In the United States there are two primary ways that property ownership is held and transferred. Some states recognize what is called the “title theory,” while other states recognize the “lien theory.” In a title theory state, the lender holds the title to the property in the name of the borrower through the instrument known as a “deed of trust.” In a lien theory state, the deed remains in the borrowers (mortgagor) possession, and the lender (mortgagee) places a lien on the property via the more commonly known instrument called a mortgage. However, the difference between these two theories is not particularly substantial, until the borrower defaults on the loan.
Most title theory states employ a non-judicial foreclosure process, whereas most lien theory states conduct foreclosure through a judicial proceeding. In a non-judicial foreclosure, the lender forecloses on a loan without a court’s interaction, and the lender is the party that holds the actual foreclosure sale. However, the mortgage must contain a “power-of-sale” clause which expressly provides for non-judicial foreclosure. This is a key requirement, because it demonstrates the borrower’s express agreement to the non-judicial foreclosure when the loan was instigated. In a judicial foreclosure, a lawsuit is filed by the lender and foreclosure is issued by the court. A public official holds an auction, which is often times on the steps of the courthouse. The public official was traditionally the sheriff, which is why a judicial foreclosure is often called a sheriff’s sale.
It is important for both hard money lenders and borrowers to understand these differences. Naturally, the title theory states are more attractive to hard money lenders, while the lien theory states provide more advantages to the borrower. Admittedly, this distinction is the reason that many hard money lenders are hesitant to lend in lien theory states. Furthermore, strict usury laws will in many instances dissuade lenders from doing deals in a particular state. For example, Florida, is a lien theory state, and has very tough usury laws. The usury laws prescribe a maximum interest rate of 18 percent on loans that do not exceed $500,000. While that may not be a deal breaker by itself, coupled with the lien theory, Florida becomes a very unattractive state to hard money lenders. If you find a hard money lender who is anxious to to give you money in a state like Florida, then you might want to consider their motives. They quite possibly are only after your “application fee.”