Mortgages & Foreclosure — Real Property

A Columbia house carries a first mortgage held by Bank A and a later second mortgage held by Bank B. The borrower defaults on both. There is a foreclosure sale, and a buyer takes the house. Does she own it free of both mortgages?

You cannot answer that yet, and neither can most candidates. It depends entirely on which bank was foreclosing. If Bank A forecloses, she takes free of Bank B. If Bank B forecloses, she takes the house still carrying Bank A's whole loan. One fact, two completely different purchases. Almost every question in this topic is that same puzzle wearing a story.

Here is the route. First, what a mortgage actually is, and the two special kinds the exam likes, purchase-money and future-advance. Then the three mortgage theories, which is the one starred piece here. Then foreclosure itself, judicial and out of court, and acceleration. Then priorities, which decide most questions. And finally the money, and the borrower's two escape hatches.

Start with the thing itself. A home loan is really two documents. The promissory note is the borrower's personal promise to repay. The mortgage is the security, a lien on the land so the note can be collected out of the property on default.

Keep the roles straight. The borrower who grants the mortgage is the mortgagor. The lender who holds it is the mortgagee. The hook is that the mortgagor goes into debt.

And because the mortgage exists only to secure the note, the two travel together. The mortgage follows the note. Whoever owns the note automatically owns the mortgage backing it, even if nobody signs a separate assignment.

Dana borrows $300,000, signing a note and a mortgage. Two years later the bank sells the loan and hands over the note, but the paperwork assigning the mortgage gets lost. Does the new lender hold the mortgage? Yes. Owning the note carries the security with it.

Two variations to recognize. First, the deed of trust, which many states use instead. Same job, three parties. The borrower conveys the land to a neutral trustee to hold for the lender. Its magic ingredient is a power of sale, letting the trustee sell on default without a court. Otherwise treat it as a mortgage.

Second, disguised mortgages. A borrower deeds land outright to a lender as collateral, and courts call it an equitable mortgage, so she keeps every protection. Same instinct with an installment land contract, where a missed payment supposedly forfeits the land and everything paid. Many modern courts make the seller foreclose instead.

Now the first special kind. A purchase-money mortgage is one given to buy the very property it encumbers. Either a loan whose money actually buys the land, or seller financing, where the seller takes back a mortgage for part of the price.

What makes it special is a super-priority. It jumps ahead of claims against the buyer that would otherwise come first in time. The reason is intuitive. She took title and gave the mortgage in the same instant, so earlier claims against her never had a moment to attach.

Watch it work. Before Marco buys anything, a creditor wins a $40,000 judgment against him and records it, making it a lien on any land he later acquires. Marco then buys a house with a bank loan and gives the bank a mortgage. Which comes first? The bank. Marco took title already encumbered, and this holds even if the mortgage is recorded late.

Two footnotes. Under the majority rule, seller beats outside lender when both take purchase-money mortgages on the same purchase. And a later bona fide purchaser can still cut off an unrecorded one, so record immediately.

The second special kind is the future-advance mortgage. It secures money the lender may hand over later, like a construction loan drawn in stages. One mortgage, often with a dragnet clause, backs the whole balance.

The tested question is priority. If a second lender records a lien before the first lender advances more money, whose claim covers that later advance? It turns on whether the advance was obligatory or optional.

Obligatory advances, ones the lender is committed to make, relate back to the recording date and beat the intervening lien. Optional advances keep that priority only until the lender has notice, and an optional advance made after that falls behind.

So a bank agrees to advance $500,000 in five draws. After the third, a supplier records a mechanic's lien and the bank gets actual notice. Obligatory draws still outrank the supplier. Optional ones now fall behind. Same money, opposite priority.

Now the one starred piece here, so learn it cold. States disagree about what a mortgage technically transfers, and that decides two concrete things. Whether the lender can possess before foreclosure, and whether one co-owner's mortgage breaks a joint tenancy.

Three theories. Most states follow the lien theory. The mortgage is only a lien, so the borrower keeps title and possession until a foreclosure sale actually happens. A minority follow the title theory, where the lender holds legal title, and possession, until the debt is paid. A few follow the intermediate theory. Lien theory until default, then possession shifts.

Test it. Two joint tenants own a house with a right of survivorship, and one mortgages only her own interest. Does that sever the joint tenancy? In a lien-theory state, no. The mortgage transfers no title. If she dies first the survivor takes the whole property, and the lien may vanish with it. In a title-theory state, yes, because the mortgage is treated as a transfer of title.

