Foreclosure Deficiency and Forgiveness

When purchasing real estate with funds from a loan, the borrower typically uses the property to secure the debt. In a mortgage loan, the lender holds a lien on the property, which gives the lender the legal right to foreclose, should the borrower default on the debt. In a deed of trust loan, the trustee holds naked title on the property, which gives him the right to foreclose and sell the property should the debtor default. Sometimes, after a foreclosure sale, the funds are insufficient to pay off the debt.

Foreclosure

Foreclosure is the legal process where a creditor liquidates or takes title of property securing a debt, after the debtor defaults on a loan. If the sale price of the foreclosed property is less than the outstanding loan balance, this creates a deficiency. For example, if Mr. Smith owes $100,000 to the lender, and funds from the foreclosure sale only pays off $75,000 of the loan, this creates a $25,000 deficiency.

Deficiency Judgment

If the lender forgives the deficiency amount, this means the debtor is not financially responsible for the repaying the lender for the difference between the outstanding loan amount and the final sale price of the property. If the lender intends to hold the defaulted borrower responsible for the deficit, the lender issues a deficiency judgment to the borrower. A deficiency judgment is a personal judgment against the borrower.

State Laws

State laws vary regarding the lenders’ ability to issue deficiency judgments. For this reason, a property owner facing foreclosure should contact his attorney, to see if he is liable for a deficiency under the laws of his state. Some states don’t allow a lender to hold the borrower responsible for the deficiency, if the property secures the loan. Yet, if the loan is a second, not used to purchase the property but to pull equity from it, the lender may be able to issue a deficiency judgment against the debtor, even if state law prevents the creditor from holding the borrower responsible for funds used to purchase the property.

Nonrecourse State

Non-recourse states are those that generally protect a debtor from deficiency judgments. They include Alaska, Arizona, California, Minnesota, Montana, North Carolina, North Dakota, Oklahoma, Oregon and Washington. Other states may pose restrictions regarding deficiency judgments. Yet, even in non-recourse states, circumstances may allow for deficiency judgments.

Bankruptcy

If state law gives the lender the right to issue a deficiency judgment and the lender refuses to forgive the deficit, some debtors turn to bankruptcy. When a deficiency judgment is discharged in bankruptcy, the debtor is no longer responsible to repay the debt.

References

• "Modern Real Estate Practice"; Fillmore Galaty, et al.; 2006
• “The Money Class”; Suze Orman; 2011