With a deed of trust, a buyer pledges an interest in real estate to secure a loan. In some states this takes the place of a mortgage document. (For a list of states commonly using deeds of trust see the section on Mortgage States and Deed of Trust States in our previous post, “You’ve Paid Off the Mortgage. What Happens Now?”)
Whereas a mortgage agreement is formed between the borrower and the lender, a deed of trust, also known as a trust deed, has one key difference. The trust deed designates a trustee—a third party who retains legal ownership of the home until the buyer completes the payoff.
This means three parties are involved in the deed of trust:
- The trustor. The home buyer who takes the loan out is the trustor.
- The trustee. The independent party holding legal title behind the scenes is the trustee. The trustee’s role is activated only if the buyer defaults and the home must be auctioned off.
- The beneficiary. The lending institution is called the beneficiary, as the trustee holds legal title for the lender’s benefit.
Thus, the trust deed represents an agreement between the borrower (trustor) and a lender (beneficiary) to have legal title to the property held in trust by a neutral third party (trustee) until the loan is paid off.
Deed of Trust: The Process and Impact on Title
A buyer gets money to purchase real estate when a lender agrees to give the buyer the funds in exchange for an IOU—a promissory note connected with the deed of trust.
The deed of trust, signed by the home buyer, is recorded in the county where the real estate is—just as a mortgage agreement would be.
The trust deed conditionally transfers legal title to the independent trustee—usually an escrow company or bank. The trustee holds the right to reclaim the property as collateral for the promissory note.
The buyer keeps equitable title to the home and is commonly known as a homeowner. Once the debt is paid in full, the lender must, by law, promptly have the trustee reconvey the real estate back to the homeowner.
But if the home buyer defaults, the trustee takes over the debt—and the property. The trustee then initiates the foreclosure process on behalf of the lender. Thus, the difference between a mortgage and a deed of trust affects only the homeowner who defaults on the loan.
Deed of Trust Foreclosures
The beneficiary of a deed of trust may ask the trustee to undertake a foreclosure outside of court, assuming state law directs trust deeds to empower the trustee with a power of sale clause.
The trustee starts the foreclosure process by recording a notice of default. In contrast to a mortgage, the deed of trust default triggers a non-judicial foreclosure, which follows the procedures outlined in the trust deed and state law.
The buyer has a final chance to pay the debt before the property goes to public auction through a trustee’s sale. Failing that, the homeowner’s equitable title automatically ends at the trustee’s sale.
If the auction proceeds and is successful, a trustee’s deed will convey the title, both legal and equitable, to the successful bidder. The new homeowner then records the deed, while the trustee disburses money to cover the remaining debt to the lender, and the borrower receives any money in excess of that payoff.
If the auction fails to draw a buyer, then a trustee’s deed is used to convey the property to its legal owner: the lender. In this way the lender recovers the value of the security for the loan in a relatively time-efficient, cost-effective manner, free from the uncertainty of suing to recover the debt.
Investing in Trust Deeds
Investors’ trust deeds are loans with homes as collateral. They also come into play when developers need to borrow money to fund their projects. Investing in trust deeds for development projects can diversify a portfolio and bring high yields to a knowledgeable investor.
If you invest, you effectively buy a real estate loan, secured by a trust deed. You earn the interest from the loan. Then, at the completion of the project, you receive your full principal back. This form of investment is needed because obtaining bank loans can be a slow, difficult exercise for today’s homeowners and developers.
There are trust deed brokers who facilitate these investments. To find trustworthy borrower, it helps to find a reputable broker. Be sure the real estate development project is appealing, and properly vetted, or that the home serving as collateral has equity above the amount of the loan. A well-vetted trust deed investment can bring predictable income, shielding the investment from market risk.
Avoid investing in a trust deed if you cannot afford to hold it until the borrower pays off the debt. Trust deeds, in contrast to stock market investments, are illiquid. Investors cannot access the principal until the loan is paid. Also, investors should not expect to benefit from capital appreciation.
Elements of the Deed of Trust Form
A standard trust deed form defines the terminology it employs, and typically includes:
- Places for the three parties’ names.
- The location of the real estate.
- The amount of the loan, principal, and interest.
- Escrow funds.
- Liens, insurance and maintenance.
- Statement that buyer must occupy the property within 60 days.
- Consequences for default or breach.
- Power of sale clause.
- Statement that the deed is not related to a home equity loan, but for purchase of real estate.
- Place for the borrower’s signature, that of two witnesses, and notarization.
The long form deed of trust is used by institutional lenders. Non-institutional lenders may use the cost-efficient short form deed of trust to preserve the parties’ rights and obligations. The short form must be recorded with a fictitious deed of trust, also called the master deed of trust. This is simply a standard deed of trust, blank and unsigned, with a cover sheet attached, requesting recording solely for reference.
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