Same act, opposite result. Memorize the majority. Lien theory. The borrower keeps title and possession until the sale, and one joint tenant's mortgage does not sever.

One more question before the sale. A borrower can sell the house with the loan still on it, and how the buyer takes it decides who is personally liable. Take it subject to the mortgage and the buyer promises nothing. She is not personally liable, but the land still carries the lien.

Assume the mortgage and she promises to pay, so the lender can pursue her for a deficiency. The original borrower stays liable too, unless released in a novation. And no transfer ever strips the lender's lien. The mortgage stays with the land.

Foreclosure is how the lender turns its lien into cash. The land is sold, the debt is paid from the proceeds, and the sale is the moment the borrower's equity of redemption is finally cut off.

Two routes. Judicial foreclosure runs through a lawsuit, a decree, and a court-supervised sale, and is available in every state. Nonjudicial foreclosure lets the trustee sell out of court under a power of sale. Faster and cheaper, but only where that power exists, and strict statutory notice applies. Defects can void the sale.

The borrower can fight it. That the debt was paid. That there was no real default. That the mortgage was procured by fraud. That the lender botched the notices. Many states also give a right to cure by paying the overdue amount, not the whole loan.

Which brings up acceleration. Loans are repaid in installments, so without a clause a default lets the lender collect only the missed payments. An acceleration clause makes the whole balance immediately due, so the lender forecloses once for the entire debt.

Priya owes $200,000 and misses one $1,500 payment. With acceleration, the bank declares the full $200,000 due and forecloses on all of it. Without it, the bank chases $1,500. Courts in equity can refuse acceleration triggered by the lender's own bad faith. And note the knock-on effect. To redeem, the borrower must now pay the whole accelerated balance.

Now priorities, which decide most questions here. The baseline is first in time, first in right. But recording acts rearrange that line, because a mortgagee gives value and counts as a protected purchaser. So the real order is first in time, as adjusted by the recording act.

And here is the single most tested foreclosure rule. Foreclosure wipes out every interest junior to the foreclosing lien. Junior mortgages, later judgment liens, leases and easements created after it. The buyer takes free of all of them. But foreclosure does not touch senior interests. The buyer takes subject to any lien that outranked the foreclosing one.

Which answers our opening. Bank A forecloses, Bank B's second mortgage is junior, so it is extinguished from the land. The buyer takes free of it, and Bank B's claim shifts to any surplus. Flip it. Bank B forecloses, and Bank A's senior mortgage rides through untouched. The buyer takes the house still carrying Bank A's loan.

So always ask which lien is foreclosing, then sort every other interest into above it, which survives, or below it, which dies.

One critical qualifier. To wipe out a junior, the foreclosing lender must name it as a party, or give it the statutory notice. Juniors are necessary parties. Leave one out and its interest survives as if the foreclosure never happened, and the purchaser takes subject to it. Seniors need not be joined, because they survive regardless.

A few doctrines shuffle the line. An unrecorded senior can be subordinated to a later bona fide purchaser. A senior can agree to let a junior go first, because priority is tradeable. And equitable subrogation. A refinancing lender whose money pays off an existing senior steps into that senior's first place, up to the amount used to pay it off.

Otherwise an intervening junior would get a windfall promotion. And a senior may modify its own loan and keep first priority, except where the change materially prejudices juniors. Extending maturity is fine. Raising the principal or rate subordinates it only for the increase.

Now the money. Once the property sells, the proceeds run a fixed waterfall. First, the expenses of sale. Second, the foreclosing lien in full. Third, any liens junior to it, in order of priority. And whatever is left, the surplus, goes to the borrower. She is last for the same reason she is the owner.

If the sale brings less than the debt, the shortfall is a deficiency. The lender can normally sue the borrower personally on the note, which was always a promise separate from the land. Anyone who assumed the loan can be pursued. A buyer who took only subject to cannot.

But many states limit deficiencies. Some forbid one after a power-of-sale foreclosure. Some bar it on purchase-money home loans. And many use a fair-value rule, capping it at the debt minus fair market value rather than a lowball sale price.

Because this topic is unstarred, expect the exam to hand you that statute. Work the numbers. Debt of $300,000, fair market value of $260,000, and the house sells for only $210,000. The raw shortfall is $90,000, but the statute measures against fair value. The lender recovers $40,000. The other $50,000 is the lender's problem.

Last, the borrower's two escape hatches, and do not confuse them. Equitable redemption comes first, and exists in every state. Any time before the sale, the borrower can pay the full accelerated debt plus interest and costs and take the land back free of the mortgage.

