Can’t Pay the Mortgage? Homeowner Worries About Deficiency Judgment.

Q: Three years my daughter and her husband bought a house. A year ago, they upgraded to a larger home and kept the first home as a rental.

They were barely getting by financially as teachers when she started to have a difficult pregnancy and was put on bed-rest. With their reduced income, they realized they can’t pay the mortgage and would not be able to keep both houses. They want to try a short sale on the rental before it goes into foreclosure. They currently are two months behind in their mortgage payments.

They had refinanced the first home and they understand that refinanced loans tend to be recourse loans where the borrowers are personally liable for the debt even if they can’t pay the mortgage. Their biggest fear is that the bank will file a deficiency judgment and try to get their teacher retirement funds and come after any other assets they have. What would you recommend or suggest they do?

A: In today’s economic environment, tens of thousands of homeowner’s are struggling. For many of these homeowners, their financial problems are tied to medical problems. I’m sorry your daughter is having problems in her pregnancy and can’t pay the mortgage on her properties. Paying the mortgage for most is one of the largest expenses and may just can’t pay the mortgage payment on a monthly basis and fall behind.

For most homeowners, whether they own a primary residence or a vacation home or a second home, the documents they signed at their closing or settlement will be quite similar. Most of those documents are standard Fannie Mae and Freddie Mac mortgage documents. These documents include a note that obligates the homeowner to repay the mortgage debt. It’s a personal promise to repay that mortgage debt that is guaranteed by the ownership interest in the home.

If the debt is not paid and the homeowner stops paying the mortgage, the lender has the right to take back title to the property by foreclosing on the home. Upon the foreclosure, the bank sells the home to settle as much of the balance owed on the mortgage as possible. Once the homeowner couldn’t pay the mortgage, the process of selling the home for the balance owed on the mortgage is generally known as foreclosure and if after the foreclosure, the bank is still owed money, the lender can go after the borrower for the deficiency. To get the deficiency, the bank usually has to go to court and obtain a deficiency judgment against the borrower. That deficiency judgment is what would allow the lender to go after the borrower after the borrower stopped paying the mortgage and after the foreclosure.

That brief summary is the way the foreclosure process starts and the way the process ends with the possibility of a deficiency judgment. But the general rule is that you are personally obligated to repay the debt owed on a home whether or not the sale of the home through foreclosure results in sufficient funds to pay off the debt enabling the lender to obtain a deficiency judgment.

But in some states, lenders who hold mortgages on primary residences can’t sue a borrower for a deficiency to get a deficiency judgment. In other states, mortgage lenders can’t obtain a deficiency judgment if the company used a trust deed to secure the mortgage debt on the property. In a nutshell, the lender’s ability to obtain a deficiency judgment is limited in those states but in addition, there are other practical limitations for lenders to obtain a deficiency judgment against the borrower.

Read our article on Anti-Deficiency Law May Protect Homeowner.

To obtain a deficiency judgment, a lender must not only foreclose on the home, but must have lost money in the process of selling the home during the foreclosure process. The lender would then be required to go back to court and obtain a deficiency judgment against its borrower. Those additional steps – and they may differ from state to state – may cost the lender more money. Considering that lenders have tens of thousands of borrowers (or more, in some cases) who can’t make their mortgage payments and go into foreclosure, spending additional money that may or may not result in more money for the bank may be something that the banks might be willing to forgo.

You can also read how Foreclosure Affects Credit But Homeowner May Avoid Deficiency Judgment

In some parts of the country where lenders have the right to obtain deficiency judgments, the banks aren’t getting those judgments or judges are unwilling to grant them. In either case, once the homes are foreclosed, the borrowers don’t need to worry about the lender chasing after them for a deficiency judgment.

Now if your daughter goes down the route of attempting to sell her home in a short sale, lenders may try various things to minimize their loss. One of the terms that some lenders insert into their short sale agreements allows them to pursue a deficiency judgment against the borrower or having the home owner agree that the borrower still owes the balance to the lender.

To avoid this issue in a short sale, your daughter would have to refuse to sign that document presented to her by her lender during the short sale process that would permit the lender to obtain a deficiency judgment or go after her for the balance owed on the debt after the short sale.

If your daughter is able to remove any language that would give the lender the right to go after her for the deficiency or obtain a deficiency judgment, she could proceed with the short sale of her home.

Just be aware that the lender doesn’t have to agree to the short sale of the home. But if the lender doesn’t, it would then have to proceed to foreclose on the home. The lender would have to decide whether it would get more cash through the short sale of the home or through the foreclosure process. And now that your daughter can’t pay on her mortgage and if she doesn’t, the lender now has no money coming in to service the loan.

Given all that, your daughter should know that if her state allows deficiency judgments either because the home she is attempting to sell is a second home or rental property or because there is no prohibition on deficiency judgments, the lender won’t be able to touch her retirement accounts.

The lender would first have to obtain the deficiency judgment and then would have to try to go after non-retirement accounts. For many borrowers these days, a lender attempting to go after other assets usually sends those borrowers into bankruptcy. That lender will stand in line with other unsecured creditors in the bankruptcy and may end up with pennies on the dollar – or nothing more than what they originally had. But retirement funds are usually protected and the lender wouldn’t be able to go after those funds even if the lender obtained a deficiency judgment.

You should speak with a good real estate attorney who can help your daughter and her husband sort through their various options.