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Refinancing and Deficiency Judgments: Understanding the Connection

Posted by  on Oct 18, 2010
 

Recent news reports highlight the trend of "strategic default," which refers to homeowners who can afford mortgage payments walking away from loans with balances that exceed their homes' value. This typically occurs when homeowners are unable to refinance or qualify for mortgage assistance programs. Unfortunately, those who have refinanced their mortgages may be liable for shortfalls resulting from foreclosure regardless of laws prohibiting most deficiency judgements. It's possible that the lender of your refinanced mortgage may have the right to pursue a deficiency judgment in a non-recourse state. Here's why.

Refinance Mortgages May Not be Protected Against Deficiency Judgments

Procedures for home loan foreclosure and deficiency judgments vary according to state law. Some states allow mortgage lenders to pursue a deficiency judgments against borrowers based on losses resulting from foreclosure. A deficiency amount is generally defined as the difference between foreclosure losses and the home's value at the time a foreclosure sale is held. In states allowing deficiency judgments, lenders can sue for payment of the deficiency amount, which can lead to liens, wage garnishments, and ongoing collection efforts.

Although mortgage lenders may not elect to pursue deficiency judgments in states where permitted, you have no guarantees. Mortgage lenders are increasingly motivated to recover losses caused by high foreclosure rates and severely reduced home values. If you've refinanced your mortgage and are at risk of foreclosure, or are considering walking away from a refinance mortgage, seeking legal advice concerning deficiency judgments in your state can assist with determining your potential financial liability.

Potential Connections Between Refinancing and Deficiency Judgments

Legal loopholes may void protections offered in non-recourse states for purchase money mortgages may not apply to other types of home loans:

  • Refinanced mortgages
  • Home equity loans
  • Home equity lines of credit

A recent San Francisco Chronicle article explains that laws offering protection against deficiency judgments were made before mortgage refinancing was common. In California, a non-recourse state, some lenders are pursuing deficiency judgments against borrowers of refinanced mortgages, which are not protected. Although the California State Senate has passed a bill that would protect consumers with refinanced mortgages, the fate of the bill remains unknown, as banking and lending interests push for its defeat. Other states are watching this legislation and may be influenced by its passage or defeat.

Cash-Out, Home Equity Loan Borrowers May be Subject to Deficiency Judgments

Borrowers refinancing for more than their original mortgage amounts may be liable for the difference between their original mortgage amount and the refinance mortgage amount if the refinance mortgage is foreclosed, regardless of laws prohibiting deficiency judgments. Again, the loophole allowing lenders of amounts not directly used for purchasing a home may permit them to collect on cash-out amounts. Here's an example based on very general terms:

  • Original loan amount: $250,000
  • Refinance with cash out $275,000
  • Amount potentially subject to deficiency judgment: $25,000

Home equity loans and lines of credit can also be subject to deficiency judgments as they are not considered purchase money mortgages. The complexity of real estate laws impacting mortgage lending suggests that consumers interested in refinancing or taking out any type of home equity financing should consult a legal or financial advisor familiar with real estate law to explore options and identify possible risks.

Your Refinance Mortgage and Foreclosure: Considering Alternatives

If you're facing financial hardship due to a situation beyond your control, you may qualify for refinancing or a loan modification through the federal Making Home Affordable program, or your mortgage lender may approve loss mitigation options including modification, forbearance, or a short sale. Examples of acceptable hardships may include:

  • A period of unemployment during which you fell behind on payments
  • Reduced income due to illness or cuts in work hours
  • Loss of home value making it impossible to refinance your mortgage to current rates

Choosing not to make payments when you can afford to do so is not considered a qualifying hardship. Contact your mortgage lender's loss mitigation department, or a HUD approved housing counselor for information about avoiding foreclosure.

Preventing foreclosure when possible is a preferable to having a foreclosure on your credit record. Consult your financial advisor for determining potential income tax liability on any amounts written off by your mortgage lender as the result of foreclosure or loss mitigation options.

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