Most people are familiar with the concept of a mortgage and the role it plays in the home buying process. However, in some states, deeds of trust are commonly used in place of mortgages. Although they serve the same purpose, there are differences between the two legal documents.
This post is intended to help those looking to buy a home understand what a deed of trust is and the way it works. You’ll also be able to tell the difference between a deed of trust and a mortgage.
What Is A Deed Of Trust?
A deed of trust is a method of securing a real estate transaction that includes three parties: a lender, borrower and a third-party trustee. The lender gives the borrower the money to buy the home in exchange for one or more promissory notes, while the trustee holds the legal title to the property until the loan is paid off.
Some states use this method instead of a traditional mortgage. Although there are some exceptions, states tend to use either a deed of trust or a mortgage, and not both options.
Deeds of trust are recorded as a public record with the county clerk in the same way that mortgages are.
How Does A Deed Of Trust Work?
The deed of trust involves a trustor, a beneficiary and a trustee. The idea of the trust is that it sets up recourse for the lender so that under conditions defined in the trust they can have the property sold by the trustee, take it back or compel accelerated payment of the loan in order to protect their investment. In effect, the trust works as a security for the promissory note– the borrower’s promise to pay the loan back.
The trustor is the person whose assets are being put into the trust. In the case of a real estate transaction, we’re talking about the borrower. The official legal title to their property is put into the trust.
While the legal title defines the actual ownership of the property and is held in the trust, as long as the borrower meets the terms and conditions of the trust (we’ll get into some of the common terms later), the borrower still holds equitable title. Having equitable title means you get to enjoy the benefits that come along with property ownership regardless of who legally owns the property at this point in time. Among other things, you have a right to live there and gain equity in the property as you make payments or the value increases.
The beneficiary of the deed of trust in a real estate transaction is the person or entity whose investment interest is being protected. In most cases, this is a lender, but it could also be a person if you have a land contract with an individual to eventually own a property outright.
In exchange for lending you the money for the property, the deed of trust serves as the lender’s guarantee that you’ll pay the loan off.
The role of the trustee is to actually hold the legal title while the payments are being made. The trustee is supposed to be impartial and not do anything that unduly benefits either the trustor or the beneficiary.
If the loan proceeds the way home loans normally do, the trustee has one of two duties:
- If the trustor decides to sell the property at some point before the loan is fully paid off, the job of the trustee is to pay the lender the proceeds of the sale that cover the remaining amount due on the loan, with the excess going to the trustor selling the property.
- If the loan is fully paid off by or before the end of the term, the trustee is the one who will dissolve the trust and transfer the legal title to the trustor.
If for some reason you default on the terms of the trust, it’s the role of the trustee to sell the property in order to help the beneficiary protect their investment.
What Does A Deed Of Trust Include?
A deed of trust has many parts. In some respects, it has the features that are common to a mortgage. There are other aspects where the deed of trust functions are a lot like a traditional property deed. Let’s run through exactly what the deed of trust includes.
Initial Loan Amount
The initial loan amount is what the lender or other trust beneficiary is giving you so you can buy the house. Typically, this is the agreed-upon purchase price of the home minus the down payment. This is important because it lets you know the exact number that has to be paid off by the end of the loan term in order to fulfill the loan requirements and dissolve the trust.
Like a traditional deed, a deed of trust includes a detailed description of the property being bought. It very specifically describes what the trustor has the rights to, assuming they follow all the guidelines in the trust in terms of repayment of the loan.
Length Of The Loan
The length of the loan describes the time frame in which the loan must be paid off, also referred to as the loan term. If you’re negotiating with a single person, this term could be anything you mutually agreed to. If you’re working with a traditional lender, the term might be anywhere between 8 – 30 years, depending on the type of loan you’re interested in and what your financial goals are, as well as what you can afford.
The loan terms don’t necessarily mean you have to only make the scheduled payments and wait to pay it off until 30 years down the line. Subject to the requirements of the loan, which we’ll get into below, you can pay it off much earlier and save on interest.
As with a traditional mortgage, a lender may impose certain conditions in order to give you the loan. For example, you may be required to occupy the property as your primary residence for a certain amount of time. You may also be required to pay mortgage insurance for a period of time, or for the life of the loan, depending on the type of loan you have.
One of the big things to know about here is whether there’s a prepayment penalty, and if so, how long it lasts. For example, you may be subject to a penalty if you pay off your mortgage within the first 3 years after buying the property. Rocket Mortgage® doesn’t charge prepayment penalties.
Power Of Sale Clause
A power of sale clause defines the circumstances under which a trustee can sell the property for the beneficiary. Typically, this comes into play only if you default on the mortgage. In general, a deed of trust has a much quicker foreclosure process because it’s a nonjudicial foreclosure. As long as the terms outlined in the deed of trust are followed regarding power of sale, there’s no need for the courts to get involved, which speeds things up.
Because a judicial foreclosure with its safeguards isn’t what’s taking place when you do a deed of trust, it’s important to know exactly what your rights and responsibilities are under this power of sale section.
Acceleration And Alienation Clauses
Acceleration and alienation clauses have similar practical effects on loan borrowers. However, they trigger for different reasons. Let’s briefly run through the way these clauses work.
An acceleration clause generally takes effect after a borrower is delinquent, or behind on their payments. Depending on the terms of the clause, it could kick in as soon as a borrower is behind with one payment, but a lender or person may also not have the clause take effect until after several payments are missed in order to give the borrower time to try and catch up. Regardless, they may take this step to try to protect their investment before going through a full foreclosure process. If the full loan isn’t paid within an amount of time specified in the acceleration notice, then they’ll likely move forward with foreclosure proceedings.
An alienation clause is also referred to as a due-on-sale clause. These provisions are inserted if the person or lender you’re dealing with doesn’t want to have anyone who buys the property to be able to assume the loan under its current terms. They would get around this by having an alienation clause in the deed of trust that says the loan must be paid in full if you sell the property.
The alienation clause may also be triggered if you do something like try to put the property in an LLC. The reasoning for this is that the LLC limits the person or lender’s ability to hold you to the loan terms because there’s a limitation of liability associated with LLCs. The loan would have to be paid off before the transfer.
Deed Of Trust Vs. Mortgage
A deed of trust is needed when a traditional lending service (i.e., a bank) is not being used or when certain states require deeds of trust instead of mortgages. Whether you have a deed of trust or a mortgage, they both serve to assure that a loan is repaid, either to a lender or an individual person. A mortgage only involves two parties – the borrower and the lender. A deed of trust adds an additional party, a trustee, who holds the home’s title until the loan is repaid. In the event of default on the loan, the trustee is responsible for starting the foreclosure process. In a traditional mortgage, a lender is responsible for initiating foreclosure, either with or without judicial approval as dictated by state law.
Because there are particular differences between deeds of trust and mortgages when it comes to foreclosure, it’s very important to take careful note of the terms outlined in your Closing Disclosure. If you’ve already closed on your loan, you can always contact your lender or mortgage servicer or check your documentation. Finally, not every state has both deeds of trust and mortgages. They often have one or the other, so you may be able to figure it out by looking at state property laws.
Although we’ve highlighted the differences in this article, there are many similarities between mortgages and deeds of trust. In addition to serving the same purpose, the same rules apply should the borrower pass away before the loan is paid off. In the event of the death of the loan borrower, a surviving spouse or other heir is allowed to keep making the payments and even assume the loan if they qualify.
Whether a deed of trust or a mortgage applies in your situation, we can help you with all of your home financing needs. You can apply online through Rocket Mortgage® or give one of our Home Loan Experts a call at (800) 785-4788.