Equity Line of Credit and Foreclosure

People generally buy a home by availing a mortgage. Since mortgage is an amortizing loan, the borrower is expected to make both principal and interest payments in lieu of the borrowed sum. The mortgage lender has the right to foreclose the property in case the borrower is unable to make good the mortgage payments. The unprecedented 90 percent increase in home prices between 2000 and mid-2006, resulted in a number of people tapping into the equity in their home. The write-up examines the lender's take on home equity line of credit and foreclosures.

Home Equity Line of Credit

Positive home equity and the belief that home prices would continue to escalate resulted in mortgage lenders providing the homeowner the benefit of home equity loan and line of credit. A number of homeowners also decided to refinance their primary mortgage to lower interest rates and a few of them, went on to explore cash-out refinancing. As discussed in the article, 'second mortgage vs. home equity loan', a home equity line of credit (HELOC) can be a second or a primary mortgage. Generally, most HELOCs are second mortgages. The crash in the housing market left homeowners with negative equity in their home and diminished their ability to make good their mortgage obligations. A large number of defaults resulted in foreclosures and encouraged lenders to consider freezing home equity lines of credit.

Home Equity Line of Credit and Foreclosure

A freeze in home equity lines of credit has been witnessed in cases where the HELOC was a second mortgage. The reason is the lender's position is compromised regardless of whether the homeowner defaults on the primary home mortgage or the second mortgage.

Case I - Primary Mortgage Lender Forecloses
A primary mortgage lender chooses to initiate foreclosure proceedings when the home owner defaults on primary mortgage payments. In all likelihood, the second mortgage lender (HELOC provider) is also not getting paid as per agreement.

If the homeowner is unable to pay the primary mortgage lender, the latter has the right to opt for a judicial foreclosure or a non-judicial foreclosure. All states in the US allow a judicial foreclosure but only 29 states allow a non-judicial foreclosure.

If there are multiple liens on the property, a judicial foreclosure is preferred by the primary lender since the court rules in the order of priority of competing liens. Generally, it results in the foreclosed property being sold at a discounted price. Since, the primary mortgage lender has priority of claim, his/her claims get settled while the HELOC lender's claim becomes akin to an unsecured debt. The second mortgage lender can then sue the homeowner and obtain a judgment for the deficiency. However if the homeowner files bankruptcy to avoid getting sued, the HELOC provider's position becomes fragile since the second mortgage lender is left holding an unsecured loan after foreclosure.

In case the primary mortgage lender decides to opt for a non-judicial foreclosure and the second mortgage lender's claim gets wiped out, the second lender is in a position to sue the homeowner directly for the amount owed. Here again, the second mortgage lender will not be able to recover the deficiency if the borrower files Chapter 7 bankruptcy.

Case II - Second Mortgage Lender Forecloses
A second mortgage lender may initiate foreclosure proceedings when the borrower is current on the primary mortgage but is unable to pay the interest on the HELOC. In this case, the second lender would have to negotiate with the primary lender, pay-off the primary lender and then foreclose the property. It's evident that the second mortgage lender will foreclose only if the property is worth more than the sum total of the primary and the second mortgage. Today, home prices have fallen to such an extent that the sum total of the primary and the second mortgage loan may not be equal to the selling price of the property. The second mortgage lender can get a deficiency judgment for the amount that could not be recovered by a foreclosures sale, only if he/she opted for a judicial foreclose. However, a judicial foreclosure is more expensive and time-consuming as compared to a non-judicial foreclosure.

From the above discussion, it is obvious that, in the current scenario a second mortgage lender has no option but to freeze the home equity line of credit. Foreclosure proceedings invariably leave the second mortgage lender in distress, irrespective of whether the proceedings were initiated by the primary or the second mortgage lender.