What Is a Deficiency Judgment?

A deficiency judgment is a ruling made by a court against a debtor in default on a secured loan, indicating that the sale of a property to pay back the loan did not cover the outstanding debt in full. It is mostly a lien placed on the debtor for further money.

Key Takeaways

  • A deficiency judgment is a court ruling placing a lien on a debtor for further funds when the sale of secured items falls short of the full debt owed.
  • Depending on your state, it may be that during a foreclosure deficiency judgments are prohibited. 
  • There are safeguards in place to prevent banks from underpaying for a property and demanding the balance from the borrower in default. 
  • Deficiency judgments are often allowed in a transaction known as a deed instead of foreclosure.

How a Deficiency Judgment Works

The legal principle of a deficiency judgment could apply to any secured loan where the property sells for less than the loan amount due, such as a car loan. In most cases, however, the term is associated with mortgage foreclosures,

Home mortgages are designed to avoid the possibility of a deficiency by requiring borrowers to make down payments, and by basing loans on the appraised value of the property. In theory, those safeguards ensure that the lender can sell the property to recoup a loan. But in a real estate downturn such as the one that occurred after the market crash of 2008, home values can drop below the amount of the outstanding loan.

Example of a Deficiency Judgment

Consider a home bought for $300,000 with a 4% interest rate and including a $30,000 down payment. The borrower defaults on the $270,000 loan after two years, leaving a principal balance of $256,000. The bank sells the home for $245,000, then seeks a deficiency judgment against the borrower for the outstanding $11,000. This is the amount the borrower will need to pay in order to stay out of further debt.

State laws against deficiency judgment claims usually don’t apply to second mortgages such as home equity loans.

Limitations of Deficiency Judgments

Many states prohibit deficiency judgments after a foreclosure. Where they are allowed, lenders generally must demonstrate through comparable listings and appraisals that the sale price is fair. This safeguard prevents a bank from accepting a lowball offer and demanding the balance from the borrower.

Even where allowed, a deficiency judgment is not automatic. The court only considers it if the lender makes a motion or asks for its granting. If the lender does not make the motion, then the court finds the money gained from the foreclosed property to be sufficient.

In addition, a debtor who receives a deficiency judgment may seek exemption from the lender or other creditors, file a motion to have the judgment overturned, or, if necessary, declare bankruptcy. In any case, when a debtor is let “off the hook” from the full repayment of a loan, the forgiven debt is considered income by the IRS and subject to taxes.

Special Considerations

Most states allow deficiency judgments in so-called short sales, which is when a bank agrees to let a borrower sell a home at a price lower than the loan amount. A low-priced sale can happen when real estate prices are falling, and a bank seeks to mitigate its loss through a quick sale rather than going through foreclosure. This action may be good for borrowers, depending on their individual circumstances.

Likewise, deficiency judgments are usually permitted in a transaction known as a deed instead of foreclosure when the bank agrees to take title to a property instead of foreclosing.