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

Financing concepts: two instruments, not one

Every financed purchase produces two separate documents, and the exam constantly tests the difference. The promissory note is the borrower's written promise to repay; it is the evidence of the debt and names the amount, interest rate, payment schedule, and maturity. The mortgage or deed of trust is the security instrument that pledges the real property as collateral for that note.

If the note is the IOU, the security instrument is what lets the lender take the property if the IOU is not paid. The note can exist without recording; the security instrument is recorded to give constructive notice and establish lien priority.

Hypothecation

Hypothecation means pledging property as security for a debt while keeping possession of it. The borrower continues to occupy and use the home during the entire loan term. Foreclosure is the process by which the lender finally takes possession after default, but until then the borrower's possession is undisturbed.

Contrast this with a pawn (pledge of personal property where you surrender the item). In real estate financing, you keep the keys — that is hypothecation.

The note also carries the interest rate, and the exam distinguishes a straight (term) note, where the borrower pays interest only and repays principal in one lump at maturity, from an installment note, where each payment chips at both principal and interest. Usury laws cap how high a lender may set the rate; a note exceeding the legal ceiling can be unenforceable as to the excess. Finally, a note may be negotiable, meaning the lender can sell it on the secondary market to an investor who becomes a holder in due course — which is why your loan servicer can change without your consent.

Title theory vs. lien theory

States split on who holds legal title while the loan is outstanding:

In lien-theory states the borrower keeps title and the lender merely records a lien. In title-theory states a trustee or lender holds bare legal title until the debt is satisfied. The practical exam payoff: title-theory/deed-of-trust setups usually permit faster non-judicial foreclosure, while lien-theory mortgages usually require a court-supervised judicial foreclosure.

The three parties of a deed of trust

A mortgage has two parties: the mortgagor (borrower) and the mortgagee (lender). A deed of trust adds a third:

1. Trustor — the borrower who conveys title to the trustee.
2. Beneficiary — the lender, who benefits from the security.
3. Trustee — a neutral third party who holds title and can sell the property via the power-of-sale clause on default, then reconvey title at payoff.

Memory trap: in a deed of trust the borrower is the trustor, not the trustee. The trustee is the neutral holder.

Clauses that decide outcomes

• Acceleration clause: lets the lender demand the entire unpaid balance immediately upon default. Without it, the lender could only sue for missed payments one at a time. Acceleration is the prerequisite to foreclosure.
• Due-on-sale (alienation) clause: the loan balance becomes due if the borrower sells or transfers the property. This blocks a buyer from simply taking over (assuming) the old loan without lender consent.
• Defeasance clause: requires the lender to release the lien / reconvey title once the debt is fully paid. It "defeats" the security instrument at payoff.
• Prepayment clause / penalty: addresses whether the borrower may pay early and whether a penalty applies. Many consumer loans now restrict penalties, but the exam tests the concept.
• Subordination clause: voluntarily lowers a lien's priority so a later loan can take a superior position (common in construction or seller financing).

Assumption vs. subject-to

When a buyer takes over an existing loan, watch the alienation clause. In an assumption, the buyer formally takes on personal liability (lender may release the seller via novation). In a subject-to transfer, the buyer makes payments but the seller stays liable on the note. A due-on-sale clause can trigger acceleration in either case.

Worked example — priority and payoff

A borrower owes $240,000 on a first mortgage and $60,000 on a second. The first lien was recorded January 3; the second on March 10. At a foreclosure sale netting $270,000, the first lien (earlier recording = higher priority) is paid in full at $240,000, leaving $30,000 toward the $60,000 second. The second lender absorbs a $30,000 shortfall. "First in time, first in right" controls unless a subordination clause changed the order.

Foreclosure Routes and Redemption

When a borrower defaults, the lender enforces its security interest through foreclosure, and the route depends on the security instrument and state law. Judicial foreclosure is a lawsuit ending in a court-ordered sale; it is the norm in lien-theory and mortgage states. Non-judicial foreclosure uses the power-of-sale clause in a deed of trust, letting the trustee sell without going to court, which is faster and common in deed-of-trust states.

Two redemption rights protect the borrower. Equitable redemption lets the borrower pay the full debt plus costs before the sale to reclaim the property, and exists in every state. Statutory redemption, available only in some states, lets the former owner redeem for a set period after the sale.

A deed in lieu of foreclosure lets a borrower voluntarily convey the property to the lender to avoid foreclosure, but the lender need not accept it and junior liens survive it. A short sale (selling for less than the loan balance, with lender consent) is another workout that avoids foreclosure but requires lender approval of the discounted payoff.

Note Types and Amortization Vocabulary

The promissory note is the borrower's personal promise to repay and is the evidence of the debt; the mortgage or deed of trust is the security instrument that pledges the property as collateral. The note's repayment shape is tested directly:

• A fully amortized loan retires the entire balance through level payments; each payment is more interest early and more principal later.
• A straight (term) loan pays interest only, with the full principal due as a single payment at maturity.
• A balloon loan has payments too small to amortize fully, leaving a large lump sum at the end.
• An adjustable-rate note resets the rate against an index plus a margin, constrained by periodic and lifetime caps.

Worked interest-only check: a $300,000 straight loan at 6% annual interest costs $300,000 × 0.06 = $18,000 per year, or $1,500 per month in interest, with the $300,000 principal still owed at maturity. Compare that to a fully amortized loan, where each payment chips away at the principal so the balance falls over time.