The difference between a mortgage and deed of trust (aka “trust deed) is subtle. Both are used in bank and private loans, create liens on real estate, and are considered, by law, evidence of a debt as they are generally recorded in the county in which the property is located. Hard money lenders tend to operate more in trust deed states because the foreclosure laws are more flexible.
Here's the scoop
Both documents, a mortgage and a trust deed, use real estate to secure repayment of a loan. The difference between the two documents relates to the number of parties involved in the lien transaction, the name of the documents, and the method of foreclosure that is used if the underlying debt is not paid per the terms of the loan agreement. In most states, law dictates whether a mortgage or a trust deed is recorded, but some states permit either document to be used.
Before diving into the differences between the mortgage and deed of trust, let’s first define a promissory note (sometimes referred to as just a “note”) and understand its role in relation to borrowing real estate.
Simply put, a promissory note is a promise to pay a debt at agreed upon terms. A promissory note is generally not recorded and contains details about the loan such as the maturity date, interest rate (i.e. fixed, variable, etc), payment amount, and frequency. A promissory note itself is not secured by the real estate. In order to secure repayment of the promissory note with real estate, a lender uses either a mortgage or deed of trust which are also sometimes referred to as “security documents” because they secure the promissory note to the real estate to create a permanent record in the county in which the real property is located. This recorded document puts the public on notice and creates “notice of the lien” to anyone who may have reason to research title to the property.
There are two primary distinctions between a mortgage and a trust deed:
- the number of parties involved in the transaction, and
- the procedure for enforcing the lien via foreclosure.
Number of Parties
A mortgage involves two parties: a Borrower (the Mortgagor) and a Lender (the Mortgagee)
A trust deed involves three parties: a Borrower (the Trustor), a Lender (the Beneficiary), and the title company, escrow company, or bank (the Trustee) that holds title to the lien for the benefit of the lender and whose sole function is to initiate and complete the foreclosure process at the request of the lender.
A mortgage is enforced by a court supervised foreclosure process which is known as a judicial foreclosure and the process includes the lender filing a lawsuit against the borrower.
A trust deed gives the lender (i.e. banks or hard money lenders) the option to bypass the court system by following the procedures outlined in the trust deed and applicable state law. This is called a non-judicial foreclosure or trustee’s sale. If the trustee conducts a foreclosure sale, title is conveyed from the trustee to the new owner via a document called a Trustee’s Deed. If there are no bidders at the trustee sale, the property reverts back to the beneficiary (lender) and title is still transferred from the trustee to the lender using the Trustee’s Deed.
This process requires the lender to file a lawsuit in order to obtain a judgment. It is time consuming and expensive, but it does have an added benefit for the lender. If the lender doesn’t get enough money from the foreclosure auction to pay off the note, they can sue the borrower(s) for the remaining balance owed -known as a deficiency judgment. In some states, even if a trust deed was used as the security instrument, lenders can elect to do a judicial foreclosure to preserve the option of a deficiency judgment. Hard money lenders prefer a non-judicial process which is why more private loans are originated in trust deed states as they are friendlier to private money lending.
A judicial foreclosure also provides a “right of redemption” to the borrower even after the property is sold at auction. This allows the borrower to repay the lender after the foreclosure sale, within a certain time frame (which varies by state), and thus reacquire title to the property.
This is becoming the most common process for foreclosure because it is faster and less expensive. Many states that, in the past, have been “mortgage” states now recently passed laws that allow for the use of trust deeds. With a non-judicial procedure, the lender issues proper notice(s) and follows certain rules. Then, if the borrower doesn’t bring the loan current, the property goes to a trustee’s sale. Unlike a judicial foreclosure, once the property is sold, the borrower has no right of redemption.
While the lender and/or state law will ultimately determine which security instrument is used to secure a loan, it is important for a prospective borrower to understand what he/she is signing, their rights as the borrower, and what the exact procedures are in the state where the property is located.