7.1 Financing Concepts, Notes, Mortgages, and Deeds of Trust
Key Takeaways
- The note is the debt; the mortgage or deed of trust is the security pledging the collateral.
- A mortgage has two parties; a deed of trust has three (trustor, beneficiary, trustee) and usually allows faster nonjudicial foreclosure.
- Acceleration makes the balance due on default; alienation (due-on-sale) is triggered by sale; defeasance forces release at payoff.
- Equity equals market value minus the amount owed, and grows as principal amortizes and value rises.
- Lien priority follows first-to-record, except property-tax liens, which come first regardless of date.
Financing Concepts, Notes, Mortgages, and Deeds of Trust
Real estate financing on the national exam rests on one core distinction: the note is the debt, and the security instrument is the collateral pledge. A borrower signs a promissory note (the promise to repay) and a mortgage or deed of trust (which lets the lender force a sale if the borrower defaults). Confusing these two is the single most common financing trap.
The promissory note
The promissory note is the borrower's personal IOU. It states the principal, interest rate, payment schedule, and maturity. It is a negotiable instrument the lender can sell on the secondary market. Without the note there is no debt to secure.
- Maker signs the note (the borrower).
- Payee receives payment (the lender).
- A straight (term) note pays interest only, with principal due at maturity.
- An amortized note spreads principal and interest over the term so the balance reaches zero.
Mortgage vs. deed of trust
The security instrument differs by state, and the exam tests the party count and the foreclosure route.
| Feature | Mortgage | Deed of Trust |
|---|---|---|
| Parties | 2 (mortgagor, mortgagee) | 3 (trustor, beneficiary, trustee) |
| Who holds title | Lien-theory: borrower; Title-theory: lender | Trustee holds bare legal title |
| Typical foreclosure | Judicial | Nonjudicial (power of sale) |
| Speed | Slower (court) | Faster |
Memory hook: the mortgagOR is the borrOWER who OWES; the mortgagEE is the lender. In a deed of trust the trustOR is the borrower, the beneficiary is the lender, and a neutral trustee holds title until the loan is paid.
Theories of title
- Lien theory: Borrower keeps title; lender holds only a lien. Most states.
- Title theory: Lender holds legal title until payoff; borrower has equitable title.
- Intermediate theory: Borrower holds title, but it shifts to the lender on default.
Key clauses
- Acceleration clause: On default, the entire balance becomes due at once. Foreclosure is impractical without it.
- Alienation (due-on-sale) clause: Loan must be paid in full if the property is sold; blocks an unapproved assumption.
- Defeasance clause: Requires the lender to release the lien (issue a satisfaction) once the debt is paid.
- Prepayment clause/penalty: Allows or charges for early payoff.
- Subordination clause: A lien voluntarily moves to a lower priority.
Amortization mechanics
In a fully amortized loan, each level payment first pays the interest due on the outstanding balance, and the remainder reduces principal. Early payments are mostly interest; later payments are mostly principal. This is why two loans with the same payment but different rates pay down at very different speeds.
Worked example: A $200,000 loan at 6% annual interest. First month's interest = $200,000 x 0.06 / 12 = $1,000. If the level payment is $1,199, then $199 reduces principal, leaving a balance of $199,801 for month two. The interest portion shrinks each month thereafter.
Hypothecation and equity
Hypothecation means the borrower pledges property as collateral while keeping possession and use. The borrower's equity is market value minus what is owed. As the amortized balance drops and value rises, equity grows.
Worked example: A home is worth $400,000 with a $260,000 loan balance. Equity = $400,000 - $260,000 = $140,000. If the owner refinances and pulls out $50,000 cash, the new balance is $310,000 and equity falls to $90,000.
Lien priority and satisfaction
Lien priority generally follows first in time, first in right by recording date, with property-tax liens taking priority over all others regardless of date. When the note is paid, a lien-theory state records a satisfaction (release) of mortgage; a deed-of-trust state records a deed of reconveyance from the trustee. Failing to record the release leaves a cloud on title.
Junior vs. senior liens
A first mortgage (senior lien) is paid first from foreclosure proceeds; a second mortgage or home-equity line is junior and paid only from what remains. Junior lienholders accept greater risk and usually charge higher rates.
Foreclosure of a senior lien generally wipes out junior liens as to the property, though the underlying debt may survive personally. A subordination agreement is how a lender voluntarily lets a later lien jump ahead, common when a borrower refinances a first loan while keeping a second.
Assumption vs. subject to
When a buyer takes over an existing loan, two outcomes exist:
- Assumption (with novation): the buyer becomes personally liable and the seller is released. Requires lender consent.
- Subject to: the buyer makes payments but the seller stays personally liable on the note. Riskier for the seller.
Without lender approval, a due-on-sale clause lets the lender accelerate the balance the moment title transfers.
Land contracts
In a land contract (contract for deed), the seller keeps legal title while the buyer takes possession and equitable title, paying in installments. The deed transfers only after full payment. This is seller financing without a conventional security instrument, and it is tested as a financing alternative for buyers who cannot qualify for a traditional loan.
Trap: A buyer assumes a loan with a due-on-sale clause and no lender approval. The lender can call the entire balance due immediately. Assumption is only safe when the loan permits it or the lender consents. A second trap confuses assumption (seller released via novation) with subject to (seller still liable).
A borrower signs documents creating a three-party security arrangement in which a neutral third party holds bare legal title until the debt is repaid. Which instrument is this, and what is the borrower called?
Which clause allows a lender to demand the entire unpaid balance immediately upon the borrower's default?