If you’ve ever signed for a loan against your home in California, you probably signed a Deed of Trust (DOT). We look at Deeds of Trust in detail. What is a deed of trust, how does it work, and how they’re different from mortgages.
What is a Deed of Trust?
Deeds of Trust, Trust Deeds or DOTs, are used to protect a third party’s interest in real estate. These parties are not the owner, but have some kind of financial interest in the home. Most often, Deeds of Trusts are used to protect a lender who loans money to you to buy a home. Your home, becomes the collateral that protects the lender should you fail to meet your loan obligations. When you sign for the loan, you also sign a Deed of Trust that says if you don’t pay back your loan, the lender can foreclose on the home to recover their money.
However, a trust deed doesn’t always have to be for the purchase of a home. Home Equity Lines of Credit or HELOC’s are also protected by a Deed of Trust. Sometimes, other interests are also protected by DOTs. For example, if someone has an option or First Right of Refusal to purchase a piece of property, they may use a Deed of Trust to let the public know that they have these options.
Who is the Trustee of the Trust?
Giving someone the power to foreclose on your home is a big risk. You can just imagine the idea of an evil loan officer who loans you money with the sole intent of foreclosing so the bank can own your property. During the Great Recession, I suspect many people were under that impression. However, a DOT helps protect you from evil lenders.
Equitable versus legal title
There are two forms of ownership, equitable and legal. Legal title means you technically own the real estate. Equitable title means you have the right to live in and use the property for your enjoyment. If you are a tenant in a rental, your landlord has legal title. As a tenant, you have equitable title. If you buy house with your own cash, you have both legal and equitable title to the home. To understand Deeds of Trust, it’s important to realize that legal title can be separated from equitable title just like being a tenant.
Deeds of Trust assign legal title to a third party
When you sign a Deed of Trust, you are giving legal title to a neutral third party, called a trustee, until you have fully repaid your loan. You still retain the equitable title, but you assign or deed the legal title to the trustee. Hence the name, Deed of Trust.
Typically, the trustee is the title company you signed closing documents with. The title company prepares the DOT as part of their process of guaranteeing your title to the property is clean of defects.
It’s important to understand, that your name is still on title as the owner, and that you have still have equitable title even with a Deed of Trust. However, the DOT is recorded in the public records along with your purchase and identifies the trustee. When your loan is paid off, the Deed of Trust is cancelled by a Reconveyance (see below) and you are given full legal and equitable title to your property.
Where is Deed of Trust recorded?
For a Deed of Trust to be found by a title company, it has to be recorded in public records in the county where the property is located.
How is a Deed of Trust Different from a Mortgage?
The word mortgage, is an Old French word meaning “death pledge“. The mortgage is said to die, when loan is paid back in full. Of course, some might argue that it really means they’ll have a mortgage until they die.
Many people think that Deeds of Trust are the same as a mortgage. While both protect a lender, a mortgage doesn’t typically involve a third party trustee. With a mortgage, the borrower gives legal title directly to the lender. However, a Deed of Trust always involves a third party trustee.
When you sign a mortgage, you are giving the lender legal title or a lien against your property, until the loan is repaid. Because there is no neutral third party like a DOT, mortgages typically require a judicial foreclosure process before the lender can foreclose.
States that use Deeds of Trust
Different states use different documents to secure real estate loans. These states are considered either mortgage states or Deed of Trust states. Mortgages are far more common, so we’ll list the few Deed of Trust exceptions:
- District of Columbia
- North Carolina
- West Virginia
The above states use Deeds of Trust. The rest, other than Georgia, use mortgages as their primary loan security instruments.
Georgia has a completely different form for loans against real estate, referred to as a Security Deed.
What happens when your loan is paid off?
When a loan is paid off, the trustee of the Deed of Trust issues a Reconveyance conveying legal title back to the borrower. In effect it states that the loan has been repaid and that the DOT no longer has any authority. The reconveyance is also recorded on public record in order to cancel out the recorded Deed of Trust.
One of the processes your title company does when they issue you title insurance for your property purchase, is to make sure every DOT recorded in the public records, has a matching reconveyance. If your title company were to find a DOT without a reconveyance, then you would be buying the property subject to the existing loan and would become responsible for the existing loan.
