Pop Quiz: Will Your Final Mortgage Payoff Trigger a Defeasance Clause?

In some states, you take title at closing. In other areas, you aren’t the legal title holder before your final mortgage payment. It all depends on the mortgage law in your state.

What’s the difference between the states? A defeasance clause. In some states, mortgage contracts have clauses that say the title will be transferred to the borrower if and when the borrower fully satisfies the obligation to repay the mortgage. This defeasance language tells you that you’re waiting until your final payoff to receive your title.

Here, we focus on defeasance in a loan agreement—and where your title is until then.

It’s My Title, in Theory… In “Title Theory” States, Bank Holds Title

In a deed of trust state, a.k.a. a title theory state, a third-party trustee is responsible for your title during the mortgage term. The title is held on behalf of the lender. In this legal sense, the lender is the owner of your home.

Are you acquiring a deed in one of these title theory states? If you are, then there’s a defeasance clause in your mortgage or refi agreement. And it tells the lender to transfer the title to you only when you have made your final payment.

This works to the lender’s advantage. Lenders in these states can use non-judicial foreclosure. In other words, no judge. No day in court for the struggling borrower.

You might have heard the term deed of trust state. Another term for it is a title theory state. In these states, the title is held in trust.

When you sign the deed of trust at closing, you’ll find that it identifies you as the borrower and also names the lender and a third party: the trustee. The trustee is responsible for your title as long as you are a mortgage borrower. The title is held on behalf of the lender, so technically the lender is the owner of your home.

You do get rights when the deed of trust is recorded. You get what’s called equitable title. You may:

• Occupy, maintain, renovate, and otherwise use the home as your own.

• Build equity in the home.

• Receive full ownership over the property and its value once you fully repay the loan.

Your final pay-off triggers defeasance. Then, the lender signs and notarizes a deed of reconveyance, a.k.a. mortgage satisfaction. The title becomes yours. The timeline for all of this is usually a few weeks. State law controls the procedure and timeline.

But what if repayment becomes impossible? In deed of trust states, when a foreclosure happens, the deed is placed in a trustee sale. The next person in the chain of title will get the home with a trustee’s deed.

In Regular Mortgage States, Lenders Get Liens Only—Not Titles

When a lender records a lien against a title, it has a way to take a non-paying borrower to court. The states that use mortgage liens are called lien theory states.

Buying a home in a regular mortgage state? You’ll be glad to know that South Carolina led a slew of states, including yours, through a major mortgage law reform. States following South Carolina’s lead use standard mortgage agreements, putting the title in a home buyer’s hands. The mortgage company is merely a lender.

So, in a regular mortgage state, your lender will not get your home’s title. Nor will a company in the middle hold your title in escrow. The lender will simply record a lien; the title is yours. You keep it with your home documents.

As you see, mortgage borrowers in states following South Carolina’s lead get both legal and equitable title to their homes. As long as a borrower keeps paying the loan back faithfully and on time, they may possess, use, and enjoy the property—as in all states. Plus, in regular mortgage states, borrowers who go into default get all the rights and safeguards of judicial foreclosure. This gives struggling borrowers their day in court. Only on the court’s say-so can a foreclosure auction take place.

Once the borrower in a regular mortgage makes a final payoff, the lender records a deed of release (rather than reconveyance). This is the end of the lien.

South Carolina is on the cutting edge for mortgage holders in a number of ways. At this time, the state is proposing portable interest rates. That is, lawmakers are proposing to let deed holders with low mortgage interest rates take those same low rates to the next home they buy.

Hybrid States: Title in the Buyer’s Hands, But Lender Gets a Superpower

In case of foreclosure, a mortgage with a power-of-sale clause lets lenders bypass the court to hold a trustee sale.

There are states that allow either option. So, there might be a regular mortgage or a deed of trust used in the loan agreement.

Does your mortgage agreement contain a power-of-sale clause? If so, you’re buying in a hybrid state. A hybrid state is also known as an intermediate theory state. The lender holds only a lien on the property. The homeowner holds the title.

Defeasance in a hybrid state directs that the lien be extinguished upon the last repayment.

Now, here’s the lender’s superpower. It can take that title back for nonpayment—without court proceedings. The lender may then be able to hold a trustee sale to recover the past-due debt. But it must seek a court order to do it.

Do you live in a state that uses regular mortgage agreements? Deeds of trust? A hybrid approach?

Know your rights. The lenders know theirs. Understand what leverage you have, should some turn of events make it impossible for you to repay the loan. And if you are in the market for a pre-foreclosure or an REO home, you’ll definitely want to know how your state sets up mortgage rights. Wherever full judicial foreclosure is involved, a case could go on for months before the title is released to a new buyer. As you can now see, deed of trust states are far more friendly to investor-buyers. But they’re not as friendly to the everyday deed holder.

When the Loan’s Paid Off, the Story Continues

Deed holders who own their homes free and clear still have to pay property taxes and homeowners’ insurance. Some also pay dues to a homeowner association for upkeep and management. It’s critical not to fall behind. Unpaid obligations can turn into liens on a title.

Thanks to our readers for staying aware of deed law and how treatment of a title in default varies by state. Mortgage provisions vary by loan company, too. For further information on your mortgage, ask your loan servicer. Or pull out your mortgage agreement and take a close look at its language.