The three devices typically used to secure real estate for a loan (such as in a sales transaction) are the land contract, the mortgage and the trust deed.
A land contract is known by different names in different parts of the country, including “agreement of sale,” “land sales contract,” “real estate contract,” “installment sales contract” and “contract for deed.”
In such a contract, the seller (or vendor) finances the purchase of his property for the buyer. The buyer (or vendee) makes payments to the seller in installments until he can pay off the entire debt, generally by refinancing, at which time he is given a deed transferring ownership of the property to the buyer. The transfer of property, and the deed itself, may be called a conveyance.
Until the contract is paid off, the seller keeps legal title to the property, even though the contract may give the buyer possession and equitable title as soon as it is signed. Equitable title means the buyer is entitled to a deed conveying the legal title when the contract is fully paid and performed. If the vendee defaults, the vendor may foreclose or, depending on state statute, declare forfeiture to regain his property.
Note and Mortgage (or Trust Deed)
In the typical real estate sales transaction, the seller gives the buyer a deed at closing and the buyer gives the lender a promissory note and a security instrument (i.e., a mortgage or trust deed) that creates a lien on the property. When the seller finances the purchase and does not actually give the buyer any cash, the loan may be called a soft money loan. When a third-party lender provides actual funds for the loan, it is called a hard money loan.
The promissory note is both a promise to repay the money borrowed with interest and evidence of the debt. It shows:
- the payor and payee.
- the amount owed.
- the rate of interest and whether it is fixed or adjustable.
- the due date(s) for payment.
- loan terms, which may include:
- a prepayment privilege, which allows the borrower to prepay the loan;
- a prepayment penalty, which imposes an extra charge if the borrower does prepay. While government-backed loans (e.g., FHA and VA loans) have no prepayment penalties,
- conventional loans (i.e., loans not backed by government insurance or guarantees) may have prepayment penalties;
- a lock-in clause, which prohibits prepayment;
- an acceleration clause, which permits the lender to declare the entire balance of the loan due at once if the borrower defaults; or
- a late payment penalty, which imposes a charge if the borrower’s payment is late.
Note and Mortgage (or Trust Deed)
Mortgage or Trust Deed
The mortgage or trust deed secures repayment of the note. In lien theory states, this instrument hypothecates the property, meaning the property is pledged as security, or collateral, but the borrower retains equitable title or possession.
The borrower, in giving a mortgage to the lender, is called a mortgagor, while the lender receiving it is called a mortgagee. The borrower, in giving a trust deed to the lender, is called a grantor or trustor; the lender receiving it is called a beneficiary; and a third party with a power of sale allowing him to foreclose without going to court is the trustee.
NOTE: Because the trust deed has the same legal effect as a mortgage, the term “mortgage” is often used when referring to a trust deed.
Among the provisions of the security instrument are:
- a due-on-sale (alienation) clause, which allows the lender to:
- declare the entire balance of the loan due at once; or
- refuse to allow another person to assume the loan if the title is transferred. FHA or VA loans are assumable by qualified buyers. Fannie Mae and Freddie Mac conforming loans may or may not be assumable based on the contents of the mortgage documents and the type of transfer.
- a defeasance clause, which provides for release of the lien when the borrower pays off the debt. However, to provide public notice that the debt has been repaid and to clear it from the public record:
- a satisfaction or release is recorded to clear a mortgage lien; or
- a deed of reconveyance is recorded to clear a trust deed lien (or in some states, a mortgage).
The security instrument typically provides that monthly payments are applied in the following order:
- Principal due
- Taxes and insurance, if paid to the lender
- Late charges
- Any other amounts due
- Additional principal reduction
Primary and Subordinate Financing
A primary mortgage (first mortgage) is a loan that has priority over all other unsatisfied mortgages secured by the same property, generally because it was recorded before them.
A subordinate mortgage (junior mortgage or second mortgage) secures a loan that is secondary to one or more other loans on the property. A mortgage is a second mortgage when:
- it is recorded after another mortgage that is still outstanding on the same property; or
- it has a subordination clause specifying that it:
- has lower priority (i.e., is subordinate) even though it may have had priority based on its date of recording; or
- will remain subordinate in the event that the first mortgage is refinanced.
In the event of a foreclosure on a first mortgage, the subordinate loan will be removed as a lien even if foreclosure sale proceeds are not sufficient to pay it off. Because of this risk, such loans have higher interest rates than first loans.
Subordinate financing can be obtained:
- at the same time as a primary mortgage to finance a down payment or closing costs (as a piggyback mortgage); or
- after closing, as either a closed-end second mortgage or as a home equity loan or home equity line of credit (HELOC).
Foreclosure laws vary from state to state. If a borrower defaults on his mortgage or trust deed loan, the lender can ask the court for a judicial foreclosure and a court-ordered sheriff’s sale of the property to repay the debt. After the sale, the sheriff will issue a sheriff’s deed conveying title to the purchaser.
If included in a trust deed or mortgage, a power-of-sale provision allows a trustee to foreclose and sell the property on behalf of the lender without a court order and issue a trustee’s deed conveying title to the purchaser.
Depending on state statute, the debtor may be liable for a deficiency judgment when sale proceeds are insufficient to satisfy the debt.
Also, depending upon state statute, an owner or other person with an interest in the property may, by paying off the entire debt and court costs, exercise:
an equitable right of redemption prior to the sale, to prevent a foreclosure sale.
a statutory right of redemption following a foreclosure, to reclaim the property. If there is a statutory right of redemption, the sheriff’s deed or trustee’s deed will not be issued until the redemption period expires.
If a mortgage or trust deed has the right of reinstatement, a defaulted borrower has a period after default to stop a foreclosure by paying all past-due payments and penalties and bringing the loan current, instead of having to pay off the entire debt.
Often, the high bidder at a foreclosure sale is the lender holding the note. Property that the lender has acquired through foreclosure is called an REO, for “real estate owned.”
The lender will attempt to recover as much as it can from resale of its inventory of REOs.
Among the options available to a lender in order to prevent or avoid foreclosure are:
- acceptance of a deed in lieu of foreclosure, or estoppel deed, from a borrower facing foreclosure in return for releasing him from his debt.
- a forbearance, which allows a borrower experiencing temporary financial difficulty to delay his monthly mortgage payments for a short period of time. It is often combined with other programs designed to help bring the monthly mortgage payments current after a negotiated period of time.