Last week’s column described how California has two types of homeowner loans with respect to personal liability. Such loans are either “recourse” or “non-recourse.” The distinctions between these two types of loans can make a significant difference on whether or not a buyer ends up with personal liability following a foreclosure.
Homeowners with two loans on their properties are particularly at risk with respect to personal liability. If a borrower has a second loan that is a “recourse” loan and if the first lender forecloses, then the second lender will become a “sold-out junior.” When this happens, the second lender will in most cases have the right and ability to file suit against the borrower for the full unpaid amount of the second loan. However, until the first lender forecloses, the second lender can’t file suit. This is because as long as the second loan is secured by a mortgage or deed of trust, the lender can’t file suit directly on the loan. Instead, the second lender is required to foreclose as long as the second loan is secured by a mortgage.
Both first and second lenders must first “exhaust” their security by foreclosing before they can ever seek personal liability against the borrower. And because some foreclosures don’t result in personal liability by the borrower to the foreclosing lender, many borrowers who have only one loan on their property find that they don’t have personal liability to their lender following a foreclosure. (However, there can be exceptions).
The situation is different when there are two loans. When the first lender forecloses, the deed of trust of the second lender is “wiped out” but the loan from the second lender isn’t “wiped out.” As a result of a foreclosure by the first lender, the borrower is exposed to full personal liability on any recourse loan from the second lender.
Some second lenders actually do file suit against borrowers following foreclosure by the first. If the borrower cannot pay or settle the claim of the second lender, then sometimes these borrowers end up in bankruptcy. With proper advance planning, these situations can sometimes be avoided. Borrowers are therefore wise to obtain competent, experienced legal counsel before committing themselves to a course of action with their lender workout negotiations.