Mortgages and Foreclosure

Many people cannot afford to pay the entire purchase price for real property at the time that they purchase it. Therefore, lenders agree to lay out the money for the purchaser to use to pay the purchase price. In exchange, the buyer agrees to pay back the loan and agrees that the purchased property itself will be collateral for the loan. If the loan is not paid back, the lender will have the right to repossess the purchased property. This is called a mortgage. The lender (almost always a bank) is called the “mortgagee.” The borrower (the buyer of the property) is called the “mortgagor.” If a mortgagee actually does repossess the mortgaged property, that is called a “foreclosure.” For example:

James wants to buy Blackacre from Joan. Joan wants $250,000 for the property. Unfortunately, James only has $50,000 to his name. So, James takes out a loan for the remaining $200,000 from First National Bank. James “mortgages” Blackacre to First National. First National pays the $200,000 to Joan and James moves into the house. If, at any point, James defaults on his loan, First National can repossess Blackacre in satisfaction of James’ debt.

Note that not all mortgage loans are for the money that is used to buy the property. Sometimes, a person will need money to go on vacation or buy a car or send a kid to college and his or her house will be the only collateral that a bank will accept. In this case, the borrower can still mortgage his or her house. A mortgage loan that is actually used to buy the house (as in the above case) is known as a “purchase money mortgage.”

Mortgage Theory

Different jurisdictions take different views as to whether a mortgagee is considered to actually have title to the mortgaged property or merely a “lien” on the mortgaged property. This is of little practical significance. The one area in which this does make a difference is whether mortgaging property breaks up a joint tenancy. Recall that if one joint tenant transfers his or her interest in the joint tenancy, the joint tenancy is severed. In a jurisdiction that subscribes to the “title” theory of mortgages, one joint tenant mortgaging his or her interest would break up the tenancy because it would be considered a transfer in title. However, in a “lien” theory jurisdiction, one joint tenant mortgaging his or her interest would not break up the joint tenancy.

A mortgage is an interest in real estate. As such, the granting of a mortgage (from the buyer to the bank, in most cases) needs to be in writing to be enforceable under the Statute of Frauds. However, in some circumstances, courts will infer an “equitable mortgage,” where there is no writing. The most common scenario in which an equitable mortgage will be inferred is where the buyer gives the deed to the lender with the intent that the lender hold the deed as collateral. Despite the lack of a writing, courts will infer that the parties meant the arrangement to be a mortgage. For example:

James wants to buy Blackacre from Joan. Joan wants $250,000 for the property. Unfortunately, James only has $50,000 to his name. So, James takes out a loan for the remaining $200,000 from First National Bank. Rather than write out a mortgage document, James hands over the deed to the house to First National with the understanding that First National will give back the deed when the loan is paid off. Later, First National claims that it owns Blackacre because it received the deed from James. A court will most likely rule that First National does not own Blackacre. Rather, they have a mortgage interest in Blackacre; they have a right to repossess Blackacre if James defaults on the loan.

As we discussed earlier, once a mortgage is properly executed, then both parties have an interest in the land. The mortgagor (the homeowner) holds the right to possess and own the property. The mortgagee (the bank) holds a lien on the property and the right to recover the property if the loan is defaulted on. Both of these interests are fully transferable to third parties. Of course, each third party can only take whatever interest the transferor had in the property.

Transferring of mortgage interests occur very often when banks, who are interested in making loans and collecting interest, are not interested in harassing creditors and bringing foreclosure actions. In such a case, the Bank might sell its mortgage interest to a collection agency which will then continue to collect the mortgagor’s debt and, if necessary, bring a foreclosure action against the mortgagor. For example:

David takes out a mortgage from Seventh Heaven National Bank to buy Whiteacre. If David sells Whiteacre to Pamela, then Pamela will take Whiteacre, but it will still be subject to the mortgage interest of Seventh Heaven. On the other hand, Seventh Heaven can also transfer its mortgage to Mean Spirits National Collection Agency. In such a case, Mean Spirits can repossess Whiteacre if David defaults on his loan.

The Holder in Due Course

An interesting problem arises when a mortgage is transferred from the mortgagee to a third party collector (e.g., a debt collection agency), but the mortgagor has a defense against the collection of the debt by the mortgagee. Does that defense apply also against the third party or not? For example:

Jenny owns Greenacre and Third American Bank holds a mortgage on Greenacre. Third American transfers the mortgage to Collectors, Inc. It turns out, though, that Third American misrepresented the terms of the mortgage loan to Jenny in a manner that would have caused a court to rule that Third American could not foreclose on the mortgage because of fraud. The question becomes whether this defense can be used against Collectors or not. On the one hand, there is the sentiment that Jenny should not lose out just because Third American transferred the mortgage. On the other hand, there is the sentiment that Collectors is an innocent purchaser, and should not be punished for Third American’s wrongful conduct.

