Deficiency Judgment: Think Again Before You Walk Away
Posted by Frugal on July 3rd, 2006
To the current homeowners: think again before you send the keys to the bank and walk away from the house. Do you think that when the housing prices fall, you can simply walk away from all the loans? Well, if you didn’t know, I am going to explain it to you. There are loans that you can walk away, and there are loans that you cannot. It’s called a recourse or a non-recourse loan.
A non-recourse loan means that there is no other recourse available to the lenders besides taking back the home. A typical non-recourse loan is a home loan for purchase. If the house falls below the balance of the purchase loan, the buyer can walk away from the house without any serious consequences (maybe except a big blemish on the credit report). On the other hand, a recourse loan means that the homeowner is personally liable for any “deficiency” when the lenders cannot recover the loan amount by selling off the house. A typical recourse loan is a home equity loan or a line of credit from home equity. As far as I could research, I don’t think a refinanced home loan is definitely a recourse loan. But I’m almost certain that a cash-out refinanced loan is recourse loan. As far as the legal language is concerned, a refinanced loan obviously is not a loan made for purchase.
So if you think that banks are so stupid of lending you a first loan of 80% LTV (Loan to Value), and piggy-back another 15% or even 20% through home equity loan, then you’re mistaken. On the first loan, the banks have a 20% cushion protection before they are not able to sell the house to recover the loan. On the other home equity loans, banks have the option of going after you in court even if after the sale, they cannot recover those loan amount. Legally speaking, you would have fare better if you took out a loan beyond 80% LTV, and pay PMI (private mortgage insurance) on the non-recourse purchase loan. The same is true for refinancing. If you have refinanced your purchase loan in the past, most likely you have just given up the ability of walking away from your home free & clear. I don’t know how adjustable rate mortgage (ARM) purchase loans are treated. But if you faked your income/asset numbers on the application, it would constitute as a mortgage fraud, and pretty much invalidate any legal protections that you have.
Of course, usually banks don’t like to resort to legal actions in recovering assets from you. If a market assessment indicates that they are able to recover most of the loan amount, they will probably not go after you, and do a quick Trustee’s sale instead of going through a judicial foreclosure. However, if the housing market turns, there is no guarantee that they won’t go after you in court for a deficiency judgment. A deficiency judgment is where you are personally liable for all the difference or deficiency between the sale of the home and the loan balances (plus all the legal costs and probably mortgage interests).
To read more about the details of trustee’s sale & deficiency judgments, including tax treatments for both, you can follow the links that I’ve found:
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July 10th, 2006 at 2:34 pm
I started to write a few additional statements for the readers, but then I read your links and I realized that a lot of those points were covered in those (great!) articles.
Also remember this: mortgages aren’t the only kinds of liens that can be attached to your property. Handymen can place mechanic’s liens on your property if your fail to pay them for service (perhaps you had a dispute over quality of work?). You might get sued, lose the case, and have a judgment attached to your real estate. Not only that, but don’t forget about tax liens from the IRS or local governments!
I would just like to re-iterate to the readers here that not all states allow lenders to collect deficiency judgments from you. Also if there is a bankruptcy involved (especially if you’re filing Chapter 11 for you and/or 13 for a business) then things can get really strange (both good and bad). A bankruptcy can actually eliminate some of your tax liabilities, but it also might cause you to lose 100% of the equity of your home.
July 10th, 2006 at 5:44 pm
Jason, thanks for your input. There are MANY details involved with things like this, and often changes from case to case.
I just read another good article exactly on the same topic. It’s from OC register. A very good article, and their advice of selling the home without going foreclosure is the same advice that I would give. It’s far better to handle the entire process yourself, instead of having lenders to give you a thousand cuts at every step of the process, when you will be due for a deficiency judgment.
August 28th, 2007 at 3:27 pm
The Orange County Register article is misleading.
The article says,
“But in California, refinanced loans, second trust deeds and home equity lines of credit are generally considered recourse loans. In these cases, a lender can file suit and go after almost any of the borrower’s assets once they obtain a court judgment.”
