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Justin Harelik, the Bankrate.com Bankruptcy AdviserForeclosures and deficiency judgments

Dear Bankruptcy Adviser,
In California, at the end of a foreclosure, what kind of mortgages require the borrower to repay any deficiencies? My understanding is the lender cannot require any deficiency payments on an original purchase loan, but they can on a refinance.
-- Jim

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Dear Jim ,
Great question. First of all, I need to say that my answer only pertains to situations in California. The reason is that the laws concerning deficiencies vary greatly from state to state. So if you're reading this column, you have a similar issue and you don't live in California, talk to an attorney in your state.
Here's what's going on, Jim. As you know, when you initially purchase a home through a lender, you don't actually own the home outright. A purchase-money security interest is created, which allows you to purchase the property while the lender maintains an interest in your home until the mortgage is paid off. In general, a purchase money security interest is a security that a lender takes in property that secures payment with regard to those assets of all or part of its purchase price.

California affords homeowner protections when you first buy a house. One protection is that you can not be held accountable for a deficiency in case you default on the mortgage; but only when the original purchase-money security interest still exists. If you refinance, you are not creating another purchase-money security interest -- you are simply refinancing your debt. When do you, you are effectively waiving this protection -- usually without knowing it.

In the case of second mortgages or HELOCs (home equity lines of credit), California law does not protect the borrower from deficiency actions. There is still some question as to whether you create a purchase-money security interest when you buy a home, create a first and second mortgage simultaneously and then default on both mortgages.

However, lenders very rarely seek deficiency judgments in most foreclosure cases. Let's suppose you've refinanced and you do not have legal protection against a deficiency. To seek a deficiency, a lender must perform a judicial foreclosure. This requires all of the basic steps of a nonjudicial foreclosure (which we'll get to in a minute), but it must go through the courts. This means a whole extra layer of officials and paperwork and the time and expenditure that goes with it.
The lender will only do this if the benefits outweigh the costs. What is the deficiency amount? What will be the out-of-pocket costs of collection and court costs to obtain the deficiency judgment? What is the likelihood that the judgment will actually be paid?  

As you can see, the deficiency would have to be significant and the lender would have to be reasonably sure that the borrowers, who are after all abandoning their home, would be able to pay. This is going to be a pretty rare situation. Thus, in California, the overwhelming proportion of foreclosures are accomplished nonjudicially. They cost less and take less time.
In general, a nonjudicial foreclosure can be accomplished in slightly less than four months. It begins with recording a notice of default, which is filed with the county recorders office. This notice indicates that the lender has decided that the borrower cannot bring the mortgage current and officially makes the situation a public record.
The lender must obtain a trustee's sale guarantee, mail copies of the notice of default, publish, post and record the notice of trustee's sale. This happens about three months after filing the notice of default. After the notice of trustee sale has been filed, the borrower has 20 days left before the foreclosure sale and usually five days to cure the default mortgage amounts. Otherwise, the trustee sells the property and records a trustee deed with the county recorders office.
While this may seem like a long process, it is still cheaper and more efficient than a judicial foreclosure. Therefore, the lender is more likely to complete a nonjudicial foreclosure rather than incur the expenses of seeking a deficiency judgment against you.

Before the foreclosure sale, you have options. You can still sell the property, you can bring the mortgage current, you can negotiate a short sale or deed in lieu of foreclosure with the lender or you can file for bankruptcy protection. If you file for bankruptcy you must file a Chapter 13, so that you can pay back the delinquent mortgage payments during the course of the bankruptcy payment period, usually three to five years.

Obviously, I cannot say with certainty that the lender will or will not seek a deficiency judgment against you. However, experience has shown that most lenders prefer to take the less costly path and file for a nonjudicial foreclosure so that they can sell the property and recover some of the remaining balance.

Justin Harelik is a practicing attorney in Los Angeles. To ask a question of the Bankruptcy Adviser, go to the "Ask the Experts" page and select "bankruptcy" as the topic.

Bankrate.com's corrections policy-- Posted: Feb. 27, 2007
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