What Is a Defeasance Clause?
A defeasance clause is a provision in some mortgage contracts indicating that the borrower will receive the title to the property once all of the mortgage payments have been made.
- A defeasance clause in a mortgage provides for the borrower to receive the title to the property once the mortgage has been paid off in full.
- Defeasance clauses apply only in states where the mortgage laws follow “title theory.”
- In states that follow either “lien theory” or “intermediate theory,” the borrower holds title to the property from the outset of the loan, although the lender may foreclose on the property if the borrower defaults.
How a Defeasance Clause Works in Real Estate
In a typical mortgage loan, the home or other property serves as collateral. That allows the lender to recoup its money if the borrower defaults on the loan.
States differ in how that process works. In states that follow “lien theory,” the borrower holds title to the property, but the lender holds a lien on the property and can foreclose on it if the borrower defaults. In states that follow what’s known as “intermediate theory,” the borrower also holds title to the property, but the title reverts to the lender in the event of a default.
The remaining states follow “title theory,” in which the lender retains the title to the property until the mortgage is paid off. In states where the lender still holds the title, the mortgage contract is likely to contain a defeasance clause. Defeasance clauses are based on the concept of defeasance, which nullifies a deed or contract.
The states that subscribe to title theory are Alaska, Arizona, California, Colorado, Georgia, Idaho, Mississippi, Missouri, Nebraska, Nevada, North Carolina, Oregon, South Dakota, Tennessee, Texas, Utah, Virginia, Washington, West Virginia, and Wyoming, as well as Washington, D.C.
Ultimately, defeasance occurs when the borrower finishes making all of the payments on the loan and no longer owes anything to the lender.
Alternative Uses for a Defeasance Clause
In some situations, defeasance clauses may also be used for transferring alternative collateral. Specifically, the borrower could provide other assets to replace the real estate as collateral at some point during the loan.
This type of defeasance clause could make it possible for the borrower to obtain ownership of the property’s title before the end of the loan by supplying sufficient alternative collateral. The alternative collateral could include investment assets or other property.
Defeasance Clause Exceptions
As mentioned earlier, states that follow title theory allow a lender to hold title to a property until the mortgage has been fully paid off. At that point, the lender can release the deed to the borrower as prescribed in the mortgage contract’s defeasance clause. Currently, 20 states plus the District of Columbia, listed above, follow title theory.
The remaining 30 states are exceptions. In those states, mortgage contracts simply come to an end when all of the payments have been made and will not include a defeasance clause.