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.

Associated mostly with mortgage foreclosures, 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.

Home mortgages are designed to avoid the possibility of 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 occurred after the market crash of 2008, home values can drop below the value of the outstanding loan.

For example, 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.

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

Even where allowed, a deficiency judgment is not automatic. The court only considers it if the lender makes a motion or ask 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.

Beyond foreclosures, most states allow deficiency judgments in so-called short sales, which is when a bank agrees to let a borrower sell her home at a price lower than the loan amount. This 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. Likewise, deficiency judgments are usually allowed in a transaction known as a deed instead of foreclosure, when the bank agrees to take title to a property instead of foreclosing.

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.