Mortgages/security devices - Security relationships

Learning Outcomes

This article explains security relationships in mortgages and other real property security devices, including:

• Identifying the legal nature, parties, and structure of mortgages and comparable security devices, and distinguishing the underlying debt from the security interest in exam hypotheticals.
• Distinguishing legal mortgages from equitable mortgages and other functional equivalents, such as deeds of trust and installment land contracts, and predicting how courts will characterize ambiguous transactions.
• Applying priority rules among multiple mortgages and security interests, including operation of recording acts, purchase-money mortgage rules, and future-advance clauses in common MBE-style sequencing problems.
• Analyzing transfers of mortgagor and mortgagee interests, including “assumption” and “subject to” arrangements, due-on-sale clauses, and the consequences for personal liability and foreclosure strategy.
• Explaining discharge, available foreclosure methods, deficiency judgments, and how foreclosure affects senior and junior interests, surplus and deficiency allocation, and remaining rights in the property.
• Describing the rights and duties of mortgagors and mortgagees before and after default, including possession, waste, assignments of rents, and the scope of the equity of redemption and any statutory right of redemption.
• Evaluating fact patterns to determine which party prevails in disputes over priority, liability, and redemption, and articulating clear rule statements suitable for high-scoring bar exam answers.

MBE Syllabus

For the MBE, you are required to understand security relationships in real property, with a focus on the following syllabus points:

• Recognizing the difference between legal and equitable mortgages and other security devices.
• Understanding the creation, enforceability, and recording of mortgages and security interests.
• Applying priority rules among multiple mortgages and security devices, including purchase-money mortgages.
• Analyzing the effects of transfer, discharge, and foreclosure on the mortgagor, mortgagee, and third parties.
• Identifying the rights and duties of mortgagors and mortgagees before and after default, including possession and waste.
• Recognizing the impact of recording statutes and redemption rights on mortgage priorities and foreclosure outcomes.

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.

1. Which of the following is NOT a valid method of creating a security interest in land?
   1. Legal mortgage
   2. Equitable mortgage
   3. Installment land contract
   4. Oral agreement with no delivery of deed or writing
2. If a mortgagor grants two mortgages on the same property, but the second mortgagee records first, who has priority in a notice jurisdiction?
   1. The first mortgagee
   2. The second mortgagee
   3. Whichever mortgagee forecloses first
   4. The mortgagor
3. What is the effect of a foreclosure sale by a senior mortgagee on junior interests?
   1. Junior interests are eliminated if joined in the foreclosure
   2. Junior interests automatically become senior
   3. Junior interests are unaffected
   4. The mortgagor is released from all liability
4. A borrower defaults and the bank starts foreclosure. Before the sale, the borrower offers to pay the full outstanding balance plus interest and costs. Must the bank accept?
   1. No, because foreclosure proceedings have already begun
   2. No, because the bank may prefer to own the property
   3. Yes, because the borrower is exercising the equity of redemption
   4. Yes, because the borrower has a statutory right of redemption before sale

Introduction

A mortgage is a security device used to secure repayment of a debt with an interest in real property. Questions on the MBE frequently test the creation, priority, transfer, and enforcement of mortgages and related security devices, as well as the rights of all parties affected by these arrangements.

Key Term: Mortgage
A mortgage is a security interest in real property given by a borrower (the mortgagor) to a lender (the mortgagee) to secure repayment of a loan or performance of another obligation, evidenced by a separate promissory note or debt instrument.

The mortgage and the note are distinct but related: the note creates personal liability for the debt; the mortgage gives the creditor an in rem right against the land if the debt is not repaid. The basic security relationship is among three things: the debt, the land, and the parties’ priorities relative to others who may also have interests in the land.

Types of Security Devices

There are several common ways to create a security relationship in land that may be tested on the MBE.

