Legal Definitions - mortgage clause

A mortgage clause is a specific provision included in an insurance policy, most commonly in property insurance like homeowner's or commercial property insurance. Its primary purpose is to safeguard the financial interest of the lender (known as the mortgagee) who holds a mortgage on the insured property. This clause ensures that if the property suffers damage or is destroyed, the insurance payout will be allocated not only to the property owner (the insured mortgagor) but also to the lender, in proportion to their respective financial stakes in the property. The common legal phrasing used is "as their interests may appear," meaning the funds are distributed based on how much each party is owed or has invested at the time of the loss.

There are generally two main types of mortgage clauses, differing in the level of protection they offer to the lender:

• Open Mortgage Clause (also known as a Simple Mortgage Clause)

  This type of mortgage clause offers limited protection to the lender. Under an open mortgage clause, if the property owner (mortgagor) takes actions that violate the terms of their insurance policy—such as committing fraud, intentionally damaging the property, or failing to maintain the property as required—the lender's right to receive insurance proceeds might also be compromised or completely voided. This clause essentially ties the lender's protection directly to the actions and compliance of the property owner.

  • Example 1: Sarah owns a small commercial building and has a mortgage with City Bank. Her insurance policy includes an open mortgage clause. Sarah intentionally sets fire to the building to collect insurance money. Because Sarah committed arson, which invalidates her claim under the policy, City Bank's ability to recover its outstanding loan amount from the insurance proceeds is also denied. City Bank would then need to pursue other legal avenues against Sarah to recover their funds.

  • Example 2: A homeowner, Mr. Henderson, takes out a mortgage with First National Bank. His homeowner's insurance policy has an open mortgage clause. Mr. Henderson fails to disclose a known structural defect in the house when applying for insurance, which is a material misrepresentation. When the defect later leads to significant damage, the insurer denies the claim due to Mr. Henderson's fraud. Under the open mortgage clause, First National Bank's interest is not protected, and they cannot claim the insurance payout for the damage.

• Standard Mortgage Clause (also known as a Union Mortgage Clause)

  The standard mortgage clause provides much stronger protection for the lender. It effectively creates a separate, independent contract between the insurance company and the lender. This means that even if the property owner (mortgagor) does something that would normally invalidate their own insurance coverage—like committing fraud, neglecting the property, or violating policy conditions—the lender's right to receive insurance proceeds for their outstanding loan balance remains intact. The insurer would still pay the lender, even if they deny the claim to the property owner.

  • Example 1: David owns a house with a mortgage from Secure Lending Co. His homeowner's insurance policy contains a standard mortgage clause. David decides to convert his garage into an illegal fireworks manufacturing operation, which is a clear violation of his insurance policy's terms. When an accidental explosion destroys the garage, the insurance company denies David's claim due to his illegal activity. However, because of the standard mortgage clause, Secure Lending Co. is still paid for the remaining balance of David's mortgage from the insurance proceeds, as their interest is protected independently of David's actions.

  • Example 2: A couple, the Millers, have a mortgage on their vacation home with Coastal Credit Union. Their insurance policy includes a standard mortgage clause. The Millers decide to leave the home vacant for over a year without notifying the insurer, which is a policy violation for extended vacancy. When a severe storm damages the roof, the insurer denies the Millers' claim. Despite this, Coastal Credit Union receives the necessary funds from the insurance company to cover the damage up to their outstanding loan balance, ensuring their investment is protected regardless of the Millers' non-compliance.

  • Example 3: Ms. Chen owns a rental property financed by Community Bank, and her landlord's insurance policy includes a standard mortgage clause. Ms. Chen intentionally misrepresents the property's condition on her insurance application to get a lower premium. Later, a fire causes significant damage. The insurance company discovers the misrepresentation and denies Ms. Chen's claim. However, Community Bank, due to the standard mortgage clause, is still able to recover the outstanding mortgage amount from the insurer, as their protection is separate from Ms. Chen's fraudulent actions.