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Defeasance Clause Explained

Defeasance Clause Explained
A defeasance clause in a mortgage deed offers security of the title to the mortgagor. The Buzzle write-up below will explain the meaning of defeasance clause in detail.
Buzzle Staff
Please Remember:
  • If you are negotiating a real-estate loan please pass on a request to defease your fixed-rate loan.
  • Be aware of all your prepayment options, defeasance being the one on the top.
Mortgage deeds and loan contracts are introduced with clauses which state the occurrence of a particular event or the execution of something on its fulfillment. That said, every contract has certain terms and conditions. Non-compliance with these terms can actually be considered illegal. The defeasance clause is one such clause that states that the property title will be returned to the borrower after the required conditions are fulfilled. The paragraphs below will explain what a defeasance clause is along with an example.
The Theory
  • The English Common Law system established the need for a defeasance clause.
  • Accordingly, the lender is provided with a deed that contains defeasible fees to the property.
  • This arrangement was basically to offer some security to the lender.
  • This title was eligible to be canceled after the mortgage payment, i.e., on the date of maturity.
  • If the borrower fails to pay the amount before the matured time, the property would be under the lender's control.
  • This practice is followed only in the common-law mortgage systems, and not in the lien law theory.
  • The defeasance clause is a provision, which ensures that once the debt is cleared, the mortgagor gets the ownership of the property.
Example
  • Assume that there is property that is jointly purchased, using a CMBS (commercial mortgage-backed securities).
  • If the earlier loan was around USD 25 million, five years hence, assume it could be around USD 35 million.
  • If the property dealing is still subject to original conditions, and your initial loan amount was USD 20 million, the new buyer would have a leverage of just more than 50%.
  • Defesance, in this case, will allow him to buy the property with a better leverage amount.
  • It will be even more beneficial if the loan restricts true repayment.
Associated Terms
Lien Theory
  • It states that the mortgage is a form of lien.
  • This means that the lender acquires a lien on the property, but the borrower retains the rights.
  • The rights in this case include the equitable and legal title.
  • If, however, the property is foreclosed, the lender retains the rights.
Defeasible Title
  • It is held by the lender.
  • It is a type of title that can be revoked in certain situations.
  • In this case, the lender will lose the claim to the title after the loan is paid off.
  • The clause will not exist if the mortgage has not made a defeasible title.
Prepayment Penalty
  • The clause gives information with regards to prepayment penalties.
  • Prepayment penalties are significant; in the sense that they secure the loan.
  • The details of these penalties are mentioned in the paperwork.
Satisfaction of mortgage
  • It is a method by which the lender records the mortgage release.
  • This is done when the borrower pays the last installment.
Risks for Lenders
  • Defeasance eliminates the risk of reinvestment.
  • Since defeasance substitutes as a collateral in real-estate deals, lenders are deprived of newer lending opportunities.
  • The concept forces them to lend the prepaid capital again, due to which there is no reinvestment.
  • If the asset in question also involves less risk, then the overall investment risk also reduces for the lender.
  • In real estate deals and Treasury bonds, the cash flow is retained and an adjusted investment is made.
  • A problem may pose itself when the market rates rise significantly; this ultimately eliminates any reason for the borrowers to pay the rate differential.
Mortgagor Issues and Advantages
  • The clause is beneficial for the borrowers, since it does not affect them even if the market rates rise.
  • The clause is especially useful where bonds and trusts are concerned.
  • A major issue may be yield management, because then borrowers are obligatorily subject to payment.
  • Whenever market rates rise, fixed-rate investments become cheaper, and borrowers can further invest in cheaper bonds.
  • The reverse causes a problem, though, since the investment rates soar as well.
The defeasance clause gives the mortgagor the right to redeem his property once the payment is cleared. Thus, in any trust deed (with this clause), once the debt is cleared, the property title gets reverted to the borrower from the trustee. This also implies that the borrower has no right on the title until the entire payment has been done, including all the interests.