In Default? The Lender-Borrower Relationship

What is the relationship between the lender and the borrower as a mortgage goes into default.  There is a lot of confusion on this by both the borrowers and real estate professionals.  I hope this helps explains a little of the lender-borrower relationship.

The Mortgage and Deed of Trust:

First, mortgage contracts in the U.S. are a promise to pay money you have borrowed, and your mortgage or deed of trust is a pledge of real estate you own (or are buying with the borrowed money) as security for that note. This means that if you fail to keep your promise to pay the loan in cash, the lender can force you to sell your property at auction (to produce cash with which to pay the loan in full). Because the mortgage instrument gives your lender a "lien," any sales proceeds are first applied to the mortgage debt before you get any of it.

The Auction:

People get very confused about this because it is often the lender who ends up buying the property at the forced auction. When that happens, it is basically because the lender simply wants to put a "floor" bid in the auction: the lender bids an amount based on what the lender is willing to lose (if any). Typically, the lender bids its "make whole amount" or the loan amount plus accrued interest and expenses. If someone else bids more than that, the lender is happy to let the property go to the higher bidder.

The lender might bid less than its make-whole amount; it might bid its "probable loss" amount. If the lender is owed $300,000 and doesn't think it could ever end up recovering more than $200,000, it might bid $200,000 at the Foreclosure auction. The lender doesn't actually want to win the auction; lenders are not really in the business of real estate investment or property management. However, the lender would rather buy the home at the auction and pay itself back eventually by re-selling the property later (as a listed property in a private sale instead of a courthouse auction) than let the property go for $50,000 (meaning the lender would recover only $50,000 on a $300,000 loan instead of $200,000). Nothing ever stops any third party from bidding $1 more than the lender's bid and winning the auction (except, of course, any third party's own inclinations).

One needs to remember when anyone talks about "giving the house back to the bank" or "mailing in the keys," they are talking metaphorically. The only situation in which "giving the house back to the bank" would literally be possible is if you bought the house from the bank (say, it was REO) and the contract explicitly gave you an option to sell it back to the bank, whenever you wanted to, at a price equal to your loan balance. Nobody writes REO sales contracts that way. In most cases, of course, you bought the house from someone other than a bank. You have no option to sell the house back to the seller.

Note: See your CPA or Real Estate lawyer concerning tax considerations if your house is sold short.  Tax laws have changed recently in this area.

Alan ‘AJ’ Nisen, a Contra Costa California Mortgage Loan professional on ActiveRain.com