• Legal mortgage
• Equitable mortgage
• Deed of trust
• Installment land contract
• Other functional equivalents (such as an absolute deed given as security)

Key Term: Legal Mortgage
A legal mortgage is a formally executed and properly recorded mortgage that complies with all statutory requirements; it creates a legal (rather than purely equitable) security interest in the property.

Key Term: Equitable Mortgage
An equitable mortgage arises when the parties intend to create a security interest in land but fail to satisfy the formal requirements for a legal mortgage; equity treats the arrangement as a mortgage.

Key Term: Deed of Trust
A deed of trust is a security device in which the borrower (trustor) conveys title to a third-party trustee to hold for the benefit of the lender (beneficiary); upon default, the trustee may sell the property, often without judicial foreclosure, and apply the proceeds to the debt.

Key Term: Installment Land Contract
An installment land contract is an agreement in which the buyer pays the purchase price in installments while the seller retains legal title as security until the price is fully paid; functionally, it operates as a security device.

In an installment land contract, the buyer has an equitable interest that can be foreclosed upon default. Modern courts usually protect the buyer by treating the seller’s retained title as similar to a mortgage, rather than enforcing harsh forfeiture clauses.

A deed that is absolute in form but intended only as security will be treated as an equitable mortgage.

Key Term: Security Device
A security device is any legal arrangement by which an interest in land is used to secure repayment of a debt or performance of an obligation (e.g., mortgage, deed of trust, installment land contract).

Creation and Enforceability

A valid mortgage relationship requires:

• A valid secured debt or obligation.
• Intent to create a security interest in land.
• Compliance with the Statute of Frauds.

Because a mortgage is an interest in land, it must generally be in a writing signed by the party to be charged (usually the mortgagor) that reasonably identifies the land and the debt.

If the parties’ documentation is defective, equity may still recognize a mortgage:

• A deed given as security with an oral agreement that it will be reconveyed when the loan is repaid.
• A signed agreement to give a mortgage in the future.
• A lender’s retention of original deed as security for a loan.

Courts look at factors such as the relationship of the parties, the adequacy of consideration, and whether the grantor remained in possession to determine whether a deed was intended as security.

Lien Theory vs. Title Theory

The nature of the mortgagee’s interest depends on the jurisdiction’s theory of mortgages.

Key Term: Lien Theory
Under lien theory, the mortgagee holds only a security lien and not title; the mortgagor is considered the owner and is entitled to possession until foreclosure.

Key Term: Title Theory
Under title theory, the mortgagee is treated as holding title (often through a deed of trust), and in some jurisdictions may have a right to possession upon default, even before foreclosure.

Most modern states are lien theory states. For MBE purposes, assume the mortgagor keeps possession until foreclosure unless the question clearly states otherwise.

Priority of Security Interests

When multiple security interests exist in the same property, priority determines who gets paid first from foreclosure proceeds and whose interests survive.

Key Term: Senior Mortgage
A senior mortgage is a mortgage that has priority over another mortgage on the same property, usually because it was created or recorded earlier.

Key Term: Junior Mortgage
A junior mortgage is a mortgage that is subordinate in priority to another mortgage on the same property, usually because it was created or recorded later.

Key Term: Priority
Priority is the order in which competing security interests in the same property are entitled to payment from foreclosure proceeds and the order in which they are protected against elimination in foreclosure.

The general common-law rule is “first in time, first in right”: the earlier-created mortgage has priority over later-created ones. However, recording statutes and certain special priority rules can change this outcome.

Recording Statutes and Mortgage Priority

Recording statutes apply to mortgages just as they do to deeds. A mortgagee who takes a mortgage without notice of a prior unrecorded interest and records first may gain priority depending on the statute:

• Race statute: First to record wins, regardless of notice.
• Notice statute: A subsequent bona fide purchaser for value without notice of prior unrecorded interests prevails, even if the prior interest is recorded later.
• Race-notice statute: A subsequent bona fide purchaser without notice who also records first prevails.

