One of the big worries borrowers have after a foreclosure is whether or not the lender is entitled to a deficiency judgment. If the property sells for less than is owed to the lender at the foreclosure sale, the difference between the sales price and the total debt is known as the deficiency. For example, if a homeowner owes $250,000 to the lender and the property sells at the foreclosure sale for only $200,000, the deficiency is $50,000. In some states, the lender is allowed to sue the homeowner for this difference and obtain a deficiency judgment, which is a personal court judgment against the borrower. The deficiency judgment allows the lender to collect the debt by garnishing the borrower’s wages or levying a bank account.
In California, a deficiency judgment is not allowed following a nonjudicial foreclosure. Cal. Code Civ. Proc. § 580d. Almost all residential foreclosures are nonjudicial foreclosures in California. (However, if you have a second or third mortgage, or a HELOC, in certain circumstances you may face a lawsuit from one of those lenders.)
A deficiency judgment is allowed with a judicial foreclosure; however, lender may not obtain a deficiency judgment if:
Furthermore, even if the lender has the legal right to obtain a deficiency judgment, the amount of the judgment is limited to the lesser of:
To obtain the deficiency judgment, the lender must apply to the court within three months of the judicial foreclosure sale and a fair value hearing will be conducted. Cal. Code Civ. Proc. § 726(b).
California’s One Action and Security-First Rules
California’s one action rule provides in part that “[t]here can be but one form of action for the recovery of any debt or the enforcement of any right secured by a mortgage upon real property”. Cal. Code Civ. Proc. § 726(a). This means that the lender may choose to:
Completing either one of these options constitutes one action.
When junior lenders lose their security in the property due to the senior lienholder’s foreclosure, they are still are entitled to their one action. This means a junior lienholder (called a sold-out, or wiped-out, junior lienholder) can file a suit on the promissory note, which is unsecured following the foreclosure, to recover the remaining balance from a borrower, so long as the borrower is not protected by the anti-deficiency rules.
With such extensive statutory restrictions on deficiency judgments after foreclosure, you may wonder why a lender whose security is severely underwater (where the balance of the mortgage debt outweighs the value of the home) wouldn’t simply choose to sue the debtor personally based on the promissory note and forego foreclosure—especially in cases where the debtor has significant assets but has simply chosen to stop paying the debt because the house has become a bad investment. Lenders can’t sue debtors personally for mortgage debts because California law requires lenders to first foreclose before attempting to sue the borrower personally to collect the debt. This is called the security-first rule.
When a home is sold by a short sale, the transaction will not satisfy the total amount that is owed. A short sale occurs when a property is sold for less than is owed on the total mortgage debt. In California, the lender cannot obtain a deficiency judgment following a short sale on a residential property that contains not more than four units. Junior lienholders are also prohibited from pursuing a deficiency judgment if they have agreed to the short sale. Cal. Code Civ. Proc. § 580e.
A deed in lieu of foreclosure may also result in a deficiency. The deficiency will be the difference between the property’s fair market value and the total debt. Although California’s prohibition against deficiency judgments after a short sale does not explicitly apply to deeds in lieu of foreclosure, a California court could potentially view this as evidence of a legislative intent to prohibit a deficiency judgment following any loss mitigation transaction, including deeds in lieu of foreclosure. If you intend to complete a deed in lieu of foreclosure and want to avoid a deficiency judgment, you should negotiate with your lender to include language in your deed in lieu of foreclosure agreement that the transaction fully satisfies your entire mortgage debt. Without such language in the agreement, there remains a risk that the lender may later attempt to obtain a deficiency judgment against you.