The Real Truth About How Title Insurance Works

By on July 9, 2015

Back when I started my real estate investing career, one of the most confusing things I encountered was title insurance.

When I bought my first house in 2006, my Realtor tried explaining the concept to me on more than one occasion. His explanation was that:

“You need title insurance to make sure nobody else owns the property you’re buying.”

All I could think was:

“Huh? Why would someone try to sell me property they don’t actually own? How is that even possible?”

Even after hearing a few other people explain it to me over the years, I had a really hard time connecting the dots and understanding why this was a necessary expense (and as I reflect back on some of the explanations I heard, I’m not sure these people understood it either). Needless to say, Title Insurance was a pretty ambiguous concept that I struggled to grasp for quite a while.

So what is title insurance? Let’s talk about that.

For most home buyers, it’s okay to get by without understanding title insurance. After all, the average person only buys a home once or twice in their lifetime (if at all) and the reality is, they don’t need to be experts in this realm.

For real estate investors, it’s a completely different story. Most of us are going to be intimately involved with a lot of real estate transactions over the course of our business, so it really is important for us to know what title insurance is all about.

What is Title Insurance?

To answer this question, let’s start with a quick illustration.

Let’s say you’re in the market to buy a used car. One day, you notice a nice car parked in someone’s front yard with a “FOR SALE” sign in the window.

The car looks nice, so you walk up to the front door and knock. A man walks answers the door.

You say to him, “Hi there! I saw this car parked in your driveway — is it yours?”

He replies with, “Nope, I have no idea who owns that car…but I’ll sell it to you for $20,000!“

You can probably spot the problem here. If you were to fork over $20,000 to this guy, you wouldn’t necessarily “own” the car because he never owned the car in the first place.

Just because you pay money to a stranger doesn’t necessarily entitle you to anything. Unless you have a clear title from the actual owner of the car, you have no ownership to speak of!

The bottom line is: A person can’t sell something they don’t legally own.

Even though this scenario may sound ridiculous, you’d be surprised at how many times I’ve encountered situations just like this in the real estate business.

The whole purpose of title insurance is to act as a safeguard for real estate buyers, protecting them from problems just like this. There are all kinds of random issues that affect the title of real property, and title insurance is a product designed to give the buyer full assurance that when they’re buying a property from someone, they’re buying it from the actual owner and they are receiving the FULL rights to that property, just as they expected.

A title insurance policy is almost always issued in the full amount of the buyer’s purchase price (i.e. if you buy a property for $100,000, you’re protected for $100,000). If a title defect ever arises and it wasn’t identified during the original title search, you as the buyer will be protected in this amount.

Where Do Title Defects Come From?

In the example above, it’s pretty obvious that the seller is knowingly selling something they don’t own. This kind of issue would be pretty easy to spot, but the problem with real estate is that oftentimes the seller doesn’t necessarily know about the title issues that exist on their property (and even if they did, they might not be so kind as to disclose them to you).

To explain where these title issues come from, we need to start with a basic explanation of how a property’s “chain of title” works.

When a property has a clear chain of title, it means that a title professional has been able to find a clear record of all the historical owners of the property, and there is a clear link between the seller and the previous historical owners. They can clearly see when the property has been transferred from one owner to another, what each party paid for it and any third parties that may have had liens, mortgages or other claims to the property.

In most cases, a title search will go back in time several decades to find all of this information and in this process, it’s not uncommon for the title search to uncover some kind of issue that needs to be resolved before the transaction is closed. These issues are most commonly referred to as “title defects” or a “cloud on title.”

Title defects can exist for any number of reasons. Here are some examples I’ve seen in the past:

  • A prior deed has a misprinted or misspelled legal description.
  • An outstanding mortgage hasn’t been “discharged” (paid off).
  • Property taxes went unpaid and thus became delinquent with the city or county.
  • There’s a pending lawsuit or divorce settlement calling the property’s true ownership into question.
  • An owner failed to pay a subcontractor for work performed on the property.
  • The seller “inherited” the property, but there was no legal paperwork to give them the “legal right” to sell it.

In some cases, these issues existed because the seller had purchased the property many years ago without doing their own title work in the first place. As a result, they owned the property for years without realizing there was a major title defect that was preventing them from holding marketable title to the property.

The great thing about title insurance is that when you order a title commitment before closing, it will identify these issues before they become your problem. You can probably understand why it’s important to know about these title defects BEFORE you’ve invested your life savings and paid off the seller.

