Risk of Refinancing Your Home Loan: Refi Means Recourse!

With interest rates and home values dropping, many homeowners are refinancing their mortgages.  Many banks have found that the refinancing market is a good way to keep their loan production up.  These refinancing packages can look quite attractive to homeowners as, in some instances, they can reduce their interest rate by 2% or more.  That being said, the biggest, and mostly unknown, drawback is that refinancing your home loan will likely expose you to personal liability in the event of default.

If the only debt on your home currently is the loan you used to buy it (a “purchase money mortgage”), then, at least in California, the lender cannot sue you personally in the event of default.  For instance, if you walk away from your mortgage with $300,000 still owing, and the foreclosure sale price is only $200,000, the lender must absorb that $100,000 “deficiency.”  The reason for this is that California Code of Civil Procedure §§ 580b and 580eshield homeowners from deficiency judgments if they default on their purchase money mortgage.  580b applies if your home is sold through a foreclosure sale (also known as a “trustee’s sale”); 580e applies if you short sell your home (please note that §580e is a relatively new law; short sales historically opened the borrower up to being sued personally for the deficiency).  It is important to note that this protection applies narrowly to homes…you can’t bootstrap the 580b or 580e shield by arguing you live next to the Quiznos in your 8,000 square foot commercial building.

Because 580b and 580e apply to purchase money mortgages only, if the nature of the loan changes, the protection offered by these statutes is lost.  In other words, refinancing turns your home loan from nonrecourse to recourse.  If you default on your refinanced loan, the bank can now pursue a “judicial foreclosure,” which is essentially a court supervised and administered foreclosure proceeding.  Judicial foreclosures are more time consuming and expensive for the bank, but they give the bank the ability to sue you personally for the difference between that amount you owe and the price for which the property sold (a “deficiency judgment”).  When borrowers obtain a purchase-money loan, the California Civil Code requires an initial disclosure of the details of the code, but it does not necessitate disclosure of the potential loss of that protection through refinancing.

The take home point is not that you should avoid refinancing, but simply that you should be fully advised of all of the risks prior to making the decision.  On occasion, you can negotiate with banks during the refinancing process for them to include nonrecourse language in the new financing agreement.  If you need any assistance with this complicated area of the law, please contact our law offices.