Because of the competing concerns that are relevant to this scenario, a rather complicated rule has developed. The simple rule part of the rule is that any defense that could have been used against the initial mortgagee (the lender- Third American in our previous case) can also be used against a transferee of the mortgage (Collectors, in our case) unless the transferee is a “holder in due course.” A holder in due course is similar to the bona-fide purchaser for value that we discussed in the previous subchapter. To be considered a holder in due course, the transferee must take the mortgage without knowledge of the defense against its enforcement, must pay fair value for the mortgage and must take possession of the actual mortgage note.

If the transferee is a holder in due course, then the law recognizes that such a holder is worthy of certain protections. Otherwise, if the transferee always were subjected to the same defenses as the mortgagee, it would be much more difficult to transfer mortgages because people would be much more hesitant about purchasing them. Since we want to encourage the transferability of notes to facilitate the availability of mortgage loans, the law affords the holder in due course certain protections.

The protection that the law affords the holder in due course is that the holder takes the mortgage note free of defenses that are “personal” to the mortgagee. “Personal” defenses include: lack of consideration, fraud in the inducement (fraud in the negotiating process for the mortgage) and unconscionability. For example:

Jenny owns Greenacre and Third American Bank holds a mortgage on Greenacre. Third American transfers the mortgage to Collectors, Inc. It turns out, though, that Third American never provided Jenny with consideration for the mortgage loan agreement (Third American never actually gave Jenny the money) and thus, the mortgage loan is unenforceable. Unfortunately for Jenny, if Collectors is a holder in due course (i.e. Collectors did not know of the lack of consideration etc.), Collectors will be able to enforce the terms of the loan against Jenny even though Third American could not have. Jenny’s only recourse would be to sue Third American for the money she was entitled to under the loan agreement.

Even holders in due course, however, do not take mortgages free of “real” defenses. “Real” defenses are defenses that go to the formation of the contract itself. Real defenses include: forgery (the mortgage note is a fake), incapacity (including infancy), illegality, duress, etc. In other words, real defenses are defenses that, in essence, claim that the contract itself was never validly executed, whereas personal defenses claim that conduct on the part of the mortgagee make the contract unenforceable. Therefore, it is only natural that even a holder in due course should be vulnerable to real defenses, since those defenses contend that the contract was never valid in the first place. For example:

Jenny owns Greenacre and Third American Bank holds a mortgage on Greenacre. Third American transfers the mortgage to Collectors, Inc. It turns out, though, that Third American forged the mortgage instrument and that Jenny never signed the instrument in the first place. This defense can be used by Jenny against Collectors just as it could have been used against Third American.

Transfers of Mortgaged Properties

A mortgage must be recorded, just like any other real property transfer. Earlier in the subchapter, we discussed the rule that any property subject to a mortgage that gets transferred still retains the mortgagee’s interest. This   is true only if the mortgage was recorded. If the mortgage is not recorded, then the transferee of the land cannot be expected to know of the mortgage. Therefore, if the mortgage is not recorded, a transferee will take the land completely free of the mortgage.

This is because it would not be fair to force the transferee to take the property subject to a mortgage that he could not reasonably be expected to know the existence of. As with the transfer issues we discussed in the last subchapter, we would rather penalize the mortgagee who was negligent in failing to record the mortgage than the innocent purchaser who had no reason to be aware of the mortgage’s existence. For example:

First National Bank holds a mortgage in Blueacre, but has failed to record it. Johnson, who owns Blueacre, sells it to Jackson. Assuming that Jackson has no actual notice of the mortgage’s existence, he will take Blueacre completely free of any mortgage. First National’s mortgage interest in Blueacre will simply be extinguished by the transfer.

The rules about whether a mortgage applies against a subsequent purchaser are the same rules as to whether a subsequent purchaser will prevail over an earlier purchaser that we discussed in the last subchapter.

It also should be noted that the same property can be mortgaged multiple times. It is very common for people to take out second and third mortgages on their homes either because they need loans or because they want to refinance their mortgages because the interest rates have dropped. All of the holders of mortgages in property own an interest in the property. The holders of the earlier mortgages, however, generally have priority over the holders of later mortgages when it comes to foreclosing on the property, as we will discuss in the next section.

Foreclosures

Of course, the whole purpose of a mortgage is to give the mortgagee (the lender) something to “look to” (to collect) if the mortgagor (borrower) cannot pay back the loan. In most jurisdictions, the lender can first go after and get a judgment against the borrower personally and then foreclose on the property when and if the borrower does not satisfy the judgment. If the mortgagee forecloses on the mortgage and collects the real property and that still does not satisfy the debt, then the mortgagee can obtain a “deficiency” judgment against the borrower.

The first thing to note about a foreclosure is that it must be sanctioned by a court. “Self-help” foreclosures are strictly forbidden in virtually all jurisdictions.

