Before we discuss lenders, loans, and loan terms, it is essential that you understand the legal fundamentals and paperwork involved with mortgage loans. By analogy, you cannot make a living buying and selling automobiles without a working knowledge of engines and car titles. Likewise, you need to understand how the paperwork fits into the real estate transaction. Without a working knowledge of the paperwork, you are at the mercy of those who have the knowledge. Furthermore, without the know-how your risk of a large mistake or missed opportunity increases tremendously.

What Is a Mortgage?

Most of us think of going to a bank to get a mortgage. Actually, you go to the bank to get a loan. Once you are approved for the loan, you sign a promissory note to the lender, which is a legal promise to pay. You also give the lender (not get) a mortgage as security for repayment of the note. A mortgage (also called a “deed of trust” in some states) is a security agreement under which the borrower pledges his or her property as collateral for payment. The mortgage document is recorded in the county property records, creating a lien on the property in favor of the lender. If the underlying obligation (the promissory note) is paid off, the lender must release the collateral (the mortgage). The release will remove the mortgage lien from the property. If you search the public records of a particular property, you will see many recorded mortgages that have been placed and released over the years.

Promissory Note in Detail

A note is an IOU or promise to pay; it is a legal obligation. A promissory note (also known as a “note” or “mortgage note”) spells out the amount of the loan, the interest to be paid, how and when payments are made, and what happens if the borrower defaults. The note may also contain disclosures and other provisions required by federal or state law. Most lenders use a form of note that is approved by the Federal National Mortgage Association (FNMA, or Fannie Mae). A sample form of this note can be found in Appendix C. The note is signed (in legal terms, “executed”) by the borrower. The original note is held by the lender until the debt is paid in full, at which time the original note is returned to the borrower marked “paid in full.”

The Mortgage in Detail

The security agreement executed by the borrower pledges the property as collateral for the note. Known by most as a “mortgage,” this document, when recorded (discussed below), creates a lien in favor of the lender. The mortgage agreement is generally a standardized form approved by FNMA. While the form of note is generally the same from state to state, the mortgage form differs slightly because the legal process of foreclosure (the lender’s right to proceed against the collateral) is different in each state. The mortgage document will state that upon default of the note, the lender can exercise its right to foreclose on the property. Foreclosure is the process of lenders exercising their legal right to proceed against the collateral for the loan (discussed later in this article). It also places other obligations upon the borrower, such as

• maintaining the property,

• paying property taxes, and

• keeping the property insured.

The Deed of Trust Some states (e.g., California) use a document called a “deed of trust” (AKA “trust deed”) rather than a mortgage. The deed of trust is a document in which the trustor (borrower) gives a deed to the neutral third party (trustee) to hold for the beneficiary (lender). A deed of trust is worded almost exactly the same as a mortgage, except for the names of the parties. Thus, the deed of trust and mortgage are essentially the same, other than the foreclosure process.

The Public Recording System The recording system gives constructive notice to the public of the transfer of an interest in property. Recording simply involves bringing the original document to the local county courthouse or county clerk’s office. The original document is copied onto a computer file or onto microfiche and is returned to the new owner. There is a filing fee of about $6 to $10 per page for recording the document. In addition, the county, city, and/or state may assess a transfer tax based on either the value of the property or the mortgage amount.

A deed or other conveyance does not have to be recorded to be a valid transfer of an interest. For example, what happens if John gives title to Mary, then he gives it again to Fred, and Fred records first? What happens if John gives a mortgage to ABC Savings and Loan, but the mortgage is not filed for six months, and then John immediately borrows from another lender who records its mortgage first? Who wins and loses in these scenarios? Most states follow a “race-notice” rule, meaning that the first person to record his document, wins, so long as • he received title in good faith, • he paid value, and • he had no notice of a prior transfer.

Example: John buys a home and, in so doing, borrows $75,000 from ABC Savings Bank. John signs a promissory note and a mortgage pledging his home as collateral. Because ABC messes up the paperwork, the mortgage does not get recorded for 18 months. In the interim, John borrows $12,000 from The Money Store, for which he gives a mortgage as collateral. The Money Store records its mortgage, unaware of John’s unrecorded first mortgage to ABC. The Money Store will now have a first mortgage on the property.

Priority of Liens Liens, like deeds, are “first in time, first in line.” Thus, if a property is owned free and clear, a mortgage recorded will be a first mortgage. A mortgage recorded thereafter will be a second mortgage (sometimes called a junior mortgage because its lien position is behind the first mortgage). Likewise, any judgments or other liens recorded later are also junior liens. Holding a first mortgage is a desirable position because a foreclosure on a mortgage can wipe out all liens that are recorded behind it (called “junior lien holders”). The process of foreclosure will be discussed in more detail later in this article. At the closing of a typical real estate sale, the seller conveys a deed to the buyer. Most buyers obtain a loan from a conventional lender for most of the cash needed for the purchase price. As discussed earlier, the lender gives the buyer cash to pay the seller, and the buyer gives the lender a promissory note. The buyer also gives the lender a security instrument (mortgage or deed of trust) under which she pledges the property as collateral. When the transaction is complete, the buyer has the title recorded in her name and the lender has a lien recorded on the property.