What is a defeasance clause?
What are its legal implications in real estate?
How does it work or how can it affect the title to a property?
In this article, we will break down the notion of “defeasance clause” so you know all there is to know about it!
We will look at what is a defeasance clause, its legal definition, see how it appears in a deed of mortgage, how it can affect the title of your property, what are its advantages, examples, sample clauses and more.
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A defeasance clause is a type of clause found in a deed of mortgage where the lender agrees to provide the borrower title to the property once all mortgage payments have been made.
Once a borrower makes all the mortgage payments, the defeasance clause acts as a legal mechanism nullifying the mortgage, deed or contract and conveying the title of the property to the borrower.
In essence, the defeasance clause allows the borrower to obtain a free and clear title once all the debt is cleared.
You may not need to have a defeasance clause in your mortgage agreement if your state follows a “lien theory” as opposed to the common law “mortgage theory” or “title theory”.
Historically, when a lender granted a mortgage, it would demand a deed of defeasible fee to the property as security to ensure the complete repayment of the debt.
Under the mortgage theory, the lender is given a defeasible title to the property.
Once the lender satisfied the terms of the mortgage agreement, the defeasance clause would “defeat” the lender’s security and allow the borrower to regain title to the property.
The defeasance clause “defeated” or “cancelled” the lender’s security when the debt was fully paid
However, if the borrower did not respect the terms of the mortgage or did not fully pay back the loan, the lender’s title would become an estate in fee simple absolute.
This means that the lender would become the absolute owner of the property.
Many states do not require a defeasance clause in a mortgage agreement.
Under the lien theory, the borrower grants the lender a lien on the property by signing the mortgage agreement.
In the event the borrower does not pay or defaults on the mortgage, the mortgagee (lender) can acquire rights in the property by initiating and completing a foreclosure procedure.
Under the lien theory, the lender is not given a defeasible title and there is no need for a defeasible clause.
To understand what is a defeasance clause, let’s first look at the defeasance definition.
According to the Merriam-Webster dictionary, defeasance is defined as:
“A rendering null or void” or “a condition (as in a deed or will) that upon fulfillment terminates a property interest”
So a defeasance or defeasement is a process of rendering something “null” or “void”.
Now let’s define defeasance clause.
According to Encyclopedia.com, a defeasance clause is defined as:
A provision of a mortgage—an interest in land given to a mortgagee-lender to secure the payment of a debt—which promises that the mortgagor-borrower will regain title to the mortgaged property when all the terms of the mortgage have been met.
The legal definition of a defeasance clause is a contractual provision where a lender promises to provide the borrower full title to property upon full payment of the loan or debt.
How does a loan defeasance work?
A defeasance clause is a provision of a mortgage agreement related to land or real estate property where the mortgagee (lender) promises that the mortgagor (borrower) will regain title to his or her property upon full payment of the mortgage.
You can consider a defeasance clause to be loan security granted by the borrower to the bank or financial institution to secure the payment of the land until full payment is made.
Not all states require a defeasance clause in a mortgage agreement.
In many states, the title of the property is given to the borrower even though they have a mortgage to pay off.
The lender does not have any title or rights on the property until the property has been foreclosed following the default of the borrower.
Assignment of title
At the same time as providing protection to the lender, the defeasance clause ensures a homebuyer that he or she will regain full, unencumbered and free title to the property once all payment is made to the lender.
When the homebuyer makes his or her final payment, the lender will be required to give up any rights it may have on the property.
Defeasance clause key considerations
The biggest advantage for a borrower is that the defeasance clause will legally impose an obligation on the lender to transfer a clear title to the borrower on the property once the loan has been paid off.
Another advantage is that a person can eventually become a homeowner or property owner by granting defeasance rights to the lender until the mortgage is fully paid.
Otherwise, and without sufficient funds, a person may never have the possibility to purchase a home.
The disadvantage is that if the borrower does not have the “title” to the property until full payment is made and that could take years.
If at any time the borrower defaults on the mortgage, the lender can claim absolute ownership on the property.
Defeasance in real estate
The defeasance clause in real estate is important as it relates to the title of a property in the context of mortgages and loan agreements.