A “purchaser” for recording-act purposes includes a mortgagee who lends value in exchange for a mortgage.

Some special priority rules often tested on the MBE include:

Key Term: Purchase-Money Mortgage
A purchase-money mortgage is a mortgage given to a lender or seller to secure funds used to acquire the encumbered property; it typically has priority over earlier non–purchase-money liens, even if those liens were recorded first.

• Purchase-money mortgages (from either a seller or a third-party lender) usually take priority over other mortgages and liens created at or before the borrower’s acquisition of the property.
• Future-advance mortgages and after-acquired property clauses can also affect priority depending on when advances are made and the mortgagee’s notice of intervening liens (often beyond MBE depth unless explicitly raised).

Transfer of Mortgages

Both the mortgagor and the mortgagee can transfer their interests, and the effect of each transfer is frequently tested.

Transfer by the Mortgagor

When the mortgagor sells or transfers the property, the mortgage typically remains on the land.

• The buyer takes either:
  • Subject to the mortgage, or
  • Assumes the mortgage.

Key Term: Taking “Subject To” the Mortgage
A grantee who takes “subject to” a mortgage is not personally liable for the debt; the land remains encumbered, and the lender can foreclose but cannot pursue the grantee personally for any deficiency.

Key Term: Assumption
When a grantee “assumes” a mortgage, the grantee becomes personally liable to the lender on the debt, along with the original mortgagor, unless the lender releases the mortgagor.

If the deed is silent, the default in most jurisdictions is that the buyer takes subject to the mortgage (no personal liability). If the buyer assumes the mortgage, the mortgagee can sue both borrower and buyer on the note and can foreclose on the property.

Many notes contain clauses regulating transfers:

Key Term: Due-on-Sale Clause
A due-on-sale clause allows the lender, at its option, to declare the entire unpaid balance immediately due if the mortgagor transfers the property without the lender’s consent.

Key Term: Acceleration Clause
An acceleration clause allows the lender, upon default, to declare the entire debt immediately due rather than only the missed installments.

Due-on-sale and acceleration clauses are generally enforceable, but they create rights against the original borrower; they do not, by themselves, make a transferee personally liable unless the transferee assumes the debt.

Transfer by the Mortgagee

The mortgagee can transfer its interest by assigning the note. The general rule is that “the mortgage follows the note”:

• Transfer of the note automatically carries the mortgage with it.
• Attempted assignment of the mortgage without the note is usually ineffective to transfer the debt.

The transferee (assignee) of the note and mortgage steps into the shoes of the original mortgagee, taking subject to all defenses that could be raised against the original mortgagee (subject to negotiable instruments rules if the note is negotiable and the transferee is a holder in due course).

Discharge and Foreclosure

A mortgage is discharged (or “satisfied”) when the secured debt is repaid in full. Once the debt is extinguished, the mortgage cannot be enforced, and the mortgagor can demand a release.

If the mortgagor defaults, the mortgagee may foreclose.

Key Term: Foreclosure
Foreclosure is the legal process by which a mortgagee or other lienholder sells the mortgaged property after default to satisfy the secured debt, applying sale proceeds in order of priority.

There are two main types:

• Judicial foreclosure: Court-supervised sale, common with mortgages.
• Power-of-sale foreclosure: Nonjudicial sale conducted by the trustee or mortgagee if authorized in the mortgage or deed of trust (frequent with deeds of trust).

Equity of Redemption and Statutory Redemption

Before foreclosure, the mortgagor has the right to redeem the property by paying what is owed.

Key Term: Equity of Redemption
The equity of redemption is the mortgagor’s right, before the foreclosure sale, to cure the default and reclaim full title by paying the overdue amount, usually the entire accelerated balance plus interest and costs if properly accelerated.

Any attempt in the original mortgage to “clog” or waive the equity of redemption is generally void.

Some states also provide a statutory right to redeem after the foreclosure sale.

