DEFEASANCE CLAUSE: Meaning And Overview

Defeasance Clause
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The defeasance clause is the idea of defeasance that exists to safeguard your interests as a homeowner or prospective buyer; it is a binding legal clause that stipulates that after you pay off the mortgage on the property, you will own it free and clear. In this post, we will explain what a defeasance clause is for real estate investors and the mortgage rate.

Defeasance Clause

When a series of payments, such as a mortgage, is made, the term “defeasance” is used to declare a contract condition null and void. It can also change the terms of the agreement, such as shifting the title from the lender to the borrower. The borrower can reserve money for loan repayments through defeasance accounts, which effectively eliminate the debt from their balance sheet.

A defeasance provision exists to safeguard you as the buyer. This is by guaranteeing that you will obtain complete ownership and management of the property after keeping your end of the deal and making your mortgage payments. These provisions are not, however, present in every mortgage contract. Defeasance clauses only exist in states that use title theory for mortgage law, as we’ll go into more depth about below.

How a Defeasance Clause Works

Mortgage law employs defeasance provisions to identify who holds the complete title to a property. New homeowners may actually feel as though they are the full owners of their properties since they are the ones who live there and make the decisions regarding property modifications. In the event of nonpayment, lenders technically still have the right to foreclose on the property and sell it to recover their losses.

Agreements pertaining to the purchase of real estate frequently contains more defeasance clause. When a loan is secured by a mortgage, the defeasance provision stipulates that the buyer will only receive the title to the property once the obligation has been settled in full (i.e., both principal and interest amounts). The lender holds this title until the date of repayment.

Depending on which state you reside in and whether it is a lien property or a title property, will determine exactly how foreclosure procedures progress. Defeasance provisions are useful in states that adhere to the title theory. We shall address more of this idea as we move forward. Your lender holds the title to your property in case you default on your mortgage loan, as long as there is still money owed on it. The defeasance provision, however, requires that you acquire the title to the property when you have fully returned the loan.

Exclusions to the Defeasance Clause

Due to the different real estate regulations and mortgage terminology used in each state, not all mortgage agreements will contain a defeasance clause.

Defeasance clauses are normally useful in states where the bank retains ownership of the home. Until they pay off the mortgage because they transfer title upon satisfaction of the loan. Title theory is useful in more than half of the states in the U.S., including:

  • From the Coast are Massachusetts, New Hampshire, and Washington, D.C.
  • South includes North Carolina, Tennessee, Texas, Virginia, West Virginia, Alabama, Georgia, Mississippi
  • The Midwest includes Idaho, Michigan, Minnesota, and Missouri.
  • Arizona, California, Colorado, Nebraska, Nevada, Oregon, South Dakota, Utah, Washington (state), and Wyoming are all located in the West.

The title theory state Alaska is also. The remaining states that we did not mention above adhere to the lien theory.

Advantages of Establishing Defeasance Accounts

#1. Makes Accounting Less Difficult

It eliminates the have to document every aspect of the aforementioned transactions. The complexity of accounting is reduced once the loan has been functionally eliminated from the borrower’s balance sheet.

#2. Lessens the Danger of Early Payment Penalties

Typically, if a borrower repays a loan before the agreed-upon date, particularly during the first five years, they are subject to a prepayment penalty. They impose fines to shield the investor from any future interest payment income losses.

On the basis of the outstanding mortgage balance, the borrower can assess the penalty. Therefore, they escape prepayment penalties by using the defeasance provision. These payments carry risk because prepayment models are frequently arbitrary.

#3. Keeps Interest Rates Low

In an economy where there is a high demand for interest rates in the future, deception is quite advantageous. It enables the borrower to avoid having to pay higher interest rates.

Disadvantages of Defeasance Accounts

#1. High Price

Defeasance accounting is incredibly difficult and calls for experienced accountants and attorneys. Because of this, it should only be pursued when the associated prepayment penalty outweighs the cost of the brokerage and consultation costs.

#2. Financial Demands

In order to replace the cost of the collateral that is being released as a result of removing the obligation from the balance sheet, the borrower must have sufficient capital.

What is an Alienation Clause?

When a borrower sells or transfers their home, the alienation clause in their mortgage contract provides rights to the mortgage lender. This right to demand immediate and complete repayment of the debt, including principal and interest. There can be a transfer of the buyer’s title to the property. But the provision stipulates that there has to be a payment for the remainder. This condition is also known as the “due-on-sale clause,” since the balance becomes due when the property is sold. This provision shall be applicable whether or not the sale or transfer is voluntary.

What is the Acceleration Clause?

A loan agreement’s “accelerated provision” specifies circumstances under which the borrower must repay the loan in full right away. An accelerated clause is often triggered when the borrower materially violates the terms of the loan arrangement.

