A defeasance clause in a mortgage agreement ensures that the lender’s claim is nullified once the loan is fully paid, providing legal release provisions tied to your original mortgage. This clause is crucial when refinancing, especially for commercial loans, where it may require purchasing Treasury bonds to cover remaining payments. Understanding this clause helps borrowers avoid unexpected costs and manage their refinancing options effectively.
What Is a Defeasance Clause?
A defeasance clause is a legal provision found in many mortgage agreements. It states that once the borrower pays off the full mortgage balance, the lender’s claim (or lien) on the property is nullified.
Think of it as the mechanism that officially transfers ownership back to you after your debt is settled.
This clause is commonly used in lien theory states like Florida, Texas, and New York. In these states, the lender holds a lien—not the title—to the property. Once you pay off the mortgage, the lien is “defeated,” hence the term “defeasance.”
Quick Summary:
- Lien Theory States: Defeasance clause activates when loan is repaid in full.
- Title Release: Ensures full ownership returns to the borrower.
- Used in Commercial Real Estate: Often tied to securitized loans (CMBS).
- Costly in Some Contexts: Can involve buying Treasury securities to replicate loan payments.
Residential vs. Commercial: How the Clause Works Differently
For residential loans, the defeasance clause usually serves a procedural role—once you repay your mortgage, your lender files a deed of reconveyance or a satisfaction of mortgage to clear the lien from the title.
But for commercial real estate, especially loans bundled into Commercial Mortgage-Backed Securities (CMBS), defeasance becomes more complicated.
When refinancing a CMBS loan early:
- You can’t just pay off the loan directly.
- You’re often required to purchase a portfolio of U.S. Treasury bonds.
- These bonds must generate cash flow identical to the remaining mortgage payments.
- This process is known as defeasance.
Instead of paying the lender back, you’re creating an alternate stream of guaranteed payments via government securities.
Numerical Example: Visualizing the Cost of Defeasance
Let’s say you have:
- A $5 million CMBS loan
- With 5 years left before maturity
- At a 5% interest rate
You want to refinance now because you’ve found a new lender offering 4% rates.
However, your loan agreement requires defeasance.
To defease the loan:
- You’ll need to purchase a series of Treasury securities that produce payments matching your current loan.
- Based on current rates, this might cost you an additional $250,000–$400,000 upfront.
- These are not penalty fees, but real costs tied to matching the debt payments.
Pro Tip: The cost of defeasance rises when interest rates fall because Treasury bonds yield less—meaning you’ll need to buy more of them to match your loan’s scheduled payments.
How the Defeasance Clause Affects Refinancing
If you’re refinancing a mortgage with a defeasance clause, here’s what you need to consider:
1. Check Your Mortgage Agreement
Look for keywords like:
- “Defeasance required upon early repayment”
- “Prepayment restrictions”
- “Yield maintenance” or “prepayment premium”
These clauses define what options you have if you want to pay the loan off before maturity.
2. Understand the Loan Type
- Residential loans (FHA, VA, conventional) rarely enforce defeasance.
- CMBS or institutional loans frequently require defeasance for prepayment.
3. Timing Matters
Refinancing closer to the loan’s maturity often reduces defeasance costs. The fewer payments left to match, the fewer securities you need to buy.
Comparison: Defeasance vs. Prepayment Penalty
| Feature | Defeasance | Prepayment Penalty |
| Common Use | CMBS and commercial loans | Residential and commercial loans |
| Involves Treasury Bonds | Yes | No |
| Upfront Cost | High (due to bond purchases) | Medium (flat percentage fee) |
| Complexity | High | Low to medium |
| IRS Implications | Often tax neutral | May have tax implications |
| Refinance Flexibility | Low | Higher |
Recommended Reading
- What Happens After You Pay Off Your Mortgage?
- Understanding Mortgage Prepayment Penalties
- Title Theory vs. Lien Theory Explained
Professional Help
- Consult a real estate attorney to interpret your loan documents.
- Work with a mortgage broker to explore refinancing strategies.
- Hire a defeasance consultant for CMBS loans.
Refinancing Strategies: Minimize Costs, Maximize Value
For Homeowners:
- Ask your lender upfront: Does this loan include a defeasance clause?
- If yes, request a cost breakdown and compare it to potential refinance savings.
For Investors:
- Consider yield maintenance as a more affordable prepayment option.
- Time your refinance to coincide with the loan’s open period, if applicable.
For Mortgage Professionals:
- Educate clients on the refinancing implications of defeasance.
- Provide side-by-side comparisons to illustrate long-term savings.
FAQs:
Can I refinance a mortgage with a defeasance clause?
Yes, but in many commercial cases, you’ll need to defease the loan by purchasing substitute securities. This adds cost and complexity.
Is defeasance the same as a prepayment penalty?
No. While both are costs incurred when paying a loan off early, defeasance involves buying Treasury securities, whereas prepayment penalties are flat fees.
What’s the biggest mistake borrowers make?
Not checking for defeasance or prepayment terms until they’re ready to refinance—by then, options are limited and costs can be steep.
How do I avoid high defeasance costs?
Refinance during your loan’s open period or choose a loan product without defeasance if early payoff is part of your strategy.
Final Thoughts:
The defeasance clause might seem buried in fine print, but it can have real financial consequences when refinancing—especially in commercial real estate. The more you know now, the better your position will be later.
