiple parcels (with partial-release clauses), or staged building draws.
Trap: A subordination clause can flip the usual order — an existing lender voluntarily agrees that a later loan (often a construction loan) will hold higher priority. Without such an agreement, recording order controls. Defeasance, by contrast, has nothing to do with priority; it simply forces the lender to release the lien once the note is fully paid, clearing the title.
A buyer finances a home and moves in immediately while the lender holds a lien on the property. Which term describes pledging the property as security while retaining possession and use?
A loan contains a clause requiring full repayment if the borrower sells the property, preventing the buyer from taking over the existing loan. Which clause is this?