The process of recovering the balance of a loan after a borrower defaults on payments is known as “foreclosure.” It typically involves taking title to property used to secure a debt, selling it, and applying the proceeds to the debt balance. It is used most often in reference to real property, especially a house or other domicile, while the term “repossession” often refers to personal property used to secure a loan or purchased on credit. Few consumer protection laws address foreclosure directly, but property owners have some legal defenses available to them if they believe a foreclosure, actual or threatened, is invalid or erroneous.
What is Foreclosure?
Understanding foreclosure requires understanding a bit about secured transactions, such as the purchase of a house. Most people do not have enough cash on hand to pay the full purchase price for a house, so a typical home purchase has three main parties: a buyer/borrower, a seller, and a mortgage lender. The buyer/borrower puts down some cash, and the lender pays the rest.
At closing, the seller signs a deed transferring title to the buyer/borrower. The buyer/borrower signs a promissory note, which obligates him or her to make payments to the lender, and a security instrument, such as a deed of trust, which conveys an interest in the property to the lender. If the buyer/borrower fails to make payments, or fails to meet other obligations, the lender has the right to foreclose. If the borrower resides at the property, he or she will eventually be forced to vacate the premises in a procedure similar to eviction.
Foreclosure by Lenders or Mortgage Holders
The lender, or other mortgage holder, usually begins the foreclosure process by declaring the borrower to be in default. It might accelerate the note, meaning it requires immediate payment of the full balance, if the note includes a clause allowing it to do so. Unless the borrower can pay the entire amount, the lender has the right to take title to the property in satisfaction of the debt. Even then, if the value of the property is less than the balance of the loan, the lender could require the borrower to pay the difference, known as the “deficiency.”
Most deeds of trust and other security instruments allow non-judicial foreclosure, by which the lender can foreclose without going through the court system. Judicial foreclosure requires a lender to file a lawsuit and obtain a court order.
Foreclosure by Contractors
Contractors who provide labor and materials to improve real property have a security interest in the property until they are paid in full. This is known as a construction lien, mechanic’s lien, or materialmen’s lien. Failure to pay a contractor may result in foreclosure.
General contractors hired by the property owner have guaranteed rights in every U.S. state. Some states, like California and Texas, have included construction liens in their state constitutions. Many states also allow subcontractors to enforce construction liens.
Foreclosure by Homeowners’ Associations
Homeowner’s associations may have the right to foreclose on a property owner for failure to pay regular fees and periodic assessments. Real property may be subject to obligations, known as restrictive covenants, which continue to apply even after the property has changed hands. When a sale of real property closes, the buyer must review and sign any restrictive covenants that apply, including membership in a homeowners’ association.
Since a contract between a borrower and a lender establishes the right of foreclosure, legislatures and courts rarely get involved. Borrowers may still be able to avoid foreclosure in several ways:
Payment of loan: Most promissory notes allow borrowers to pay the balance of the mortgage loan early, and most lenders would prefer to get paid than to carry out a foreclosure. Not many people would be able to pay the balance of their loan so soon after defaulting, though, and large, bureaucratic banks might not even know how to process such a request.
Forbearance: Borrowers may formally request that a lender put off foreclosure while the borrower catches up on payment. This is almost entirely within the lender’s discretion.
Deed in lieu of foreclosure: A lender may agree to take title to the property, in full satisfaction of the loan, without going through the foreclosure process. Potential benefits for the borrower include a release from substantial indebtedness, as well as avoiding significant damage to a credit score.
Short sale: A borrower may be able to negotiate the sale of the property to an investor, who might also negotiate the payoff of the borrower’s loan with the lender. As with the other options discussed here, the lender has near-total discretion over whether to agree to any modification of the borrower’s obligation. Borrowers also face the risk of fraud from individuals and companies who might, for example, charge a fee to open negotiations with the lender, which they fail to do.
Many foreclosures have resulted from misunderstandings, bad advice, and outright fraud. Egregious examples from recent years have often involved “robo-signers,” people employed by lenders whose only job is to sign documents claiming personal knowledge of real estate transactions. Since foreclosure is usually based on a private contract, many courts have expressly rejected challenges to foreclosure based on due process. See Apao v. Bank of New York, 324 F.3d 1091 (9th Cir. 2003).
Contract law and general rules of civil procedure are a borrower’s main forms of recourse in the event of a wrongful foreclosure. Some homeowners have successfully challenged a foreclosure by showing that the party trying to foreclose lacked standing to do so. Others have demonstrated that a mortgage holder violated the terms of the deed of trust, or that he or she was not in default at the time of foreclosure. In some cases, the borrower’s willingness and ability to fight back was enough to prevent the foreclosure.