For instance, if the borrower skips too many payments, the acceleration provision in most mortgages kicks in. Commercial and residential mortgages are the ones that typically have acceleration clauses. Some leases may also include them.

How Does Defeasance Compare to Maintaining Yield?

Borrowers have the option to release the underlying real estate asset through yield maintenance or defeasance clause. However, the two procedures are very dissimilar from a legal and economic standpoint. While defeasance involves the replacement of collateral and the formal absorption of the loan by the succeeding borrower, yield maintenance is the real prepayment of the loan.

The loan’s unpaid principal sum and a prepayment penalty make up a yield maintenance prepayment. The present value of the remaining loan payments, discounted at the current yield on the U.S. Treasury security maturing closest to the loan’s maturity date, is commonly used to calculate the prepayment penalty. The loan servicer pays a minor processing cost as the only transaction fee.

In contrast, the price of a portfolio of bonds that is adequate to cover the outstanding loan installments, along with transaction costs to various third parties, determines the cost of defeasance.

Ways to Buy the Defeasance Bonds

Normally, the funds from a refinance or sale of the property are vital to pay for the defeasance bonds.

The borrower may buy the bonds from any seller of securities, as long as the loan agreement permits it. Chatham has created an extremely successful auction procedure that ensures our clients will receive cost-effective pricing on the bond acquisition. Chatham runs the auction, making sure that every bid is fiercely competitive. Lastly, Chatham does not offer incentives to banks and is not a broker-dealer. We don’t get paid any fees, premiums, or profits for buying the bonds. Our sole concern is obtaining our clients the best deal possible.

What part does Chatham play in defeasance?

Chatham serves as the defeasance consultant for the borrower and is an impartial, professional advisor. He offers cost estimates and guides the borrower through the defeasance procedure. He coordinates with counterparties and makes sure the defeasance is carried out efficiently and affordably. Chatham may also buy the defeasance bonds and create the successor borrower organization. And this will take over the loan after closure if permitted by the loan agreements.

Defeasance consultants are the only parties with a thorough understanding of the entire procedure who also represent the borrower, making their position special. As a defeasance consultant, Chatham aims to make the process as simple as possible. This will make the clients concentrate on the underlying real estate transaction, in their defeasance clause.

What Does Defeasance’s Residual Value Entail, and Where Does it Come From?

Cash in the defeasance account that is not committed to paying the debt is known as residual value. Float value and prepayment value are the two different sources of residual value.

Over the course of the defeased loan’s remaining life, the float value grows progressively. It results from minute timing discrepancies between the inflow of cash from the bonds and the outflow of cash for loan repayment. Short-term deposits of money earn money market interest rates in the defeasance account. There is a float value transfer to the succeeding borrower when there is repayment of the loan in full at maturity.

Prepayment value develops when clauses in the loan contracts specify that the defeasance bonds must cover all outstanding loan payments up until the loan’s maturity date while still enabling the repayment of the loan to be early on the open prepayment date. On the early open prepayment date, the successor borrower will settle the principal balance of the discharged debt. There is a release of the remaining bonds in the defeasance account to the succeeding borrower. This is upon repayment of the loan, who then sells them right away on the market. The prepayment value is the difference between the sale price of the released bonds and the cost of repaying the discharged debt.

Defeasance Cost

Prepaid interest, yield maintenance or other prepayment premiums, legal, accounting, and consulting fees are directly attributable to the defeasance of debt. The write-off of deferred financing fees; servicer processing fees; custodial account fees; rating agency fees; and computed defeasance premium.

Defeasance Clause Real Estate

It’s crucial to comprehend secured title and secured mortgage ideas in order to fully comprehend defeasance.

A secured title is a property title that the lender holds as collateral for a loan. If the borrower does not pay back the loan, the lender has the authority to seize control of the asset and sell it to recoup its losses. Also, a secured mortgage is when there is a registration of a mortgage against the title of a property. This gives the lender a legal claim to the property in the event of a default.

A mortgage’s defeasance clause is crucial because it enables an early mortgage repayment without jeopardizing the borrower’s secured title or secured mortgage. This provision is crucial because it allows the borrower freedom to pay off their mortgage without incurring penalties if they are able to do so. For instance, if the borrower sells their property before the mortgage term is over, they might be able to pay off the loan early without incurring any costs.

A good tool for obtaining an understanding of what it means to have or not have a defeasance clause in a mortgage is theoretical examples.

What are the Additional Parties in a Defeasance Clause in Real Estate

#1. Loan Servicer 

The loan servicer requests an upfront deposit as well as a notification of defeasance. Official copies of the loan agreements and the loan amortization schedule are provided. They continue to service the loan after defeasance.