“Generally considered” by WHOM? The court? The lender? The borrower? The article is misleading because it does not consider that the terms of the contract are going to be what determine the outcome of the proceeding. I am only personally liable for any shortfall if I have specifically agreed to that as a personal loan. The author should seriously reconsider revising. This is serious business and it amazes me how much misinformation is spread.
August 30th, 2007 at 7:36 am
Andy,
You can take your turn in the court. But home equity loans are recourse loan. You’re 100% liable for your debt, even if your asset doesn’t cover it.
December 19th, 2007 at 9:25 pm
Good Wednesday evening December 19th Frugal,
So let me see if I understand this correctly.
Let’s say that I am a resident of California.
I have a 1st mortgage at $375k and a second mortgage at $50k, totaling $425k owing to two different banking institutions.
Because of the housing market, my home is on the market for $325k, which is $100k less than what I owe the bank(s).
I have not had an offer in the 18 months that the house has been on the market.
Plus, I owe back property taxes of $12k.
I have not paid the last two of my mortgage payments, and intend to let the bank take the house via foreclosure.
Does this mean I am able to walk away from the house and the only real liability is to have my credit rating drop perhaps 250 points;
OR
does it mean that I will have my credit rating drop, AND owe the I.R.S. taxes on the $112k differential between where the house is now priced and my outstanding mortgages plus the overdue property taxes ?
(I thought that the latter only occured in a short-sale situation, rather than a foreclosure)
Thank you.
December 20th, 2007 at 8:14 am
p.s. and even if I DO owe the difference in the taxes, doesn’t the I.R.S. 544 ‘home-sale exclusion of $250k’ still apply as long as I have lived in my home at least 2 years prior to the sale ?
December 20th, 2007 at 8:17 am
I think the IRS 544 means a cancellation of indebtedness in this case. – or in almost everyone’s now facing foreclosure.
I might be missing something here though, so just wanted to check with you on what you thought before I assume anything.
January 8th, 2008 at 8:59 pm
Thanks – I was going to let my house – with equity loan – default because I could rent a better house for $600 less per month. After reading your articles, I believe I will hang on to it. I would rather be paying a bigger monthly payment than potentially having the same payment without any asset tied to this over payment.
do you have any other thoughts on this?
January 28th, 2008 at 10:47 pm
The author is WRONG and contradicts himself.
He talks about “purchase money” being the defining characteristic of a non-recourse loan, but in the same breath says that 80/20s, both which are “purchase money” (i.e. used to buy the house) have the 20 as a recourse loan.
This is incorrect. The author compounds his mistake by going on and on about how the banks aren’t so stupid..you’re right, they aren’t. They were just greedy.
A second mortgage is not the same as a HELOC. If used to buy the house, and not refinanced, it is a recourse loan. Get your facts straight, Frugal. A little “googling” on this subject would serve you well.
January 28th, 2008 at 10:47 pm
The author is WRONG and contradicts himself.
He talks about “purchase money” being the defining characteristic of a non-recourse loan, but in the same breath says that 80/20s, both which are “purchase money” (i.e. used to buy the house) have the 20 as a recourse loan.
This is incorrect. The author compounds his mistake by going on and on about how the banks aren’t so stupid..you’re right, they aren’t. They were just greedy.
A second mortgage is not the same as a HELOC. If used to buy the house, and not refinanced, it is a non-recourse loan. Get your facts straight, Frugal. A little “googling” on this subject would serve you well.
January 31st, 2008 at 12:34 pm
I’m fairly certain that the details on the recourse/non-recourse loans are in the 50 pages of the loan document that anyone has initialed to obtain the loan.
There is a definitely difference between a purchase loan as a second mortgage, and a HELOC loan. To my best knowledge, most of the piggy-back loan deals are structured as HELOC loan, and that is WHY you are NOT paying the PMI mortgage insurance. And that also means that you fall under HELOC, and it is fully a recourse loan.
Sorry that I haven’t had time to reply these. Certainly, I would advise anyone to talk to professionals.
Best luck to everyone.
January 31st, 2008 at 3:26 pm
Here is a link that invalidates this article:
http://loansafe.org/forum/showthread.php?p=5350
Best luck to everyone,
Phil