When you pay off your loan and meet the terms of your mortgage agreement, the defeasance clause kicks in. It’s a little complicated when it comes to closing on a house, and it all depends on where you stay. Depending on the state, you may never see or hear of it at all.
In this article, we’ll look at the definition of the defeasance clause, what it truly means in law, how it occurs in a mortgage, how it affects your property’s title, the benefits, and more.
Stay with us and find the information you need about the clause and how it can impact real estate.
What Is a Defeasance Clause?
According to Investopedia, defeasance is:
“Defeasance is a provision in a contract that voids a bond or loan on a balance sheet when the borrower sets aside cash or bonds sufficient enough to service the debt. For example, the borrower sets aside cash to pay off the bonds; therefore, the outstanding debt and cash offset each other on the balance sheet and do not need to be recorded.”
A defeasance clause in a mortgage deed states that the lender will give the borrower ownership of the property once all mortgage payments are made.
The defeasance clause functions as a legal instrument, negating the mortgage, deed, or contract and passing the property’s title to the borrower once the borrower has made all of the mortgage payments.
The defeasance clause, in short, allows the borrower to get a free and clear title once all debts have been paid off. However, if your state uses a ‘lien theory’ rather than the common law ‘mortgage theory’ or ‘title theory,’ you may not require a defeasance clause in your mortgage agreement.
How Does Mortgage Defeasance Clause Work?
The idea of defeasance occurs legally to safeguard your rights as a home buyer; it’s lawfully binding terminology that states that if you pay off the house loan, you will own the property outright and complete.
Essentially, it depends on your state’s interpretation of a concept in real estate law known as mortgage theory.
Mortgage Theory
In the past, when a lender granted a mortgage, it required a deed of defeasible charge to the property as security to ensure that the loan was fully paid off. Under the mortgage theory, the lender gets a defeasible title to the property.
The defeasance clause would “negate” the lender’s security and allow the borrower to reclaim title to the property if the provisions of the mortgage agreement were met.
The lender’s title would change to a fee simple absolute estate if the borrower did not follow the mortgage rules or did not fully repay the debt. That essentially makes the lender the sole owner of the property.
Lien Theory
A defeasance clause in a mortgage agreement is not required in many states. However, by accepting the mortgage agreement, the borrower grants the lender a lien on the property, according to the lien theory.
If the borrower fails to pay or defaults on loan, the lender can take possession of the property by starting and completing a foreclosure process. When it comes to lien theory, the lender is not granted a defeasible title under the lien theory; hence there is no need for a defeasible clause.
Intermediary Theory
According to the intermediary theory, the borrower keeps the title, but the lender can take it all back if the borrower defaults on the loan (without judicial proceedings).
Title Theory vs Lien Theory
Real estate laws differ by the state regarding mortgage law theory and defeasance clause, but they generally fall into one of two groups: lien theory or title theory.
- According to title theory states, the bank retains ownership of the home until the loan is repaid.
- According to lien theory states, the person buying the property owns it, but when the buyer takes out a loan, the bank creates a property lien against it.
In a lien theory state, a borrower executes a security deed along with the mortgage contract, giving the bank legal title to the property but keeping equitable ownership. The equitable title is not the same as a legal title; it simply implies that the borrower has the right to occupy the property for the length of the loan unless they sell or fail.
When foreclosure actions are required, the fundamental difference between the two is clear regarding legal matters. Foreclosures in a title theory state must proceed through the courts. On the other hand, foreclosures in lien theory states are non-judicial and handled by trustees, usually without the intervention of the courts.
In other words, it’s more difficult for a bank to evict you from a home where you have an equitable title (lien theory states) than it is to evict you from a home where the bank owns the property outright (title theory states), and you’re paying off debt.
Defeasance in Real Estate
In the context of mortgages and loan deals, the defeasance clause in real estate is critical since it relates to the title of a property.
A mortgage’s defease clause compels the mortgage lender to execute a deed of defeasance charge to the property in exchange for receiving bank funds to purchase the property.
Defeasance Clause in Real Estate: Understanding Secured Title
There are two types of loans: secured and unsecured.
Unsecured debt is most commonly found on low-balance financial products such as credit cards. Most lenders ask borrowers to put up collateral to obtain substantial money for major purchases like a home.
In most home purchase transactions, the buyer obtains a mortgage and secures the loan with the same property as collateral. Loan defeasance and a clean house title are given when borrowers can fully return their interest payments, principle, and any additional payment restrictions on a secured mortgage.
The security deed is used to “protect” the mortgage rather than the property itself in a lien theory state. A security deed is employed to transfer legal ownership from the borrower to the bank at closure.