A Break in the Chain of Title

One issue I’ve encountered more than once in my years of real estate investing is called a “break in the chain of title.” This happens when the title records skip from one party to another without accounting for ALL the previous owners (via deeds, death certificates, foreclosures, divorces and so on).

Let’s say there have been 3 different owners of a property over the past 100 years. If this is really the case, then a title professional should be able to clearly identify them (and in the correct order no less).

When a property has a break in the chain of title, it means the public records aren’t showing the evidence to outline the proper flow of ownership from one owner to the next.

A break in the chain of title is a big problem.

Think about it: how do we know that “Owner B” ever relinquished their ownership to “Owner D?” There is no record of any transactions linking this transfer. Unless we can clearly see where the link is (with all the proper paperwork to support it), Owner D doesn’t technically own anything and if you “buy” this property from them, you wouldn’t own anything, either.

When Title Insurance Kicks in

This is why title insurance is such a valuable tool that’s worth paying for.

Simply put, title defects are unacceptable. When you order title insurance, you don’t have to worry about doing the mind-numbing work of finding these for yourself. You’re paying a title professional find these problems for you and when they do, they’ll list them as “exceptions” on their title commitment (i.e. we will insure your clear title to this property except for this issue).

No title company in their right mind is going to give you a title insurance policy when there are known title defects lurking in the background. Instead, their “title commitment” is their chance to notify you if there are any problems and what they are, so you can get them resolved BEFORE you close on the deal and those problems fall into your lap.

When title defects exist and they get resolved, the title insurance policy will insure over these problems because they’ve established that the problem has been fixed and you are indeed buying a clear and marketable title to the property (i.e. the seller does have the legal right to sell it to you).

If you try to purchase a property WITHOUT doing any title work, you could find yourself devastated by the consequences of an unknown title defect. Can you imagine learning about a serious title issue after you’ve paid an unspeakable sum of money for something that you don’t hold clear title to? It’s a real estate investor’s worst nightmare — so unless you’re perfectly fine with this kind of risk, I wouldn’t recommend going there.

What Happens Without Title Insurance?

The truth is, it’s quite rare for title defects to come back and bite a person in the butt. Even though it’s a very real danger, it’s not a common occurrence.

Why is it so uncommon? Because most real estate transactions don’t happen without title insurance. If a Realtor or Mortgage Lender gets involved with a real estate transaction, chances are almost certain that they’ll require you to use title insurance. They aren’t willing to risk the liability (and you probably shouldn’t either). By default, this ensures that the vast majority of real estate deals across the country have a clear title — because the deals wouldn’t close without it!

It’s also worth noting that even when title defects are found, many of them are curable.

  • Got a subcontractor with a lien on your property?
    • Pay them off!
  • Got a mortgage company who forgot to discharge your mortgage?
    • Call them and tell them to take care of it!
  • Did you inherit a property but you’re missing the proper paperwork?
    • Dig it up in your files and get it recorded!

Even though it’s not uncommon for a title search to uncover the occasional issue, it doesn’t mean these issues can’t be resolved, and it doesn’t mean you shouldn’t pay a professional to find these things (because let’s be honest — they’ll be much better at finding these problems than you will be on your own).

At the very least, you’ll be fully aware of what you’re walking into so you can protect yourself against potential problems.

It’s also worth noting that mistakes can be made, even by a title company. Another benefit of title insurance is that IF an issue ever arises in the future (and it was never disclosed to you through the title commitment), your title insurance policy will allow you to fall back on this policy as a safety cushion to protect you from any liability. If someone ever comes to you demanding compensation to fix a problem that the title company missed, your title company will be on the hook, not you.

If you don’t have a title insurance policy and a serious issue ever arises, you’ll be on your own. Even though this isn’t a common scenario, it is NOT a situation you want to find yourself in — ever.

Is it Possible to Buy Real Estate Without Title Insurance?

Yes. In fact, I’ve done it myself on several occasions.

Why would I knowingly expose myself to this kind of risk?

There are a couple of valid reasons, so hear me out:

  • I was buying these properties for anywhere from $100 – $1,000 a piece.
    • Did it make sense to pay $250 for a policy that only insured me for $100 – $1,000? No. No, it didn’t.
  • I was performing my own title searches for a cheaper price than a policy, and I knew what I was doing.
    • This is something most real estate investors can’t say for themselves, so I wouldn’t necessarily recommend going this route unless you’ve taken the time to understand how to do a title search.

As a personal rule, I always defer to a title professional whenever I’m buying a property with a full market value that exceeds $10,000. This is the point at which I don’t want to run the risk of letting my own stupidity getting the best of me.

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