Collateral is an essential component of loan transactions. Realty (real estate) or personalty (personal property) can serve as collateral. The creditor’s (lender’s) interest in the collateral depends on the transaction, loan, property and law. The debtor (borrower) will acknowledge that it is conveying an interest to the creditor. In real estate transactions, the security agreement acknowledging the conveyance is well known as a “mortgage.”
Agreements to convey real estate are not fully performed or “executed” until closing. At closing, the purchaser pays the sales price, and the seller conveys the title to the purchaser by signing a deed.
Between signing and closing, each party must fulfill contractual obligations. Usually, among other things, purchasers must apply for a mortgage to pay the sales price. Typically, lenders will issue a commitment letter to a qualified borrower. The letter states that the lender will lend a particular amount of money under certain conditions. Like the sales contract, the lender’s commitment is not fully executed until it lends the money at closing.
The lender performs due diligence on the prospective borrower and property. The lender will examine, among other things, the applicant’s income, percentage of income dedicated to paying the loan, down payment, credit history and net worth. It evaluates the property in case it must foreclose upon it.
To the extent the collateral’s value exceeds the value of the loan principal, the loan is “over-collateralized.” To the extent the collateral’s value falls below the value of the loan’s principal, the loan is “under-collateralized.” Over-collateralization provides a cushion of protection for the lender.
For example, suppose the loan principal is $1 million, and the asset is worth $1.2 million. If the asset falls in value by $200,000 and the lender had to foreclose on the devalued asset, its value would still cover the principal of the loan.
The debt is evidenced by a promissory note which usually states the principal, maturity date, frequency of payment, interest rate, events of default and lender’s remedies. If the note is “negotiable,” the lender can sell or transfer it. The note creates an unsecured debt. This means that if the debtor defaults, the lender has general creditor’s rights but no rights to a specific piece of collateral.
Secured creditors have priority over unsecured creditors. When making a mortgage, the lender must comply with the state’s real property laws. When taking an interest in personal property, the lender must comply with the state’s version of the Uniform Commercial Code (UCC). This creates a lien.
The act of recording the lien gives the public constructive notice of the creditor’s rights. In New York, mortgages are recorded with the appropriate county clerk. The creditor records a financing statement for a piece of personalty with the state’s Department of State.
The borrower must maintain the collateral as agreed. Failure to do so is an “event of default.” The borrower can cure minor defaults. If the borrower intentionally defaults, or if the default is incurable or persistent, the secured creditor can foreclose. Where a debtor has multiple creditors, default on one obligation usually results in a “cross default” under other agreements.
Earlier secured creditors have priority over later secured creditors and unsecured creditors. Senior unsecured creditors have priority over junior unsecured creditors. Priorities are particularly important if the borrower declares bankruptcy. Higher priority creditors tend to be repaid more.
Remedies for default and foreclosure laws vary by state. Usually, lenders can sue to recover on the note (i.e., breach of contract), or they may foreclose. Because judicial foreclosure requires court involvement, it tends to take longer and be more expensive than non-judicial foreclosure. In foreclosure, usually, the lender sells the property at auction and distributes the proceeds to creditors in order of priority. Any remainder goes to the debtor.
An anti-deficiency statute may limit the lender’s recovery to the value of the borrower’s interest in the real estate. Under a “nonrecourse” loan, the lender agrees that the collateral alone will satisfy the debt. Under a “recourse” loan, the lender can sue the debtor for any unsatisfied portion of the debt.
Debtors and creditors should understand their respective rights and obligations and take steps to protect their interests.