One of the challenges that arose during the Great Recession was missing reconveyances. During the run up to the Recession, there were lots of low quality title companies that failed to record reconveyances when loans were paid off or homes refinanced. When the Recession hit, many of these companies closed up shop without recording the reconveyances. The result was that some properties became difficult to obtain title insurance for because of the missing reconveyances
Deeds of Trust have priority based upon their recording date. Let’s assume you have a home loan for $200,000 and equity line of credit for $25,000. If you were to default on your loan and your house sold at auction, the first recorded Deed of Trust would have to be paid before the second recorded Deed of Trust. Normally, this would mean your home loan must be paid before the line of credit because it would probably have been recorded first.
We refer to this as the position of the Deed of Trust. Your purchase money loan is in first position, while the line of credit would be in second position.
Second Deeds of Trust
However, let’s assume you refinanced your primary home loan sometime after you took out your equity line of credit. Your new loan requires a new DOT. If we record the new Deed of Trust, it’s recording date would be later than the line of credit, changing the primary home loan to second position. It would be subordinate to the line of credit due to the recording date. We call this a second deed of trust, or simply a second.
Since lenders prefer first position in case of foreclosure, the lender who is refinancing the $200K loan will send a subordination agreement to lender of your line of credit DOT. The primary lender will explain that they are currently in a superior position on title, but that they are refinancing your home and ask the subordinate position lender to agree to be in a subordinate position to the new loan.
Since the loan is just a refinance and nothing is changing in the loan amount, the bank holding the line of credit will probably sign the subordination agreement and maintain the status quo. However, if the loan terms change significantly, the subordinate lender may choose not to sign the agreement.
Second position trust deeds and foreclosure
During the Recession, when many home owners were under water and trying to sell their homes for less than they owed, they were forced to do short sales. During the short sale process, the seller’s real estate agent would attempt to negotiate with the both the first and second deed of trust lenders. For the short sale process to work, all of the lenders would have to be willing to accept an amount short of the total loan due, hence the name short sale. Often the second or even third position lenders would only receive pennies on the dollar for their original loan.
Isn’t this fun? Now you see why we hire title companies and attorneys to figure all of this out for us.
Can my Deed of Trust be sold?
When you borrowed the money to buy your home, you may have gone to your local bank where you do business. While your bank may have the money to do a few loans, it probably doesn’t have the funds to do them indefinitely.
If your bank runs low on funds to loan on houses, they have to sell your loan to another lender in order to have more funds to loan. Unless your bank is a small community bank, it probably sells it’s loans to other banks on what is known as the secondary market. The secondary market is made up of larger banks, wall street companies, hedge funds, and even the government.
While it’s easier to understand if you think of the secondary market as buying your loan, they are really buying your Deed of Trust. These Deeds of Trust get gathered up and bundled with other loans, totaling millions of dollars. The secondary market may split your loan up across several other loans to “balance” their risk. Imagine a large hedge fund who buys several high risk loans and several low risk loans. They may mix all of these loans into a large pot and then sell off slices, called “tranches” to other investors in an effort to balance their risk. This was part of the problem with the Great Recession. When the mix of high risk Deeds of Trust were added to just a few quality Deeds of Trust, investors lost millions of dollars when the high risk loans defaulted.
When a trust deed is sold, the lender has to sign an Assignment of Trust deed. This document is recorded in the public records and tells the general public that there’s a new lender who owns the Deed of Trust. While lenders can freely buy and sell the loans, it requires a special Assignment of Trust deed to transfer the Deed of Trust to the new lender. It’s important to remember, that without the Deed of Trust, a lender cannot foreclose on a defaulted loan.
Mom and pop buyers of Deeds of Trust
Not every lender is bank or corporation. Have ever seen a house offered with owner financing? The seller more than likely also required a mortgage and a DOT. There’s lots of people collecting monthly interest income from properties they have sold and carried the financing.
There’s also plenty of buyers of these notes. All you have to do is look in your local want ads to find small mom and pop investors advertising “We buy notes” or “We buy Deeds of Trust”. These trust deeds are sold al of the time. If you are the lender, called the beneficiary, for a loan chances are you’ve seen or even called some of these ads. Many investors buy these mortgages from other private parties for additional monthly income.