We have consumer mortgage loans secured by balloon notes that will be converted to adjustable rate notes prior to maturity. Under Regulation Z, these transactions must be disclosed as refinances. Some of the borrowers have large second mortgages, and we are concerned that these transactions could result in the loss of our priority lien position. The amounts of the loans will not be increasing, and the original mortgages will not be released, but we will be entering into new notes with the borrowers. Under Illinois law, can we replace an original note with a new note without extinguishing the original mortgage lien? Must we record a new mortgage with a new note, or can we record a modification of mortgage instead?

Yes, a lender may replace an original note with a new note without extinguishing the lender’s original lien — but the facts in each case and the language in the loan documents are crucial. Consequently, irrespective of our general guidance here, we recommend consulting with your bank counsel to determine how these refinancings can be structured in a manner that protects your bank’s lien priority.

Generally, when a mortgage note is renewed, Illinois courts determine lien priority by looking at the intent of the parties to determine “whether the renewal extinguishes the original mortgage lien.” In one case, an Illinois court found that “a mortgage lien survived the renewal of the original mortgage and the tender of an additional loan because there was no evidence that the original mortgage was ever canceled or released.” Additionally, several Illinois courts have adopted the doctrine of “conventional subrogation,” by which an original mortgagee may refinance its original loan while preserving its original lien position under certain circumstances. But again, your bank would need to show that it intends to retain its original priority lien, among other requirements noted in the cases below.

Accordingly, we believe your bank may issue a new note and modify the original mortgage without disturbing your original lien position, provided the renewal documents make clear that it is not your intent to extinguish the original debt, and the original mortgage is not canceled or released. In addition, we are not aware of any authority that would prevent you from recording a modification of the mortgage (as opposed to recording a new mortgage) when the new note is issued, provided the new note does not give rise to an inference that it has extinguished the original debt.

Also, we agree that for purposes of Regulation Z, the conversion from a balloon loan to an adjustable rate mortgage loan must be treated as a refinancing for disclosure purposes. However, Regulation Z also recognizes that a new transaction converting a fixed-rate loan to an adjustable-rate loan does not necessarily cancel and replace the original obligation — even if this transaction must be treated as a “refinancing” for disclosure purposes.

For resources related to our guidance, please see:

Aames Capital Corp. v. Interstate Bank of Oak Forest, 315 Ill.App.3d 700, 704 (2nd Dist. 2000) (citing State Bank v. Winnetka Bank, 245 Ill.App.3d 984 (2nd Dist. 1993)) (“A renewal note and mortgage do not ordinarily operate as payment and in discharge of an original note for purposes of determining whether the renewal note maintained priority position. In cases of a dispute concerning priority when the original note and mortgage are renewed, the court looks to the intent of the parties in determining whether the renewal extinguishes the original mortgage lien. In Winnetka Bank, the court was persuaded that the mortgage lien survived the renewal of the original mortgage and the tender of an additional loan because there was no evidence that the original mortgage was ever canceled or released.”)

State Bank of Lake Zurich v. Winnetka Bank, 245 Ill.App.3d 984, 991 (2nd Dist. 1993) (“Here, the evidence indicates the parties did not intend the September note and mortgage to be a new and separate transaction which extinguished the June note. The June mortgage was never cancelled or released, and the language therein provides for additional advances at the option of the mortgagee. The face of the June note was stamped ‘paid by renewal,’ and the September note specifically states it is a renewal of . . . the June note. . . . The testimony of State Bank loan officers also established that when a balance of a loan is increased, a new note and mortgage are typically executed. The trial court erroneously concluded that the September mortgage was a new and independent mortgage. Accordingly, we find the September mortgage was a renewal or modification of the June mortgage and the June mortgage was a valid and subsisting lien on the subject property.”)

Aames Capital Corp. v. Interstate Bank of Oak Forest, 315 Ill.App.3d 700, 710 (2nd Dist. 2000) (“We hold that a refinancing mortgagee that records its mortgage lien is entitled to be subrogated to the original lien, and its corresponding priority position, established by the original mortgagee, under the doctrine of conventional subrogation, up to the amount that the original mortgage secured at the time of its perfection. The doctrine of conventional subrogation will apply if the original mortgage lien is in full force and effect at the time that the refinancing mortgage lien is recorded. . . . What is relevant is the value of the prior liens as determined by the mortgage documents.”)

UnionBank v. Thrall, 374 Ill.App.3d 785, 792–793 (2nd Dist. 2007) (An examination of earlier cases “enables us to discern the elements that must exist in order to apply the doctrine recognized in those cases, in which the original lienor who refinances the mortgage retains the priority of his lien over that of an intervening lienor despite the release of the original mortgage. The refinancing lienor must have intended to retain the priority of his original mortgage; the new mortgage must have been used to pay off the first mortgage; the intervening lienor must have been on notice of the original mortgage’s priority at the time he issued the indebtedness secured by his lien; and the first mortgage must not have been released prior to the intervening lien.”)

Regulation Z, Official Interpretations, Paragraph 20(a), Comment 3(ii) (“Even if it is not accomplished by the cancellation of the old obligation and substitution of a new one, a new transaction subject to new disclosures results if the creditor either: A. Increases the rate based on a variable-rate feature that was not previously disclosed; or B. Adds a variable-rate feature to the obligation.”)