State laws regulate the actions that creditors can take when trying to collect on a secured loan. In some cases, states prohibit the creditor from seeking more than the collateral used to secure the loan. This is called “non-recourse” or “anti-deficiency,” meaning that a creditor cannot hold the borrower personally liable for more than the value of the property at the time of sale.
A strategic default occurs when a homeowner stops paying their mortgage even though they are still financially able to do so. Surprising to many people, a substantial amount of the people that walk away from their homes have excellent credit ratings. So why would someone strategically decide to leave their mortgage? In California, there are many good reasons.
Strategic defaults are greatly concentrated in negative-equity markets where home values plummeted during the bubble burst. In California last year, the number of strategic defaults was 68 times higher than it was in 2005. Homeowners with large mortgage balances generally are more likely to walk away than those with lower balances. Likewise, people with high credit ratings are much more likely to default strategically than people who have low scores.
Most people believe if they stop paying their mortgage the bank can come after them for a deficiency judgment. Those people may be surprised to learn, in California, they are probably protected by the many anti-deficiency statutes.
What are the anti-deficiency statutes? Well, one of them is California Code of Civil Procedure Section 580(b), which states in relevant part:
"No deficiency judgment shall lie in any event after a sale of real property or an estate for years therein for failure of the purchaser to complete his or her contract of sale, or under a deed of trust or mortgage given to the vendor to secure payment of the balance of the purchase price of that real property or estate for years therein, or under a deed of trust or mortgage on a dwelling for not more than four families given to a lender to secure repayment of a loan which was in fact used to pay all or part of the purchase price of that dwelling occupied, entirely or in part, by the purchaser."
In plain English – the statute addresses 2 types of loans:
- Purchase money loans and
- Seller carryback loans.
Under the statute, seller carryback loans are not entitled to seek a deficiency judgment against the borrower. However, there is an exception under California’s case law that does permit the seller to recover against the borrower under certain circumstances.
As for the purchase money loans, there is no deficiency if the subject property is owner-occupied and is a residential property with one to four units. What does that exclude? (1) Vacation Homes, (2) Home-Equity Lines of Credits, (3) Investment Properties where the borrower does not reside in the subject property, and (4) Apartment buildings more than 4 units.
Many people ask what if my loan is not purchase money? Well, if the foreclosing lender seeks a non-judicial foreclosure, they generally can’t come after you for a deficiency. This begs the question, what if the foreclosing lender opts for a judicial foreclosure? Chances are they won’t. The reasons why are too complicated to go into detail in this posting, but it essentially is not in their financial best interest and the process will take much longer than the lender can afford to wait. In the last twenty years, I only know of one residential judicial foreclosure in Sonoma County.
Some people have moral issues with strategic defaults. People ask me, is it immoral to foreclose, even when you can afford the payments? Well I ask you this, is it immoral to take all necessary legal steps to protect the best interest of your family?
I also remind my clients that it was their tax dollars that bailed out the banks that hold their mortgages, yet they have nothing to show for it. Remember, a mortgage is a legal contract with the penalties for breach explicitly spelled out. There’s nothing moral or immoral about it. I advise my clients all the time, whatever legal matter they seek my advice on, in the words of the Godfather, “it’s not personal, it’s just business.”
Other authorities have suggested, and I agree, that the five things to do before you strategically default are as follows:
- Contact the bank and explain your situation. Explain how they could prevent the strategic default by renegotiating your loan principal balance, and how a foreclosure will certainly cost them more money in the long run. They probably won’t do anything, but at least you’ll be able to say you tried.
- Consult an attorney to make sure that all the anti-deficiency statutes protect you regarding your specific circumstances.
- If you have a co-borrower, try and remove them from the mortgage.
- If you have a co-borrower, try and remove their name from the title.
- If you plan on making any big purchases in the near future (car, boat, another house…), finalize the deal before you default.
- Be sure you did not misrepresent anything on your loan application. If you provided the bank with false information, the anti-deficiency statutes may not protect you!
Let me know your thoughts and opinion.DISCLAIMER: THIS IS NOT INTENDED TO BE A PRIMER ON HOW TO AVOID YOUR DEBTS AND LOAN LIABILITY. CONSULT WITH A BANKRUPTCY SPECIALIST AND TAX ADVISER.