To represent them in the defeasance, the loan servicer hires a law firm. On behalf of the loan servicer, the lawyer creates the defeasance documents, gathers information for the due diligence process, and certifies certain components of the deal.

#3. Rating Agencies 

To avoid the downgrading of the securitization pool, rating agencies may examine significant defaults to ensure that it will not happen. There can be a delay in the defeasance process by up to 10 working days due to the rating agency review.

#4. Securities Intermediary 

The securities intermediary, also known as a custodian, is a bank that keeps the defeasance bonds in a limited account. And they sends the bond’s cash receipts to the loan servicer to settle the balance of the loan.

#5. Accountant

An independent CPA firm certifies in a report that the portfolio of defeasance bonds’ cash receipts will be sufficient to cover all outstanding loan payments.

#6. The Successor Borrower 

This is the setting up of a single-purpose, bankruptcy-remote LLC, to take over the borrower’s financial responsibility for the loan. While maintaining ownership of the defeasance bonds.

#7. Attorney for the Successor Borrower 

This attorney evaluates the defeasance documents and submits the necessary paperwork to establish the successor borrower entity.

#8. Title firm 

The same title business that handles the underlying refinance or sale also handles the title and escrow for the defeasance.

#9. Counsel for the Borrower 

Most borrowers retain legal counsel to evaluate the defeasance records and help them send back the necessary paperwork to the loan servicer.

Defeasance Clause in a Mortgage

A mortgagee who lent money to a mortgagor under early English common law was given a deed of a defeasible fee to the property in return. Which served as security for the obligation. When the debt was paid on the due date, or at its maturity, such a title was subject to defeat or cancellation.

At that point, the mortgagee would recover ownership of the property. If the mortgagee in a defeasance clause gained absolute ownership of the property if the mortgagor didn’t pay the obligation, even by a single day, at which point the mortgagee’s title changed to an estate in fee simple. These common-law principles that apply to this kind of mortgage agreement are embodied in a defeasance clause.

According to this condition, there will be a full repayment of the loan before you receive full title to the property you have a mortgage on.

Based on the lien theory, which is prevalent in most states, a defeasance clause is not common in a mortgage. The mortgage places the mortgagee’s name as a lienholder on the mortgaged property, reserving possession for the mortgagee only once the mortgage has been foreclosed. There is no requirement for a defeasance clause provision because the mortgage has not been granted the defeasible title.

How Defeasance Clause Works In A Mortgage

Defeasance is a legal term that states that you, the home buyer, will own the property outright and in full once the mortgage is paid off. It exists officially to safeguard your interests.

Once more, in defeasance clause how your state interprets mortgage theory, a component of real estate law, will depend on where you live.

Title Theory vs Lien Theory

States may have different real estate laws, but when it comes to mortgage law theory, they invariably fall into one of two categories: lien theory or title theory.

“Until there is a repayment of the loan, the bank retains ownership of the house” this is according to the “title hypothesis”.

According to the lien theory, when a buyer obtains a mortgage, the bank registers a property lien as a claim against the buyer’s ownership of the property.

In a state where there is a lien theory when a borrower signs a mortgage contract, they also sign a security deed. Thereby, giving the bank legal title to the property but keeping their equitable ownership. The equitable title simply implies the borrower has the right to possess the property for the life of the loan, barring a sale or default. An equitable title is not the same as a legal entitlement.

The requirement for foreclosure proceedings is where the biggest distinction between the two can be noticed. Foreclosures must go through the court system in a title theory state. A trustee handles the foreclosure in a state where the lien theory is in effect in a non-judicial manner, frequently without the assistance of the court system.

In essence, it is more difficult for a bank to forcibly evict you from a house where you have an equitable title (lien theory states) than it is in a state where the bank has full ownership of the property (title theory states) and you are making payments on a debt.

Defeasance Clause FAQs

What is an alienation clause?

When a borrower sells or transfers their home, the alienation clause in their mortgage contract provides the mortgage lender the right to demand immediate and complete repayment of the debt, including principal and interest

What is acceleration clause?

A loan agreement’s “accelerated provision” specifies circumstances under which the borrower must repay the loan in full right away. An accelerated clause is often triggered when the borrower materially violates the terms of the loan arrangement.

What is the difference between yield maintenance and defeasance?

Borrowers have the option to release the underlying real estate asset through yield maintenance or defeasance. However, the two procedures are very dissimilar from a legal and economic standpoint. While defeasance involves the replacement of collateral and the formal absorption of the loan by the succeeding borrower, yield maintenance is the real prepayment of the loan.

What's the definition of defeasance?

When a series of payments, such as a mortgage, is made, the term “defeasance” is used to declare a contract condition null and void and change the terms of the agreement, such as shifting title from the lender to the borrower.

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