Deficiency Judgment

A deficiency judgment is a court ruling against a debtor who is in default on a secured loan, when the sale of the property that secured the loan fails to cover the debt in full. It allows the lender to collect additional money from the debtor to make up the difference.

How a Deficiency Judgment Works

The legal principle of a deficiency judgment could apply to any secured loan, such as a car loan, where property seized from a defaulting debtor sells for less than the lender is still owed on it. In most cases, however, the term is associated with mortgage foreclosures.

Home mortgages are designed to avoid a deficiency by basing loan amounts on the appraised value of the property and requiring borrowers to make a down payment. That way, the lender is putting less money at risk than the property is worth.

In theory, those safeguards ensure that the lender can sell the property for enough money to recoup its loan should the borrower default. But in a real estate downturn, such as the one that occurred in 2008, a home’s value can drop below the amount of the outstanding loan on it. This is sometimes referred to as an underwater mortgage. When a borrower defaults on their mortgage under such circumstances, the lender may seek a deficiency judgment.

Example of a Deficiency Judgment

Consider a home bought for $300,000 with a $30,000 down payment and a $270,000, 30-year mortgage at an interest rate of 4%. The borrower defaults on the $270,000 loan after two years, leaving a principal balance of about $260,000. The bank sells the home for $245,000, then wins a deficiency judgment against the borrower for the remaining $15,000. That is the amount that the borrower would need to pay.

How Do Lenders Collect Deficiency Judgments?

Many states prohibit deficiency judgments after a home foreclosure. Where they are allowed, a lender generally must demonstrate through comparable listings and a professional appraisal that the price it received from selling the home was fair. This safeguard prevents a bank from accepting a low offer and demanding the balance from the borrower.

Even where they’re allowed, deficiency judgments are not automatic. The lender must make a motion to request one. If the lender does not make the motion, then the court will find the money obtained from the sale of the foreclosed property to be sufficient.

If the lender succeeds in obtaining a deficiency judgment, it can attempt to collect the money in a variety of ways, including putting a lien on other property that the debtor owns, garnishing the debtor’s wages, or levying (taking money from) the debtor’s bank account.

What to Do When Facing a Deficiency Judgment

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, if a debtor is let off the hook from the full repayment of a loan, the forgiven debt is considered income by the Internal Revenue Service (IRS) and subject to taxes, with certain exceptions depending on the situation.

Deficiency Judgments and Short Sales

Most, but not all, states allow deficiency judgments following short sales, which is when a bank agrees to let a borrower sell a home at a price lower than the loan amount. A short sale can happen when real estate prices are falling, and a bank seeks to lessen 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 in lieu of foreclosure, when the bank agrees to take title to a property instead of foreclosing on it.