As much as you may want to think that your fixed investments will always grow uneventfully until maturity while throwing off the anticipated interest, this is not the reality of every investor’s experience. Even fixed investments like bonds and trust deeds have some risk of default. But unlike bonds, trust deeds expose you less to loss of principal.
In the unlikely event that the borrower of your trust deed investment stops making payments to you on the loan, you can initiate a foreclosure. Of course, non-payment of loan is not the only situation in which a foreclosure is appropriate. If the borrower breaches or defaults on your agreement by failing to pay property taxes, insurance or assessments (HOA) you may be permitted to begin the foreclosure process.
Foreclosures are processed very differently depending on the state where the property is located and the type of security instrument used. When a real estate loan is made, a security instrument is used to tie the promissory note (note) to the collateral (property). The security instruments typically used are either a mortgage or trust deed a.k.a. deed of trust (DOT) and they also specify what constitutes loan default. The differences between a mortgage and a deed of trust affect borrower only when foreclosure is an issue. The biggest distinction is between the judicial process and non-judicial process. Judicial foreclosures are normally conducted in states where a mortgage is used as the security instrument. Non-judicial foreclosures are normally conducted in states using a deed of trust as the security instrument. The principal difference between the two is that the judicial procedure requires court action on a foreclosed property.
Judicial Foreclosure Drawbacks
In most traditional lending agreements, judicial foreclosure is required when the borrower is in default of the terms of the loan. During a judicial foreclosure the lender must file a complaint with the courts and record a Lis Pendens (lawsuit pending) notice. A notice of the registered complaint is sent to the borrower and they are given their day in court. The court who hears the case then finds either in favor of the borrower or the lender. When the court finds in favor of the lender, they issue a writ that allows the property to be sold at public auction. If the property is sold at auction, the court then has to confirm the sale, the bidder must pay within 30 days and then a deed must be delivered to the winning bidder. If it sounds like a long process, that is because it is and when you have your investment funds tied up in a loan that is in default, the last thing you need is a long, drawn out, court-driven process.
The Benefits of Non-Judicial Foreclosure
Trust Deed foreclosure is easier and faster than that of a mortgage foreclosure because there are no courts involved. Simply put, most investors refer to trust deed foreclosure as a third party action. Because there is no court action involved, the trustee has the authority to sell the property for the beneficiary in the event the trustor fails to make the monthly mortgage payments.
That is why trust deed agreements contain a power of sale clause. This clause states that the property can be sold by the lender through the trustee (or a separately appointed trustee) without going through the courts once the loan is in default. This clause allows trust deeds to avoid judicial foreclosures and instead enjoy non-judicial foreclosures.
There is also some different terminology to remember when dealing with a trust deed foreclosure.
- The borrower is called the trustor.
- The lender is called the beneficiary.
- The third party representative (the one who is holding the title) is called the trustee. The trustee, who represents the lender (or beneficiary), is brought on for the sole purpose of holding the title of the property as a security measure against the debt.
The process of a trust deed foreclosure varies from that of mortgage foreclosures and new laws are applicable for non-judicial California Foreclosures under a Deed of Trust. See our article The New California Foreclosure Time Line to understanding the foreclosure timeline and what takes place during each portion of the cycle.
After the sale auction is completed, if the property sells to an outside third party bidder, all funds that are owed to the lender will be prepared for immediate payout. If a property is sold at a foreclosure trustee sale for more than the opening bid (which is usually equal to the outstanding loan balance, interest accrued, and any additional fees and attorney fees plus property taxes) the funds above the opening bid go first toward settling junior liens. Any remaining funds (known as “Excess funds”) go to the borrower. If the property reverts to the lender at the sale, a Trustee’s Deed will be issued and the lender will have ownership to the property securing the debt.
Overall, the default of a trust deed borrower’s obligation works more to the lender’s advantage than the default of a bond issuer at maturity of a bond. Investors are made whole and, as the lone investor, they are the only interested creditor. This ensures them repayment and gives them some control over the process of foreclosure.