The two types of security instruments commonly employed in real estate are mortgages used in title theory states and deeds of trust used in lien theory states. A deed of trust is a security instrument. The main difference between security instruments centers on the title. The title remains with the borrower with deeds of trust. The title transfers to the lender with mortgages.
Title Theory Versus Lien Theory
Title theory holds that a loan secured by real estate actually conveys title to the property to the lender until the loan is repaid. The mortgage is the security instrument in title theory. If you default on your loan in title theory states, the lender typically must obtain court approval to initiate foreclosure proceedings.
Lien theory holds that a loan secured by real estate merely creates a lien against the property until the loan is repaid. Title remains with the borrower. The deed of trust is the security instrument in lien theory. The lender is the beneficiary in the deed of trust, with a third-party trustee usually holding title to the property "in trust" until the loan is repaid. The trustee can begin foreclosure without court interference if you default on the loan in lien theory states.
U.S. states that adhere to title theory require court approval to start the foreclosure process. Judicial foreclosures give you, the borrower, a chance to formally challenge the lender's complaint — your day in court, so to speak. One negative feature is that many states permit borrower "deficiency judgments" in instances where the so-called "short sale" at a foreclosure auction does not fully recover the amount of your outstanding mortgage. For example, if a short sale recovers $70,000 of your hypothetical $100,000 outstanding mortgage, the lender can pursue a deficiency judgment against you for the remaining $30,000.
The positive feature is that judicial foreclosures typically include a "right of redemption" that grants you the right to reclaim the foreclosed property within a specified time period depending on the state.
If you default on your loan in lien theory states, the trustee, at the direction of the lender, can start foreclosure independent of court involvement. As a borrower, you can still challenge the foreclosure. But it's your responsibility to make the challenge. Borrowers seldom challenge because of the cost involved. Many lenders prefer nonjudicial foreclosures because they're faster and less costly. Lenders do have the option of choosing between judicial and nonjudicial foreclosures in many lien theory states, however.
Which Foreclosure Laws Apply to Your Real Estate Loan?
State law and lender preference determine the security instrument used to secure a loan. As a borrower, it's good to be informed about what the documents you're signing really mean. You can find the foreclosure laws for your state online.
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