In certain states of the United States, if you’re buying real estate with a mortgage loan, you’ll need a defeasance clause in your mortgage agreement.

This contract provision ensures that the title for a piece of property is transferred clearly to the buyer, that’s you — on full repayment of a secured mortgage loan, and after resolution of all terms and conditions. 

Read more: What’s a protection mortgage clause and is it important?

What is a defeasance clause?

what is a defeasance clause

A defeasance clause is a provision in a mortgage that allows a homebuyer to claim full rights of a property after the last payment has been made to the mortgage lender.

Basically, the defeasance clause specifies that the loan lender must surrender all rights to the property, including title, to the loan borrower on complete payment of the mortgage amount. 

If you live in a title theory state, whereby the property title is held in the lender’s name until the final payment is made, it’s important to ensure that your mortgage loan terms mention a defeasance clause in the fine print.

When you’re drawing a mortgage contract, the defeasance clause should clearly indicate that the property ownership will be transferred from the lender (mortgagee) to the borrower (mortgagor) on meeting all the payment conditions. As a homebuyer, once you pay off the full loan amount, you’ll get a clear title or homeownership.

What is lien theory vs. title theory in mortgage law?

Mortgage law theories or real estate laws vary depending on the state you’re in. Broadly, they fall into two categories: lien theory and title theory.

In title theory states, the loan lender or bank holds the title ownership until the mortgage loan is paid off.

In lien theory states, on the other hand, the property buyer owns it but the lender or bank places a property lien against it as soon as the buyer takes out a mortgage to buy the real estate.

How defeasance clause works

Defeasance clauses work to nullify a deed or contract if the terms of the mortgage are not met properly. Basically, it’s used to summarize the final procedures in a mortgage loan contract. Here, the mortgaged property is secured as collateral for a loan.

On completion of the repayment schedule, when the borrower no longer owes anything to the lender, the clause legally transfers the property title rights from the mortgagee-lender to the mortgagor-borrower.

Who does a defeasance clause benefit?

defeasance clause real estate

Defeasance clause exists to protect the interests of the home buyer. The lender is legally bound to hand over all property rights to the buyer when they pay off the loan. The homebuyer then gets to own the house outright and in full. This type of mortgage provision ensures that the lender doesn’t take unlawful advantage of the borrower in title theory states.

What are special considerations for a defeasance clause?

In some cases, you may be able to use defeasance clauses to transfer alternative collateral. For example, if you, as a loan borrower, plan to accumulate an alternative asset that you’d like to use as a replacement for the original real estate collateral during the loan term, such a clause allows you to do it. Your alternative collateral could include financial assets such as investment securities, money market accounts, or other investment assets.

This type of defeasance clause would let you exchange alternative collateral for the secured real estate property collateral. And, still, obtain the title ownership before the expiration of the loan. 

There’s usually a prepayment penalty or a defeasance penalty. It’s calculated by keeping in mind the current value of the remaining loan payments.

Read more: Why you should not pay off your house early

Key takeaways

  • A defeasance clause is only required in some states of the U.S.
  • Some of these states include Massachusetts, Washington D.C.,  Alabama, Georgia, Minnesota, Missouri, Arizona, California, Colorado, and many more.
  • This clause specifies that the mortgage borrower will be given the property title once all the mortgage payments are over.
  • Defeasance works as soon as a mortgage is fully paid.
  • It then helps legally transfer the title ownership from the lender to the borrower. 

Read more: Is it worth investing in real estate this year?

What is a defeasance clause, and how does it work? was last modified: October 10th, 2022 by Ramona Sinha
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