It’s understandable if it sounds puzzling. Basically, the defeasance clause comes down to legal semantics, and it all depends on how the state in which you live interprets real estate ownership concerning the law.
The only time you’ll want to look into your legal rights and what you’re eligible to (legally) is if your mortgage loan is foreclosed or defaulted.
Title Determination
The defeasance provision protects the lender while also ensuring that the homeowner regains complete, unrestricted, and free title to the property when all lender payments are fulfilled.
When the purchaser makes the last payment, the lender is obliged to release any property rights it may have.
Defeasance Clause: Advantages and Disadvantages
The defeasance provision would legally obligate the lender to give a clear title to the borrower on the house once the debt is paid off, which is the most significant benefit for a borrower.
Another advantage is that a person can potentially become a homeowner or property owner by giving defeasance privileges to the lender until the loan is paid in full. Otherwise, without appropriate finances, a person may never be able to acquire a property.
The downside is that the borrower does not have “title” to the property until complete payment is made, which could take many years. If the borrower fails on the mortgage at any point, the lender can have full possession of the property.
Exceptions to Defeasance Clause
Since real estate rules and terminology differ from state to state based on the mortgage theory, not all mortgage agreements will have a defeasance clause.
Defeasance clauses are almost always used in title theory states, where the bank keeps possession of the house until the loan is paid off. Then, they transfer title upon debt fulfillment. Title theory is used in more than half of the states in the United States, including:
- Washington, D.C., Arizona, California, Colorado, Nebraska, Nevada, Oregon, South Dakota, Utah, Washington State, Wyoming, Idaho, Missouri, Georgia, Mississippi, North Carolina, Tennessee, Texas, Virginia, and West Virginia.
Alaska is a title theory state as well. The rest of the states in the United States that aren’t included above are lien theory states:
- Arkansas, Connecticut, Delaware, Florida, Illinois, Indiana, Iowa, Kansas, Kentucky, Louisiana, Maine, New Mexico, New York, North Dakota, Ohio, New Jersey, Pennsylvania, Puerto Rico, South Carolina, and Wisconsin.
The intermediary theory states:
- Alabama, Hawaii, Maryland, Massachusetts, Michigan, Minnesota, Montana, New Hampshire, Oklahoma, Rhode Island, and Vermont.
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Example of a Defeasance Clause
Let’s look at some defeasance provision examples and how they occur in a contract, a debt indenture, or bonds to comprehend the concept better.
These examples demonstrate how contract parties can deal with legal defeasance requirements.
Defeasance of Debt
The Company must deposit in trust for the benefit of all Debenture Holders a combination of Dollars or US Government Obligations that will generate appropriate money to make interest, principal, and other payments on the Debentures on their respective due dates.
Defeasance Provision in Business Law
A defeasance provision is a contractual clause in business law that makes an agreement or sections of a contract unenforceable. For example, companies may employ a defeasance provision to cover their debts or obligation in business transactions.
As an example:
- A business may be required to set aside a particular amount of cash or bonds as low-risk collateral to secure a loan. The rights of one party may be changed after the alternative collateral is provided.
- A defeasance provision is used to complete specific accounting processes in other cases.
A corporation can offset the asset and liability by having a loan and a corresponding asset account, thus removing both amounts from the borrower’s balance sheet. That is comparable to accounting’s liability matching approaches.
How Can a Firm Employ a Defeasance Provision?
A defeasance provision can also be used in business to allow a company to exchange one lender’s security with another. For example, a borrower may have agreed to employ a real estate property as collateral to secure specific obligations (real estate collateral) but no longer wishes to do so.
To replace the real estate collateral with another, the borrower gathers low-risk assets such as secure investments or marketable securities and exchanges them for the real estate collateral initially issued.
What Does a Covenant Defeasance Mean?
A covenant defeasance is a contractual term that waives a person’s or entity’s responsibilities under a contract or waives certain default circumstances. Essentially, it is a technique to get out of a contract’s obligations.
What Is the Meaning of Legal Defeasance?
A legal defeasance occurs when a person can completely avoid a contractual obligation to pay. That can be accomplished by placing sufficient funds in escrow or trust to meet all principal and interest payments or simply paying off all outstanding debt.
The ultimate goal of any loans, mortgages, bonds, papers, indentures, or debentures is to secure legal defeasance for the borrower (meaning the full payment of the debt or liability).
Conclusion
Defeasance provisions aren’t alarming, and in most places, they aren’t even required. However, your mortgage loan terms will almost certainly include a defeasance clause if you live in a title theory state.
If you live in a title theory state, you’ll want the loan to include a defeasance clause. It works in your favor because it clearly says that once you’ve paid off your loan in full, you’ll have a complete and clear title to your house. You can also consider states with an intermediary theory. However, you have to be careful not to default on the loan.
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