In a foreclosure, it's important to know if your mortgage loan is a recourse loan or a nonrecourse loan. For recourse loans, the bank can get a deficiency judgment; but for nonrecourse loans, the bank cannot. Usually, whether your mortgage is recourse or nonrecourse depends on your state's laws. (To learn what to do—and what not do—if you’re facing a foreclosure, see Foreclosure Do's and Don'ts).
With a recourse loan, the borrower is personally liable for the debt. With respect to foreclosure, a debt is considered to be recourse if the bank is able to get a deficiency judgment against you.
When a bank forecloses, the total debt the borrower owes sometimes exceeds the foreclosure sale price. The difference between the sale price and the total debt is called a “deficiency.”
Example. Say the total debt owed is $300,000, but the home sells for $250,000 at the foreclosure sale. The deficiency is $50,000.
A deficiency judgment is a personal judgment that the bank obtains against the debtor to recover the deficiency. Generally, once the bank gets a deficiency judgment, it may collect this amount—in our example, $50,000—from the borrower by doing such things as garnishing the borrowers’ wages or levying the borrowers’ bank account. (To learn more about deficiency judgments in the foreclosure context, see Deficiency Judgments: Will You Still Owe Money After the Foreclosure. To learn how a bank can collect on a deficienty judgment, see How Do Mortgage Lenders Collect Deficiency Judgments?)
With a nonrecourse mortgage loan, the bank can't do anything other than foreclose on the property to recoup the money it loaned you. This means that the bank may not obtain a deficiency judgment—even if the sale proceeds don't repay the total debt owed on the loan.
Whether a mortgage loan is recourse or nonrecourse varies from state to state, depending on a particular state's laws. Many states allow a bank to obtain a deficiency judgment, but typically there are restrictions. For example, the deficiency is usually limited by the fair market value of the property.
Example: If the total debt is $300,000 and bank bids $250,000 at the foreclosure sale and purchases the property using a credit bid, the deficiency is $50,000. Generally, this means the bank could file a subsequent action where it would be granted a deficiency judgment for $50,000 and be able to collect that amount from the borrower. But if the fair market value of the property is really $275,000, the lender could only obtain a deficiency judgment in the amount of $25,000.
Because the bank is typically the only bidder at the foreclosure sale, the fair market value limitation prevents a bank from making an extremely low bid in order to collect a big deficiency judgment.
Also, some states—like Arizona, California, and Oregon—prohibit deficiency judgments in certain circumstances, such as if the foreclosure is nonjudicial or for purchase money mortgages. In other states, the process for obtaining a deficiency judgment is so burdensome or time-consuming that banks typically opt to forgo pursuing one.
If your state allows deficiency judgments, you can potentially escape liability once the judgment is obtained by filing for bankruptcy. In Chapter 7 bankruptcy you can discharge the deficiency relieving you of the debt. In Chapter 13 bankruptcy, you might have to pay a portion of the owed amount (it's often a very small portion). When you complete all of your plan payments, the deficiency judgment will be discharged along with your other dischargeable debts. (To Learn how Chapter 7 and Chapter 13 bankruptcy can get rid of deficiency judgments after foreclosure, see Bankruptcy & Deficiency Judgments After Foreclosure.)
If you’re facing a foreclosure and want to find out if your mortgage loan is recourse or nonrecourse, as well as learn whether you have any possible defenses to the foreclosure, consider talking to a local lawyer. Also, it's a good idea to consider making an appointment to talk to a HUD-approved housing counselor to get information about different ways to avoid a foreclosure.