Once a mortgaged property is foreclosed on by the mortgagee, the property is put up for sale by a local official (e.g. a sheriff). The proceeds of the sale are then used to pay off debts in the following order:

1. Attorney fees and costs involved in the foreclosure
2. The debts owed to the mortgagee(s)
3. Any remaining proceeds go to the mortgagor

Order of Preference Among Mortgagees:

As we discussed earlier, the general rule in any foreclosure is that the first mortgagee has preference over subsequent mortgagees. One caveat to this rule is that a mortgage must be recorded to get this preference. A mortgage that was recorded first has preference over a mortgage that was recorded later, regardless of which one was actually agreed to first. An exception to this rule of priority is the “purchase money mortgage” (a mortgage loan whose funds are used to buy the mortgaged property). The holder of a purchase money mortgage inherently has priority over other mortgagees, even previous ones. For example:

John borrows money from Linda. As collateral for the loan, John pledges any real property he acquires in the future as collateral for that loan. One year later, John buys Blackacre from Terry. In order to obtain the funds necessary to make such a purchase, he takes out a loan from Monolithic Monster Bank and gives Monolithic a mortgage interest in Blackacre. Even though Linda’s mortgage was executed before Monolithic’s mortgage, Monolithic will have priority because its mortgage is a purchase money mortgage.

A foreclosure action can be brought by any mortgagee in the property, even if there are other mortgages on the property with a higher preference. However, any foreclosure that results from such an action will not affect any mortgages of superior preference. For example:

Apple Bank has a mortgage on Blackacre, owned by Jerry, which was recorded on January 1, 2013. Baker Bank has a mortgage on Blackacre that was recorded on June 1, 2013. The mortgagor defaults on Baker’s mortgage loan and so Baker forecloses. At the foreclosure sale, Mike buys Blackacre. The money from the purchase goes to pay off Baker’s loan. However, Apple’s mortgage on Blackacre will not be affected. In other words, Mike’s possession of Blackacre will be subject to the mortgage held by Apple. If Jerry defaults on his loan to Apple, Apple can foreclose on Blackacre, even though Mike now owns it. Obviously, at any foreclosure sale, therefore, a buyer must be very careful to determine whether there are any superior mortgages on a property before he buys the property.

On the other hand, if there is a foreclosure, all mortgages that are inferior in preference to the foreclosing mortgage are automatically extinguished. Thus, the proceeds of any such foreclosure sales are distributed, if there is enough money left after satisfying the debt of the foreclosing mortgagee, to the mortgagees with inferior mortgages. None of the foreclosure sale revenue is distributed to those with superior mortgages, because the superior mortgage stays intact in any case.

See Valentine v. Portland Timber & Land Holding Co., 15 Wn. App. 124 (1976).

As you can tell, these rules are very complicated. Let’s look at a couple of examples to see if we can simplify things just a bit:

1. Apple Bank has a mortgage of $100,000 on Blackacre, owned by Jerry, which was recorded on January 1, 2013. Baker Bank has a mortgage on Blackacre of $200,000 that was recorded on June 1, 2013. Cedar Bank has a mortgage on Blackacre of $300,000 that was recorded on August 1, 2013. Dutch Bank has a mortgage on Blackacre of $400,000 that was recorded on October 1, 2013.
   On November 1, 2013, Baker brings a foreclosure action against Blackacre. Blackacre is sold at a foreclosure sale to Mike. After costs and attorney fees, the sale nets $1,000,000. Since Baker foreclosed, its debt gets paid first. Next would come Cedar, followed by Dutch. Since there is plenty of money in the revenues generated by the sale, Baker, Cedar and Dutch will all have their debts paid in full. There will be $100,000 remaining after Baker, Cedar and Dutch get paid off, and this money will go to Jerry, the mortgagor. Apple does not get paid off, but its mortgage also does not become extinguished. Therefore, Apple still holds a $100,000 mortgage on Blackacre, even though Mike now owns it.
2. Suppose that, in the above case, the foreclosure sale to Mike only netted $300,000. Since Baker foreclosed, its debt gets paid first. So, the first $200,000 goes to Baker. Next comes Cedar. However, there is only $100,000 left for Cedar. Therefore, Cedar collects the $100,000 and the rest of its mortgage is extinguished. Dutch gets no money and its mortgage is extinguished. (Of course, Cedar and Dutch can bring deficiency actions against Jerry for the balance of Jerry’s debts.) Apple’s mortgage, on the other hand, is not affected at all. It still has a $100,000 mortgage on Blackacre, even though Mike now owns it.

Redemption

Finally, many states allow a mortgagor who has had his or her property foreclosed, to “redeem” the property by paying off all the mortgage loan debts plus interest and costs. In some states, this right of redemption only lasts until the foreclosure sale is completed. Other states allow the mortgagor a period of time(usually six months or a year) after the foreclosure sale to exercise his or her right of redemption.