Defeasance clause: Definition and overview

The “defeasance clause” – the phrase just sounds intimidating, doesn’t it? But in reality, the defeasance clause isn’t scary at all; it’s only invoked once you pay off your loan and meet the terms of your mortgage agreement.

When you close on a home, you own it, right? Not necessarily. It’s a bit more nuanced and it depends on the state you live in.

Let’s go over what the defeasance clause in real estate means for homeowners.

What is a defeasance clause?

A defeasance clause is a term within a mortgage contract that states the property’s title will be transferred to the borrower (mortgagor) when they satisfy payment conditions from the lender (mortgagee). If your mortgage contract has a defeasance clause, it means you don’t hold the title to your home until you have fully repaid your loan.

How do defeasance clauses work in a mortgage?

Legally, the concept of defeasance exists to protect the interests of you, the home buyer; it’s legally binding language that states when you pay off the loan of the house, you will then own the house outright and in full.

Owning a property outright and in full depends on the state where you live and how they interpret an aspect of real estate law called mortgage theory.

What is lien theory vs. title theory?

Real estate laws vary from state to state, but they generally do fall into one of two main categories when it comes to mortgage law theory: lien theory or title theory.

In title theory states, the bank holds the ownership of the home until the loan is paid off. The following states follow title theory:

• Alaska
• Arizona
• California
• Colorado
• Washington, D.C.
• Georgia
• Idaho
• Mississippi
• Missouri
• Nebraska
• Nevada
• North Carolina
• Oregon
• South Dakota
• Tennessee
• Texas
• Virginia
• Washington State
• West Virginia
• Wyoming

In lien theory states, the person who buys the property owns it – but the bank places a property lien against it when the buyer takes out a mortgage. The following states follow lien theory:

• 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
• Utah
• Wisconsin

In a lien theory state, upon signing the mortgage contract, a borrower also signs a security deed that gives the bank legal title of the property, with the borrower retaining equitable title. Equitable title isn’t the same as legal title, it just means the borrower has the right to possess the home for the duration of the loan unless they sell or default.

How do lien theory and title theory impact foreclosures?

The main difference between title theory and lien theory is seen when foreclosure proceedings happen. In a title theory state, foreclosures must go through the court. In a lien theory state, foreclosures are non-judicial and managed by a trustee, typically without the involvement of the court system.

Essentially, it is harder for a bank to kick you out of a home that you have equitable title to (lien theory states) than in a state where the bank wholly owns title to the property (title theory state) and you’re paying off a debt.

What is intermediate theory?

There is also a modification of the two theories as an alternative option. In intermediary theory states, the borrower holds the title, however, the bank can take it back without judicial proceedings if the borrower defaults. The following states follow intermediate theory:

• Alabama
• Hawaii
• Maryland
• Massachusetts
• Michigan
• Minnesota
• Montana
• New Hampshire
• Oklahoma
• Rhode Island
• Vermont

Understanding secured title in real estate

Loans come in two varieties: secured and unsecured.

Unsecured loans

Unsecured debt is typically seen on smaller-balance financial products like credit cards. To give out large sums of money for expensive purchases like a home, most mortgage lenders require borrowers to secure the debt with collateral.

Secured loans

In most home purchase transactions, a buyer uses a mortgage to purchase the home, and secures the mortgage loan using that same property as collateral. With a secured mortgage the borrower is granted loan defeasance and a clear house title when they are able to fully repay their principal and interest payments and any other mortgage payment conditions.

Security deeds

In a lien theory state where a security deed is used to transfer legal title from the borrower to the bank at closing, the security deed is used to “secure” the mortgage rather than the home itself.

You’ll want to carefully examine your rights and what you’re legally entitled to in the event of foreclosure or default of your mortgage loan.

Defeasance clause exceptions

Not all mortgage agreements will include a defeasance clause because real estate laws and language vary from state to state depending on the type of mortgage theory they use.

Since a defeasance clause conveys title upon satisfaction of the loan, these types of clauses are typically only used in title theory states where the bank holds ownership of the home until the mortgage is paid off. Simply put, the states listed above that follow lien theory and intermediate theory are exceptions.

Other uses for a defeasance clause

A defeasance clause may also be used in some situations to transfer alternative collateral, such as other real estate or investment assets, to secure a loan. If enough alternative collateral is provided in these cases, the borrower could obtain their property’s title before the loan is fully repaid since the loan is secured by something other than the property.

The bottom line

If you live in a title theory state, your mortgage loan terms will likely come with a defeasance clause in the fine print. A defeasance clause states that your mortgage lender will hold the title to your home until your loan is repaid in full, at which time the title will be transferred to you.

If you live in a title theory state, you want the defeasance clause language in the loan terms. It is to your benefit because it simply states that once you’ve paid off the loan in full, you then get full and clear title (ownership) of your home.

Looking for ways to pay off your mortgage faster? Start your refinance application today and see what options are right for you.