What is a defeasance clause, and how does it work?

Defeasance probably isn’t a word you hear used in everyday conversation. When you’re buying a home, though, it’s important to know what it means — it refers to terminating something, or rendering it null and void — because some mortgages come with what’s called a defeasance clause. And that clause has a serious effect on who has legal ownership of your house: you or your lender.

Defeasance clause: Definition

If your home loan includes a defeasance clause, it essentially means that you don’t actually hold the title to the property until your mortgage is paid in full. Until then, your mortgage lender holds the title. So, as long as you still owe money on the mortgage, they technically own the house.

Fortunately, that doesn’t mean the lender is going to move in and start cooking in your kitchen. It just means that if you fail to make your mortgage payments, they can initiate foreclosure proceedings in court. Foreclosure would mean they could sell the house to recoup their losses.

If you pay off your mortgage in full and meet all other terms of the loan agreement, the defeasance clause kicks in and the title is transferred from the lender to you. At that point, you own the home free and clear.

How defeasance clauses work

Review your mortgage documentation to see if it includes a defeasance clause — whether it does or not will vary depending on what state you live in (see below). If the clause is there, your lender holds the property title during the entire time that you still owe them money. Once you finish paying off your loan, the process of having the title transferred to you can be initiated. When your loan balance reaches zero, you’ve officially reached loan defeasance and will get full legal ownership of your property.

Title theory vs. lien theory vs. intermediate theory

Whether or not your mortgage has a defeasance clause largely depends on what type of mortgage theory your state adheres to: title theory, lien theory or intermediate theory. In any of these three cases, the lender has a route to take ownership of the house if the borrower defaults on the loan.

If you live in a title theory state, a defeasance clause will be included in the contract you have with your lender. Title theory allows a lender to place the title of a home into a trust, holding it as collateral for the loan until the borrower pays off the balance in full. These states adhere to title theory:

• Alaska
• Arizona
• California
• Colorado
• Georgia
• Idaho
• Mississippi
• Missouri
• Nebraska
• Nevada
• North Carolina
• Oregon
• South Dakota
• Tennessee
• Texas
• Utah
• Virginia
• Washington
• Washington, D.C.
• West Virginia
• Wyoming

States that adhere to lien theory, on the other hand, allow the borrower to hold the title even while they owe money on the mortgage. But in exchange, the lender may place a lien on the house. To remove that lien and clear your title, you need to pay off your mortgage. Lien theory states are:

• Arkansas
• Connecticut
• Delaware
• Florida
• Illinois
• Indiana
• Iowa
• Kansas
• Kentucky
• Louisiana
• Maine
• New Mexico
• New York
• North Dakota
• Ohio
• New Jersey
• Pennsylvania
• South Carolina
• Wisconsin

The third option is intermediate theory. In these states, the borrower holds the title, but failure to make mortgage payments activates a clause that reverts the home’s title back to the lender. The intermediate theory states are:

• Alabama
• Hawaii
• Maryland
• Massachusetts
• Michigan
• Minnesota
• Montana
• New Hampshire
• Oklahoma
• Rhode Island
• Vermont

Bottom line

Getting the keys to your house doesn’t necessarily mean you own it outright. If you’ve financed your purchase with a mortgage, your mortgage lender has an ownership stake until the loan is paid off. The exact type of stake varies depending on your state and the mortgage theory it follows: If you live in a title theory state, your home loan probably comes with a defeasance clause.