Key Term: Statutory Right of Redemption
A statutory right of redemption is a right created by statute allowing the mortgagor (and sometimes certain lienholders) to recover the property after the foreclosure sale by paying the foreclosure sale price or the amount of the debt within a set period.

The equity of redemption exists up to the time of sale; statutory redemption (if recognized) exists only after the sale and for a limited period.

Deficiency Judgments

If the foreclosure sale proceeds are insufficient to pay the debt and foreclosure costs, the mortgagee may seek a deficiency judgment against the mortgagor (and any assuming grantee).

Key Term: Deficiency Judgment
A deficiency judgment is a personal money judgment against a debtor for the unpaid portion of a debt after foreclosure sale proceeds have been applied.

Some states limit or bar deficiency judgments in certain contexts (e.g., purchase-money mortgages on residential property).

Effect of Foreclosure on Other Interests

Foreclosure affects junior and senior interests differently:

• Foreclosure by a senior mortgagee:
  • Eliminates properly joined junior interests.
  • Leaves unaffected any senior interests.
• Foreclosure by a junior mortgagee:
  • Does not affect senior interests; the buyer takes subject to them.
  • Eliminates junior interests that are subordinate to the foreclosing mortgage and are properly joined.

Sale proceeds are applied in the following order:

• Foreclosure sale expenses and attorney’s fees.
• Payment of the foreclosing mortgage.
• Payment of junior liens in order of their priority.
• Any surplus goes to the mortgagor.

If the sale proceeds are insufficient, the foreclosing mortgagee may seek a deficiency judgment as allowed by state law.

Rights and Duties Before and After Default

Before foreclosure, the mortgagor usually retains possession and the right to use and enjoy the property, but with limitations.

Key Term: Waste
Waste is an unreasonable and harmful use of property that substantially impairs the value of the land or the security interest; the mortgagor must avoid waste that impairs the mortgagee’s security.

• Mortgagor’s duties:

  • Pay principal and interest on the debt.
  • Pay property taxes and keep required insurance.
  • Avoid committing waste that decreases the property’s value.

• Mortgagee’s rights:

  • Receive payments as due.
  • Enforce covenants (such as to insure or pay taxes).
  • In some jurisdictions, take possession after default (especially in title theory states or where the mortgage so provides), but must account for rents and profits.

Assignments of rents and profits from the property are often part of the mortgage arrangement; the mortgagee’s right to collect rents usually ripens upon default and, in many jurisdictions, some affirmative step such as obtaining the appointment of a receiver.

Worked Example 1.1

A homeowner borrows $200,000 from Bank A, granting a mortgage on her house. Later, she borrows $50,000 from Bank B, granting a second mortgage. Bank B records its mortgage before Bank A records. The homeowner defaults on both loans. Who has priority if the property is foreclosed in a notice jurisdiction?

Answer:
Bank B has priority if it took its mortgage for value without notice of Bank A’s earlier unrecorded mortgage and recorded first. As a subsequent bona fide mortgagee in a notice jurisdiction, Bank B would prevail over the prior unrecorded mortgage. If Bank B had notice of Bank A’s mortgage, then Bank A, as first in time, would have priority.

Worked Example 1.2

A property owner gives a deed to a lender as security for a loan, but the parties orally agree that the deed is not a true sale. The owner defaults, and the lender tries to keep the property, claiming absolute title. What result?

Answer:
A court is likely to treat the deed as an equitable mortgage because it was intended merely as security. The owner retains the equity of redemption and can recover the property by repaying the loan (usually the full balance plus interest and costs). The lender may foreclose if the debt is not paid, but cannot simply keep the property as if it had been sold.

Worked Example 1.3

A corporate officer purchases land with a loan from her corporation. She grants the corporation a properly recorded mortgage and signs a note containing a due-on-sale clause. After three years of timely payments, she sells the land to a buyer without the corporation’s consent. The deed states that the property is conveyed “subject to” the existing mortgage. The buyer records promptly and makes no payments. The corporation sues the buyer personally for the full loan balance based on the due-on-sale clause. Is the buyer liable?

