|Spring Real Estate 2008
Publication Date: Friday, April 18, 2008
Avoiding the refinancing trap
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.
Post-Purchase Secondary Financing.
Sold-out Secondary or Junior Loans.
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.