A trust deed, also known as a deed of trust, is a document sometimes used in real estate transactions in the U.S. It is a document that comes into play when one party has taken out a loan from another party to purchase a property.
The trust deed represents an agreement between the borrower and a lender to have the property held in trust by a neutral and independent third party until the loan is paid off.
How a Trust Deed Works
In a real estate transaction—the purchase of a home, say—a lender gives the borrower money in exchange for one or more promissory notes linked to a trust deed.
This deed transfers legal title to the real property to an impartial trustee, typically a title company, escrow company, or bank, which holds it as collateral for the promissory notes—security for the loan. The equitable title—the right to obtain full ownership—remains with the borrower, as does full use of and responsibility for the property.
This state of affairs continues throughout the repayment period of the loan. The trustee holds the legal title until the borrower pays the debt in full, at which point the title to the property becomes the borrowers.
If the borrower defaults on the loan, the trustee takes full control of the property.
Trust Deed vs. Mortgage
Trust deeds and mortgages are both used in bank and private loans for creating liens on real estate, and both are typically recorded as debt in the county where the property is located.
However, a mortgage involves two parties: a borrower (or mortgagor) and a lender (or mortgagee). In contrast, a trust deed involves three parties: a borrower (or trustor), a lender (or beneficiary), and the trustee.
The trustee holds title to the lien for the lender’s benefit; in case the borrower defaults, it will initiate and complete the foreclosure process at the lender’s request.
Contrary to popular usage, a mortgage is not technically a loan to buy a property; it’s an agreement that pledges the property as collateral for the loan.
Foreclosures and Trust Deeds
Mortgages and trust deeds have different foreclosure processes. A judicial foreclosure is a court-supervised process enforced when the lender files a lawsuit against the borrower for defaulting on a mortgage.
The process is time-consuming and expensive. Also, if the foreclosed-property auction doesn’t bring in enough money to pay off the promissory note, the lender may file a deficiency judgment against the borrower, suing for the balance.
However, even after the property is sold, the borrower has the right of redemption: He may repay the lender within a set amount of time and acquire the property title.
In contrast, a trust deed lets the lender commence a faster and less-expensive non-judicial foreclosure, bypassing the court system and adhering to the procedures outlined in the trust deed and state law.
If the borrower does not make the loan current, the property is put up for auction through a trustee’s sale.
The title transfers from the trustee to the new owner through the trustee’s deed after the sale. When there are no bidders at the trustee sale, the property reverts to the lender through a trustee’s deed.
Once the property is sold, the borrower has no right of redemption.
Furthermore, a trustee has the responsibility of paying the proceeds from the sale to the borrower and lender after the sale is finalized.
The trustee will pay the lender the amount left over on the debt and pay the borrower anything that surpasses that amount, thereby allowing the lender to purchase the property.
Pros and Cons of Investing in Trust Deeds
Investors who are searching for juicy yields sometimes turn to the real estate sector—in particular, trust deeds.
In trust deed investing, the investor lends money to a developer working on a real estate project. The investor’s name goes on the deed of trust, as the lender.
The investor collects interest on his loan; when the project is finished his principal is returned to him in full. A trust deed broker usually facilitates the deal.
- High yielding income stream
- Portfolio diversification
- No capital appreciation
What sort of developer enters this arrangement? Banks are often reluctant to lend to certain types of developments, such as mid-size commercial projects—too small for the big lenders, too big for the small ones—or developers with poor track records or too many loans.
Cautious lenders may also move too slowly for developers up against a tight deadline for commencing or completing a project.
So these developers are often in a bit of a crunch. For these reasons, trust deed investors may often expect high-interest rates on their money.
They can reap the benefits of diversifying into a different asset class, without having to be experts in real-estate construction or management:
This is a passive investment.
Trust deed investing has certain risks and disadvantages. Unlike stocks, real estate investments are not liquid, meaning investors cannot retrieve their money on demand. Also, investors can expect only the interest the loan generates, with any additional capital appreciation unlikely.
Invested parties may exploit any legal discrepancies in the trust deed, causing costly legal entanglements that may endanger the investment.
The typical investor with little experience may have difficulty, as a certain set of expertise is required to find credible and trustworthy developers, projects, and brokers.
Details about payment of principal and interest
- Escrow funds
- Property insurance and structure maintenance
- Structure occupancy—stipulating the borrower must take up residency within 60 days
The form also includes non-uniform covenants, which specify default or breach of any of the agreement terms.
There is also a specification that the loan the document deals with is not a home equity loan—that is, something the borrower will receive cash from—the loan is for purchasing the property.