In Part 1 of our overview, we discussed some general features of mortgages (or, in some states, deeds of trust) and how they are the most common method of financing the purchase of real estate. In this article, we look at some of the key provisions of these security documents.
There several important clauses that might be found in a mortgage document. For a start, it must properly describe the property serving as the loan's security.
Property Covered by Mortgage. The property serving as security for the mortgage usually includes not only the land but all the buildings on it, as well as related easements, fixtures, mineral rights, and any rents that are obtained from the property. The inclusion of property rents is often covered in detail, covering (for example) the lenders’s right to collect rents directly from tenants in the event of a borrower’s default.
Payment of Taxes and Insurance. It’s important that the mortgagor (the borrower) keep up with the property taxes and the fire/casualty insurance; some mortgage provisions even have the mortgagor paying the premiums in advance, into a fund, so that the mortgagee (the lender) can pay these charges out of funds already provided. Keeping property taxes current is of prime importance to a lender, because liens for taxes have priority over the first mortgage. Similarly, the lender has an insurable interest in the property equal to the amount of the debt, so most lenders insist on being the loss payee on the property’s insurance policy.
Preservation and Maintenance of the Property. This clause obligates the mortgagor to maintain the property in good conditions and to not permit acts of waste – that is, abusive or destructive uses which would reduce the property’s value. The lender clearly has an interest in preventing the property from deteriorating to such an extent that its collateral value is impaired.
Due-On-Sale. This provision allows the lender to accelerate the debt (make it immediately due and payable) if the property is transferred without his consent. It effectively means that the lender must approve any new owner and gives him latitude to increase the loan’s interest rate to market rates if he chooses; in practice, it simply means that the loan is paid off at the time of any sale.
Right of Entry. If the loan goes into default or the property is abandoned, the lender needs the right to enter the property (or have a receiver enter it) to protect the property and/or collect any rents from it until the property is finally foreclosed.
Power of Sale (Deed of Trust). As we've discussed in other blogs, a deed of trust has a crucial advantage over a mortgage (from the lender's point of view): if the borrower defaults on the loan, the trustee has the power to foreclose on the property on behalf of the lender. In most U.S. states, a deed of trust (but not a mortgage) can contain a special “power of sale” clause that permits the trustee to exercise these powers. The borrower's equitable title normally terminates automatically by operation of law (under applicable statutes or case law) at the trustee's sale. The trustee then issues a deed conveying the legal and equitable title to the property in fee simple to the highest bidder. In turn, the successful bidder records the deed and becomes the owner of record. Thus, the advantage of deeds of trust is that the lender can recover the value of the collateral for the loan much more quickly, and without the expense and uncertainty of suing the borrower, which is why lenders overwhelmingly prefer such deeds to mortgages.
The nature of mortgages and/or deeds of trust ultimately affects the value of entering into a loan transaction, since the legal rights of borrowers and lenders affect the degree of risk assumed by each party. The availability of various legal alternatives represent different ways of controlling and shifting that risk. The legal alternatives available to each party, and not just the probability of default or bankruptcy, can dramatically affect the expected return to a lender on a loan.