Answer:
The buyer is not personally liable. By taking “subject to” the mortgage, the buyer did not assume the debt and has no personal obligation on the note. The due-on-sale clause permits the corporation to accelerate the debt against the original borrower and to foreclose on the property, but it does not create personal liability in the buyer absent an assumption agreement.

Worked Example 1.4

A woman receives a home loan from a bank secured by a mortgage. After eight years, she defaults. The bank gives proper notice and initiates judicial foreclosure. Before the foreclosure sale, the woman inherits money and offers to pay the full outstanding balance plus accrued interest and costs. The bank prefers to complete the foreclosure and take the property. Must the bank accept her payment?

Answer:
Yes. Before the foreclosure sale occurs, the woman has an equity of redemption. By tendering the full accelerated amount plus interest and any allowable costs, she is exercising this right. Initiation of foreclosure does not cut off the equity of redemption; it is cut off only by the foreclosure sale itself (subject to any statutory redemption rights afterward).

Exam Warning

Be careful: If a mortgage is not properly recorded, a subsequent bona fide purchaser or mortgagee may take priority under the applicable recording statute. Also distinguish carefully between a grantee who assumes a mortgage (personal liability) and one who takes subject to the mortgage (no personal liability).

Revision Tip

Always identify: (1) the type of jurisdiction (notice, race, or race-notice), (2) the timing of each mortgage and recording, (3) whether later mortgagees had notice, and (4) whether the mortgagor’s transferee assumed or took subject to the mortgage when analyzing priority and liability questions.

Key Point Checklist

This article has covered the following key knowledge points:

• A mortgage is a security interest in land securing repayment of a debt evidenced by a separate note or obligation.
• Legal and equitable mortgages are both recognized; intent to create security and compliance with the Statute of Frauds are central.
• Deeds of trust and installment land contracts are functionally similar security devices and are treated like mortgages for many purposes.
• Priority among mortgages is generally determined by the order of creation, but recording statutes and special rules (e.g., purchase-money mortgages) can alter priority.
• Recording statutes apply to mortgages; a later bona fide mortgagee may take priority over a prior unrecorded mortgage.
• Mortgagors can transfer property subject to or with assumption of existing mortgages; only an assuming grantee is personally liable on the mortgage debt.
• Due-on-sale and acceleration clauses allow lenders to accelerate repayment on transfer or default but do not create new personal liability in transferees.
• Mortgagees can assign notes; the mortgage follows the note, and the assignee takes the mortgage subject to applicable defenses.
• A mortgage is discharged on full repayment of the debt; otherwise, the mortgagee may foreclose, either judicially or via power of sale if authorized.
• Foreclosure sale proceeds are distributed first to costs, then to the foreclosing mortgagee, then to junior lienors in order of priority, with any surplus to the mortgagor.
• Foreclosure by a senior mortgagee eliminates properly joined junior interests but leaves senior interests intact; foreclosure by a junior mortgagee does not affect senior interests.
• The mortgagor has an equity of redemption before foreclosure sale and may have a statutory right of redemption after sale, depending on state law.
• Mortgagors must avoid waste and keep taxes and insurance current; mortgagees in possession must account for rents and profits.
• Attempts to waive or “clog” the equity of redemption in the original mortgage are generally ineffective.

Key Terms and Concepts

• Mortgage
• Security Device
• Legal Mortgage
• Equitable Mortgage
• Deed of Trust
• Installment Land Contract
• Lien Theory
• Title Theory
• Senior Mortgage
• Junior Mortgage
• Purchase-Money Mortgage
• Priority
• Due-on-Sale Clause
• Acceleration Clause
• Assumption
• Taking “Subject To” the Mortgage
• Equity of Redemption
• Statutory Right of Redemption
• Foreclosure
• Deficiency Judgment
• Waste