Learning Outcomes
This article examines mortgages and deeds of trust as security interests in real property. It details the nature of these interests, the rights and obligations of the parties involved, the impact of transfers, the rules governing foreclosure, and the concepts of priority and redemption. Upon completion, you will be able to identify the different types of mortgages, analyze priority disputes, understand the foreclosure process, and apply the rules of redemption, preparing you for related MBE questions.
MBE Syllabus
For the MBE, you are required to understand the creation and effect of mortgages and deeds of trust as security interests in land. This includes the nature of the secured obligation, the rights of the parties upon transfer, and the procedures and consequences of default and foreclosure. You should be prepared to:
- Identify the components of a mortgage transaction (note and mortgage/deed of trust).
- Distinguish between lien theory, title theory, and intermediate theory states.
- Analyze the consequences of transferring the mortgagor's interest ("subject to" vs. "assuming").
- Analyze the consequences of transferring the mortgagee's interest (note follows mortgage vs. mortgage follows note).
- Apply rules governing foreclosure, including priorities among competing interests (PMMs, future advances, modifications).
- Understand the concepts of equity of redemption and statutory redemption.
- Determine rights to proceeds from a foreclosure sale and liability for deficiency judgments.
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
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In a "lien theory" jurisdiction, who holds legal title to mortgaged property prior to foreclosure?
- The mortgagee
- The mortgagor
- Both mortgagor and mortgagee as tenants in common
- A third-party trustee
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Buyer purchases Blackacre from Seller, financing the purchase with a loan from Bank A secured by a mortgage, which is immediately recorded. One week later, Buyer takes out a home equity loan from Bank B, secured by a second mortgage, which Bank B also immediately records. If Buyer defaults on both loans and Bank B initiates foreclosure, what is the status of Bank A's mortgage?
- Bank A's mortgage is extinguished by Bank B's foreclosure.
- Bank A's mortgage remains on the property and is superior to the interest of the foreclosure sale purchaser.
- Bank A's mortgage is converted into an unsecured claim against Buyer.
- Bank A's mortgage becomes subordinate to the interest of the foreclosure sale purchaser.
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A homeowner defaults on her mortgage payments. The lender initiates foreclosure proceedings. The homeowner manages to secure funds sufficient to pay the full outstanding loan balance, accrued interest, and foreclosure costs one day before the scheduled foreclosure sale. This right to pay off the debt and stop the foreclosure is known as:
- Statutory redemption
- Equity of redemption
- Right of first refusal
- Deficiency right
Introduction
A mortgage is a security interest in real estate, typically used to secure an obligation, usually the repayment of a loan documented by a promissory note. The borrower is the mortgagor, and the lender is the mortgagee. If the mortgagor defaults on the obligation, the mortgagee can foreclose on the property to satisfy the debt. A deed of trust functions similarly, but involves a third-party trustee who holds title for the benefit of the lender (beneficiary). This article focuses on the creation, transfer, and enforcement of these security interests.
Key Term: Mortgage
A security interest in real property held by a lender (mortgagee) as security for a debt, usually a loan, owed by the borrower (mortgagor).Key Term: Deed of Trust
A security device similar to a mortgage, where the borrower (trustor) transfers title to a third party (trustee) to hold as security for a debt owed to the lender (beneficiary).
Mortgage Theories
Jurisdictions differ in their conceptualization of the interests held by the mortgagor and mortgagee, primarily affecting the right to possession before foreclosure.
Lien Theory
In the majority of states (lien theory states), the mortgagee holds only a security interest (a lien) in the property, while the mortgagor is considered the owner until foreclosure. The mortgagee has no right to possess the property before foreclosure is complete.
Key Term: Lien Theory
The majority view where a mortgage is considered only a lien on the property, and the mortgagor retains both legal and equitable title and possession unless and until foreclosure occurs.
Title Theory
In a minority of states (title theory states), legal title is transferred to the mortgagee upon execution of the mortgage. The mortgagee technically has the right to take possession at any time, although mortgage terms usually grant possession to the mortgagor until default.
Key Term: Title Theory
The minority view where legal title passes to the mortgagee upon execution of the mortgage, granting the mortgagee the right to possess the property upon demand (though typically only exercised after default).
Intermediate Theory
A few states follow an intermediate theory, where legal title remains with the mortgagor until default, at which point title passes to the mortgagee.
Transfer of Interests
Both the mortgagor's and mortgagee's interests can be transferred.
Transfer by Mortgagor (Sale of Property)
When the mortgagor sells the property, the mortgage remains attached to the land unless the mortgagee releases it. The grantee takes the property subject to the mortgage.
- Assuming the Mortgage: If the grantee signs an assumption agreement, they become primarily personally liable for the mortgage debt. The original mortgagor remains secondarily liable as a surety.
- "Subject To" the Mortgage: If the grantee takes "subject to" the mortgage (which is presumed if the deed is silent on liability), they are not personally liable for the debt. However, if the original mortgagor defaults, the lender can still foreclose on the property, potentially wiping out the grantee's investment.
Transfer by Mortgagee (Sale of Loan)
The mortgagee can transfer their interest by transferring the note and mortgage.