It is so fundamental that she cannot waive it in the mortgage itself. Any clause cutting off the equity of redemption in advance is an illegal clog, and void. She can later give that right to the lender in a separate, arm's-length deal, a deed in lieu of foreclosure. What she cannot do is sign it away at the outset.

The second hatch is statutory redemption, granted by about half the states, and it operates after the sale. For a window fixed by statute, often six months to a year, the former owner can buy the property back. Usually by paying the sale price rather than the full debt, and often she keeps possession meanwhile.

Test it. A statute gives six months and requires paying the purchaser the sale price plus interest. A house sells at foreclosure for $250,000. Four months later the former owner comes into money. What does she pay? The sale price. $250,000 plus interest, not the larger loan balance. Read any redemption statute for three things. How long the window is, what must be paid, and whether the owner keeps possession.

A word on authorities. This episode named no cases, and that was deliberate. The exam gives you a fact pattern and asks what result the rule produces. It will not ask for case names. Where a modern rule is unsettled, the notes follow the Restatement (Third) of Property: Mortgages. And because this topic is unstarred, expect provided statutes.

If you keep only three things, keep these. Juniors below the foreclosing lien die and seniors above it survive, because that decides most questions. Lien theory is the majority, because that is the starred sub-part. And the two redemptions, because equitable pays the debt and statutory pays the sale price.

Now the traps, straight from the examiners' favorites. One, priority direction. Foreclosure destroys interests junior to the foreclosing lien and leaves senior interests standing. The buyer takes subject to seniors and free of juniors. Two, the omitted junior. A junior not joined or notified is not wiped out, and its lien survives the sale.

Three, purchase-money super-priority beats a prior judgment lien against the buyer, even if recorded late. Four, the two redemptions. Equitable is before the sale and pays the debt. Statutory is after the sale and pays the sale price. Five, anti-clogging. A borrower can never waive the equity of redemption in the mortgage itself.

Six, a deed of trust means nonjudicial foreclosure through a power of sale. Otherwise treat it as a mortgage. Seven, deficiency depends on the note, so anti-deficiency statutes and fair-value caps can shrink or bar it. Apply the provided statute rather than assuming full recovery.

And eight, in a lien-theory state one joint tenant's mortgage does not sever the joint tenancy. That is the starred point hiding inside a cotenancy fact pattern.

Time for the quick check, and this one comes straight from the BARGO question bank. A parcel carries a first mortgage and a later second mortgage, both properly recorded. The first mortgagee forecloses after default but, through an oversight, never names or serves the second mortgagee in the judicial action. The property sells to a purchaser who believed the sale wiped out all junior liens.

The second mortgagee, left out entirely, now says its lien still encumbers the property. What is the effect of the foreclosure on that omitted second mortgage? Option one. It was extinguished anyway, because recording gave notice to all. Option two. It survived, but only as a personal claim against the foreclosing lender. Option three. It survived the sale, because the junior was a necessary party and was omitted. Pause here if you want a moment.

The answer is option three. To extinguish a junior interest, the foreclosing lender must join it as a party, or give it the required statutory notice. Juniors are necessary parties. A junior left out is not wiped out. Its lien survives the sale as if the foreclosure never happened, and the purchaser takes subject to it.

Option one misuses recording. The second mortgagee's own recording protects its priority. It does not excuse the foreclosing lender from joining it. Option two mischaracterizes what survived. The lien still burdens the land, and the omitted junior can foreclose or redeem. There are thirty-plus more questions on this topic alone, each option explained like that.

Five things to take away. One. The mortgage follows the note, so owning the debt carries the security. Two. A purchase-money mortgage jumps ahead of earlier claims against the buyer, because she never held clear title for an instant.

Three. Lien theory is the majority. The borrower keeps title and possession until the sale, and one joint tenant's mortgage does not sever the joint tenancy. Four. Ask which lien is foreclosing, then sort. Below it dies, above it survives, unless a junior was never joined, in which case it lives.

Five. Money runs downhill. Costs, the foreclosing lien, juniors in order, then the surplus to the borrower. And the two redemptions differ. Equitable comes before the sale and pays the debt. Statutory comes after and pays the sale price.

Which is why our buyer needs to know one thing before she bids. Not what the house is worth, but which bank brought the sale. Next time, Adverse Possession and Deeds.

Practice this topic with more than 2,900 exam-style questions, free to start, at nextgenbargo.com. This episode is for education and exam preparation only, not legal advice, and we are not affiliated with or endorsed by the NCBE or any bar examining authority.