The defease clause in a mortgage requires the mortgagee to execute a deed of defeasance fee to the property in exchange for getting funding from the bank to purchase the property.
Defeasance clause in a mortgage
In title theory states or mortgage theory states, when a bank or financial institution provides you with a mortgage or loan, they will include a defeasance clause in the deed of mortgage.
You can call this a defeasance mortgage or defeasance loan.
This means that the lender keeps the title to the property until the last day you have to make a mortgage payment.
Once your final mortgage payment is made, the property title is transferred to you, free and clear, in accordance with the defeasance clause.
With the last payment, the security granted to the bank is defeased or cancelled.
Secured title in a mortgage
Today, many loans are granted using a secured mortgage loan which includes a provision for the assignment of the collateral rights to the lender instead of a defeasance clause.
In other words, the borrower acquires the title to the property immediately but offers the property as collateral to the bank or lender in case of non-payment.
This means that if the bank does not get paid, it can use the lien to seize the property (the secured collateral) and eventually acquire the title to the property.
In the event the loan is fully paid, even without a defeasance clause, there is loan defeasance (or legal defeasance) whereby the lender’s security or lien is cancelled and the borrower’s title becomes clear and fully unencumbered.
Defeasance clause example
To better understand the concept, let’s look at some defeasance clause examples and how they appear in an agreement, a debt indenture or bonds.
These examples show parties to a contract may handle legal defeasance provisions.
DEFEASANCE. The Company must irrevocably deposit in trust for the benefit of all Debenture Holders, a combination of Dollars or U.S. Government Obligations that will generate enough cash to make interest, principal and any other payments on the Debentures on their applicable due dates.
The indenture will cease to be of further effect as to all debt securities of any series when either: (i) we have delivered to the trustee for cancellation all debt securities of that series that have been authenticated; or (ii) all debt securities of that series have become due and payable or will become due and payable at their stated maturity within one year or are to be called for redemption under arrangements satisfactory to the trustee, and in any case, we have deposited with the trustee as trust funds money in an amount sufficient to pay the entire indebtedness of all these debt securities to their stated maturity or redemption date; and we have paid all other sums payable by us under the indenture with respect to that series.
Defeasance clause FAQ
What is defeasance in real estate
Defeasance in real estate refers to a form of security given by a borrower to protect a lender against default on the loan agreement.
Some states follow the common law mortgage theory whereby a lender will receive a deed of defeasible fee to the property in exchange for providing the borrower funding.
In such states, a defeasance clause will be required in a mortgage agreement.
What is a defeasance provision in business law
In business law, a defeasance provision is a contractual clause rendering an agreement or parts of an agreement void.
In business dealings, companies may use a defeasance provision to cover their debt or liability.
For instance, a company will be required to set aside a certain amount of cash or bonds to provide low-risk collateral to cover a loan.
Once the alternative collateral is furnished, the rights of one party may be altered.
In other situations, companies perform certain accounting operations using a defeasance provision.
By having a loan and a corresponding asset account, a company may offset the asset and liability so that functionally both amounts are removed from the borrower’s balance sheet.
This is similar to liability matching techniques used in accounting.
How can a defeasance provision be used in business
Another way a defeasance provision can be used in business is to allow a company to swap a lender’s security for another security.
A borrower may have granted a real estate property as collateral to secure certain obligations (real estate collateral) and no longer wants to use that property as collateral.
To swap the real estate collateral for another collateral, the borrower accumulates low-risk assets such as safe investments or marketable securities and exchanges it as alternative collateral for the real estate collateral initially granted.
What is a covenant defeasance
A covenant defeasance is typically a contractual provision waiving a person or entity’s obligations under an agreement or waiving certain events related to default.
A covenant defeasance is a way to escape the covenants made under a contract.
What is a legal defeasance
A legal defeasance is when a person can fully get out of an obligation to pay under a contract.
This can be done by depositing a sufficient amount of money in escrow or in trust to cover all the principal and interest payments or merely paying off all the outstanding debt.
The ultimate objective for any loan, mortgage, bonds, notes, indentures or debentures is to have the borrower achieve legal defeasance (meaning the full payment of the debt or liability).
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