In a divorce, sometimes a house goes into foreclosure during a divorce because the spouses cannot pay the mortgage, and it ends up being sold at foreclosure for less than the amount the spouses owe. This is called a short sale.
A deficiency judgment is a marital debt if it derives from a short sale of the family house as a result of a divorce. When a house is sold in foreclosure for an amount less than the outstanding mortgage debt, the difference between the amount owed on a mortgage and the price at which a house is sold in foreclosure is the deficiency. This applies to mortgages secured by a borrower’s principal residence. In many states, the banks can come after the borrower for the difference. For example, when Rufus married Rhonda, he owed $200,000 on his mortgage from Miser Bank and Trust. Rufus stopped making mortgage payments, Miser Bank foreclosed, and Rufus’ house is sold at a foreclosure auction for $100,000. The deficiency in this example is $100,000 ($200,000 minus $100,000).
After a judgment of divorce, normally one person owns the home. That person has title and a mortgage carrying his or her name. If the short sale happens after the judgment of divorce is handed down, only that person is responsible to pay off the deficiency judgment. However, if both names are on the title, then both spouses are responsible for the debt.
In most states, lenders can sue borrowers to recover the deficiency. If the court awards the lender a deficiency judgment, Miser Bank can use the judgment to garnish Rufus’ wages or freeze his bank accounts until the deficiency judgment is paid off.
The laws governing deficiency judgments vary according to the jurisdiction. Some jurisdictions have anti-deficiency laws that prohibit lenders from suing borrowers for deficiencies. Anti-deficiency laws typically provide no protection for second or third mortgages, home equity lines of credit, and mortgages secured by vacation or investment properties.
Some states give lenders an unfettered right to seek deficiency judgments after a foreclosure sale. Twenty jurisdictions allow deficiency judgments if the foreclosure goes through court, which is called a judicial foreclosure; 30 jurisdictions prohibit them if the foreclosure takes place outside the court system, which is called a nonjudicial foreclosure. Some states prohibit deficiency judgments in foreclosures of mortgages used to purchase a borrower’s primary residence and others restrict the amounts that may be recovered in a deficiency action.
Lenders do not always sue for deficiencies because of the time and cost in seeking a deficiency judgment, as well as the fact that most debtors who have lost a home in foreclosure are “judgment proof,” which means they have no assets that the bank can collect on the judgment. Unfortunately, with lenders finding new ways to recoup their losses, deficiency judgments are becoming more common.
A borrower who contemplates bankruptcy and lives in a state that allows deficiency lawsuits should consider filing for Chapter 7 bankruptcy, which may wipe out any liability to repay any deficiency. The elimination of any deficiency liability is typically an added benefit to filing for bankruptcy.
A delinquent borrower who has come to terms with losing his or her home should contact the mortgage servicer to learn about eligibility for any foreclosure alternatives, such as a short sale or deed in lieu of foreclosure.
In addition to a short sale, the borrower can sign the house over to the lender, and in exchange the lender foregoes foreclosure and releases the borrowers from their mortgage. In a deed in lieu of foreclosure, the deficiency is the difference between the fair market value of the property and the total debt
In either a short sale or deed in lieu of foreclosure, the borrower should try to get the lender to agree to a written release from liability for any remaining debt.
When a borrower lives in a state that allows deficiency judgments in a short sale, he or she can negotiate a waiver of the deficiency. The short sale agreement must expressly state that the lender waives its right to the deficiency and that the transaction is in full satisfaction of the debt. If the short sale agreement does not contain this waiver, the lender may later file a lawsuit against borrower to obtain a deficiency judgment after the short sale.
If a borrower cannot complete a short sale or deed in lieu of foreclosure, and the house is then sold in foreclosure, filing for bankruptcy will eliminate any liability to pay a deficiency.