Defeasance clause explained: how it affects borrowers

A defeasance clause is one of the most critical parts of a mortgage document, particularly in title theory states. It ensures that the borrowers gain full rights over their property once they have satisfied all the loan conditions. The defeasance clauses play an equally important role in commercial real estate, as they offer flexibility for refinancing or early loan payoff.

Let’s define defeasance in real estate, then take a closer look at the details and the theories behind them. We will also go over their uses in residential and commercial real estate.

What is a mortgage defeasance clause?

A defeasance clause in real estate is a provision in a mortgage contract. It guarantees the borrower (mortgagor) will gain full ownership of the property once all loan obligations are satisfied. Those loan obligations include principal and interest payments.

It implies that the lender (mortgagee) retains the title to the property until the borrower fulfills their financial obligations. Upon repayment, the defeasance clause requires the lender to transfer the title to the borrower, clearing any claim on the property.

For example, if a borrower pays off their mortgage on a home in a title-theory state, the defeasance clause ensures they receive full ownership without additional hurdles.

Defeasance clause in title theory vs. lien theory vs. intermediate theory states

Understanding lien theory, title theory, and intermediate theory states is key to grasping how defeasance clauses in real estate work.

• Title theory: In these states, the lender retains legal ownership of the property until the borrower pays off the loan. The borrower has equitable title, allowing them to use the property. The states following the title theory include Alaska, Arizona, California, Colorado, and others. A defeasance clause is typically included in title theory states to ensure the transfer of ownership after loan repayment.
• Lien theory: Here, the borrower retains legal ownership of the property from the start. The lender places a lien on the property as collateral, which they can enforce if the borrower defaults. States like Florida, New York, and Illinois follow the lien theory. Defeasance clauses are not typically included in these states.
• Intermediate theory: This approach combines aspects of both. The borrower holds the title unless they default, at this point, the lender gains legal ownership without requiring judicial proceedings. States like Michigan, Massachusetts, and Vermont follow this theory.

How does a defeasance clause work?

A defeasance clause becomes operative at the close of the loan term or when the borrower fully paid the loan, inclusive of interest. This clause ensures the lender that he loses any legal claim over the property and thus the property is freed from being a collateral.

Here’s how it works in practice:

1. Initial loan agreement: The lender holds the property title while the borrower pays off the loan.
2. Loan fulfillment: Once the borrower satisfies all payment conditions, the defeasance clause nullifies the lender’s claim.
3. Title transfer: The borrower gains full ownership, free of liens or encumbrances.

This process highlights the importance of understanding state laws, as defeasance clauses primarily apply in title-theory states.

Commercial real estate and the defeasance clause

Defeasance clauses are not limited to residential mortgages; they also apply to commercial mortgages. In commercial real estate, they often play a significant role in securitized loans, such as those tied to mortgage-backed securities (MBS).

When a borrower wants to pay off a commercial loan early, they may encounter penalties. However, defeasance offers an alternative by allowing borrowers to replace the property collateral with other securities, like government bonds. This ensures that the lender or investors continue to receive steady returns while the borrower gains flexibility.

For example, a commercial property owner may invoke the defeasance clause to refinance or sell their property without breaking the loan agreement.

Defeasance vs yield maintenance

Defeasance and yield maintenance are common methods to manage early loan payoff in commercial real estate.

• Yield maintenance: It is a type of prepayment penalty that allows investors to get the same yield as if the borrower made all scheduled interest payments up until the loan maturity date. It forces the borrower pays a premium to the lender, calculated as the present value of the remaining loan payments, adjusted for the difference between the loan’s interest rate and current Treasury yields. The main purpose is to compensate lenders for the loss of future interest income.
• Defeasance: The borrower replaces the property collateral with securities that provide equivalent income to the lender.

Cost comparison

• When Interest Rates Go Up: Both defeasance and yield maintenance cost less. Higher interest rates mean the borrower needs fewer replacement securities, or they pay a smaller premium.
• When Interest Rates Go Down: Costs increase for both options. Lower rates require more replacement securities for defeasance or higher premiums for yield maintenance.

The choice between the two depends on market conditions and the borrower’s financial goals.

Example in commercial real estate

Defeasance clauses are widely used in commercial real estate to address prepayment penalties in securitized loans.

For instance, a commercial property owner may want to pay off a loan early to sell or refinance the property. 

However, the loan terms include prepayment penalties due to bondholder obligations backed by the loan. Instead of paying the penalty, the borrower can use the defeasance clause to substitute the property collateral with securities like government bonds.

These securities will then match the remaining loan payments. It enables the lender to keep receiving returns, while the borrower gets the flexibility to do with the property as they wish.

Defeasance vs prepayment penalty clause

While defeasance and prepayment penalties both address early loan payoff, they function differently:

• Prepayment penalty: Borrowers pay a financial penalty for repaying a loan early, compensating lenders for lost interest.
• Defeasance: Borrowers replace the property as collateral with securities that provide equivalent income to the lender.

Defeasance is a little more complex but offers more flexibility, specifically in commercial real estate.

Practical example

Imagine that a fictional character named Samantha buys a house in a title-theory state and mortgages it with the First National Bank. The mortgage has a defeasance clause. Because of that the bank holds the legal title to the property during the loan term. Samantha makes regular payments over 30 years and at the end of that time has satisfied all the terms of the loan.

Thanks to the defeasance clause, the bank transfers the title to the property to Samantha, upon final payment, clearing the mortgage lien. Now Samantha owns her home outright.

Is a defeasance clause the same as a deed of release?

No, although they share similarities, defeasance clauses and deeds of release differ in scope.

• A defeasance clause applies specifically to mortgage agreements, detailing how the property title transfers to the borrower upon loan repayment.
• A deed of release can refer to the termination of any legal claim or agreement between two parties, not limited to mortgages.

They both signify the resolution of an agreement. But a defeasance clause is more precise in its application to real estate loans.

Do I need a defeasance clause if I’m selling my house?

Whether you need a defeasance clause depends on the laws in your state.

• In title theory states, a defeasance clause is standard, ensuring the lender transfers the title to the borrower upon repayment.
• In lien theory states, the lender places a lien on the property, and the borrower retains ownership throughout the loan term. Selling the house simply involves clearing the lien.

Check your mortgage agreement to understand your state’s requirements.

Wrapping-up

The defeasance clause is a vital provision that ensures borrowers receive full ownership of their property upon satisfying loan terms.

It bridges the gap between lenders’ interests and borrowers’ rights, offering clarity and security in real estate transactions.

Understanding defeasance clauses prepares real estate professionals and exam-takers to navigate title-theory nuances confidently. With knowledge of how these clauses work, you’ll excel in exams and real-world applications alike.

Ready to master real estate terms like this and pass your real estate exam with confidence? Start your journey with Lexawise today; your success starts here.