- Note Follows Mortgage: Some states hold that transferring the mortgage automatically transfers the note.
- Mortgage Follows Note: The prevailing view is that the mortgage automatically follows a properly transferred note. The note can be transferred by indorsement and delivery (potentially creating a holder in due course) or by separate assignment.
Foreclosure
Foreclosure is the process by which the mortgaged property is sold to satisfy the secured debt upon the mortgagor's default.
Key Term: Foreclosure
A legal process by which a lender (mortgagee) forces the sale of mortgaged property to recover the outstanding debt owed by the borrower (mortgagor) after the borrower defaults.
Priorities
When multiple liens exist on a property, the priority typically follows the "first in time, first in right" rule, meaning older mortgages/liens get paid before newer ones from foreclosure proceeds. This can be altered by:
- Recording Acts: A junior mortgagee who records first without notice of a prior unrecorded mortgage may gain priority.
- Purchase Money Mortgages (PMMs): A mortgage used to finance the purchase of the property generally has priority over other liens arising before the mortgagor acquired title (e.g., prior judgment liens). A vendor PMM usually has priority over a third-party lender PMM.
- Subordination Agreements: Parties can contractually agree to change lien priority.
- Modifications: A modification of a senior mortgage that makes it more burdensome subordinates the modification (but not the original loan amount) to existing junior interests.
- Future Advances: Optional future advances made by a senior lender may lose priority to a junior lien if the senior lender had notice of the junior lien when making the advance (majority rule, often altered by statute).
Key Term: Purchase Money Mortgage (PMM)
A mortgage granted to secure funds used to purchase the property itself, either given to the seller (vendor PMM) or a third-party lender. PMMs often have special priority rules.
Effect of Foreclosure
- Junior Interests: Extinguished (provided they were made parties to the foreclosure action).
- Senior Interests: Unaffected. The buyer at the foreclosure sale takes the property subject to senior interests.
- Mortgagor: The mortgagor's interest is eliminated.
- Deficiency Judgments: If the foreclosure sale proceeds do not fully satisfy the debt, the mortgagee may be able to sue the mortgagor personally for the deficiency (subject to state anti-deficiency statutes).
Redemption
A mortgagor facing foreclosure has rights to redeem the property.
- Equity of Redemption: Universally recognized right allowing the mortgagor (and sometimes junior lienholders) to pay off the entire loan balance (plus accrued interest and costs) before the foreclosure sale occurs, thus terminating the foreclosure. This right cannot be "clogged" (waived) in the mortgage instrument itself.
Key Term: Equity of Redemption
The right of a mortgagor, prior to a foreclosure sale, to prevent foreclosure by paying the full amount of the outstanding debt, plus accrued interest and costs, thus terminating the foreclosure. This right cannot be "clogged" (waived) in the mortgage instrument itself.
- Statutory Redemption: Available in about half the states, this right allows the mortgagor (and sometimes junior lienholders) to redeem the property after the foreclosure sale by paying the foreclosure sale price (plus interest and costs) within a statutorily defined period (e.g., 6 months or 1 year).
Key Term: Statutory Redemption
A right provided by statute in some states allowing the mortgagor to reclaim property after a foreclosure sale by paying the foreclosure sale price (plus interest and costs) within a specific period.
Worked Example 1.2
David defaults on his 155,000 (representing the full debt plus costs) to Bank. Must Bank accept the payment and halt the sale? Five months after the foreclosure sale (at which Paula purchased the property for the sale price), David tenders the foreclosure sale price plus statutory interest and costs to Paula. Assume the state has a six-month statutory redemption period. Must Paula accept the payment and return the property?
Answer: Yes, Bank must accept the payment on June 30th. David is exercising his equity of redemption, which exists until the moment of the foreclosure sale. Yes, Paula must accept the payment five months after the sale. David is exercising his statutory right of redemption, which exists for the six-month period following the sale in this jurisdiction.
Exam Warning
Be careful to distinguish between the Equity of Redemption (pre-foreclosure, pays off debt) and Statutory Redemption (post-foreclosure, pays sale price). Note also that only about half the states recognize Statutory Redemption.
Key Point Checklist
This article has covered the following key knowledge points:
- A mortgage secures a debt using real property; a deed of trust involves a trustee.
- Jurisdictions follow lien, title, or intermediate theories regarding possession before foreclosure.
- Transferring mortgaged property "subject to" the mortgage does not impose personal liability on the grantee; "assuming" the mortgage does.
- Transferring the note generally transfers the mortgage automatically.
- Foreclosure sales typically extinguish junior interests but do not affect senior interests.
- Priorities are generally chronological but can be altered by recording acts, PMM status, subordination agreements, modifications, and future advances rules.
- The Equity of Redemption allows payoff of the debt to stop foreclosure before the sale.
- Statutory Redemption (in some states) allows payoff of the sale price to reclaim property after the sale.
Key Terms and Concepts
- Mortgage
- Deed of Trust
- Lien Theory
- Title Theory
- Foreclosure
- Purchase Money Mortgage (PMM)
- Equity of Redemption
- Statutory Redemption
