Publication Date: Friday, April 18, 2008
Avoiding the refinancing trap
Foreclosure isn't always worst-case scenario
Last spring I wrote about the "Good, Bad, and the Ugly of Subprime Loans." Four months later, we had the "subprime meltdown." The results in the financial market have been well-chronicled and need not be rehashed here.
The refinancing trap has rarely been discussed but looms large for many borrowers who are losing their homes or investment properties through foreclosure.
First, a few simple definitions:
A promise to pay back funds borrowed from a lender with interest on the terms stated in the note agreement.
Deed of Trust. A security instrument for a promissory note that allows the lender to have an interest in the property ahead of the borrower (owner) and other later recorded liens. Lenders gain legal authority to conduct a foreclosure sale based on the deed of trust.
Purchase Money Loan.
A loan secured by a deed of trust obtained from the seller or a lender at the same time the property was purchased.
A loan that has been obtained after the purchase of a property to pay off the original debt that was used to purchase the property.
Post-Purchase Secondary Financing.
This is a new loan obtained after the purchase of a property that is usually secured by a second (or third) deed of trust. The most common form of secondary financing is a home-equity line of credit.
A loan that allows the lender to sue you personally for the debt and go after your assets above and beyond the deed of trust that secures the loan.
A non-recourse loan is a purchase money loan that prevents the lender from suing you personally for any money beyond what the lender can obtain through foreclosing on the deed of trust.
The process of foreclosure wherein the lender holds a sale auction of the deed of trust and obtains funds at the auction, which extinguishes both the deed of trust and the debtor's interest in the property. Thus, the high bidder becomes the new owner of the property after the auction.
The process of filing an action in Superior Court to foreclose on the deed of trust to obtain the proceeds from the sale of the property as well and sue the debtor for any amount of money owed that is not satisfied through the sale of the property by the court.
Sold-out Secondary or Junior Loans.
This is a term used to describe a situation when the first deed of trust holder conducts a foreclosure sale and the interest of the secondary or junior lender's deed of trust is thereby eliminated.
Many homeowners who purchased their property in the last few years with 90 to 100 percent debt are facing foreclosure today because the value of their property has dropped, and the payments and/or interest rate on their loans have increased substantially. The worst-case scenario for these owners is that they will lose their home to a foreclosure sale.
The lender who forecloses will be able to claim only the proceeds of the sale because purchase money loans are non-recourse, meaning the lender cannot sue the borrower for any deficiency in funds not obtained at the foreclosure sale. Consequently, even if the property had a $500,000 loan and it sold at the foreclosure sale for $300,000, the lender cannot make a claim against the debtor for the $200,000 deficiency.
You may wonder, what might happen if it were not a purchase money loan but instead a refinanced loan? These types of loans are recourse, meaning the lender may seek a deficiency by suing the debtor conducting a judicial foreclosure. Judicial foreclosure of residential property is rare and generally lenders proceed to hold a trustee sale. After a trustee sale, the lender foreclosing on the deed of trust is not allowed to sue the debtor for any deficiency.
The trap comes with the line-of-credit secondary loans. If the first lender forecloses by means of the trustee sale, then the secondary lender loses his or her interest in the deed of trust that secures the promissory note. As a result, the secondary lender no longer has the security to foreclose on and can sue the borrower for the amounts owing on the now unsecured note. Therefore, even if the borrower has lost his or her home in foreclosure, he or she could face a further lawsuit from the secondary lender for the funds due on the note. In many cases, this involves more than $100,000.
Why don't the second lenders foreclose? Generally because there is no equity to support their loans, meaning if they foreclose and bought the properties at foreclosure sales they would still have to pay off the first deed of trust, which by itself may exceed the present market value for the home. The second lenders refuse to foreclose because they are in a better position if the house goes through foreclosure with the first lender. This is especially true if the lenders know you have other assets that they can attach after they win their lawsuit.
When will you know if the secondary lender(s) are going to sue? You may have to wait a long time. The statute of limitations may allow them to wait up to four years to sue you on the note after you have defaulted.
The borrowers that have and will yet suffer the most from the subprime meltdown are those that have refinanced and taken cash out from properties they have owned for many years and have huge taxable capital gains whenever a sale of the property takes place. They can end up being sued by sold-out junior lenders and having a huge tax bill from the IRS as well. If you are in foreclosure you should examine the potential liabilities you may have if you walk away from your home and let the lender foreclose. Your loss could be much greater than just your home and your credit rating.
Next time you think about refinancing, you might want to consider consulting a real-estate expert other than your lender or mortgage broker. Lenders and mortgage brokers have an inherent conflict of interest never to disclose to you the risks inherent in refinancing.
J. Robert Taylor, J. D., a real estate attorney and broker for more than 20 years, has served as an expert witness and mediator and is on the judicial arbitration panel for Santa Clara County Superior Court. Send questions to Taylor c/o Palo Alto Weekly, P.O. Box 1610, Palo Alto, CA, or via e-mail at firstname.lastname@example.org.