Mortgages/security devices - Deficiency and surplus

Learning Outcomes

After reading this article, you will be able to explain how deficiency and surplus are handled when a mortgage or security device is foreclosed. You will understand the rules for deficiency judgments, the distribution of surplus sale proceeds, and the order of priority among creditors. You will be able to apply these principles to MBE-style questions and avoid common pitfalls.

MBE Syllabus

For the MBE, you are required to understand the consequences when the proceeds from a foreclosure sale are less than or greater than the debt secured by a mortgage or other security device. This includes the rights of creditors and debtors, and the procedures for deficiency judgments and surplus distribution.

• Identify what happens when foreclosure sale proceeds are insufficient to pay the secured debt (deficiency).
• Explain the process for obtaining a deficiency judgment.
• Determine how surplus proceeds from a foreclosure sale are distributed.
• Analyze the priority of claims among multiple creditors.
• Recognize limitations and defenses to deficiency judgments.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. If a foreclosure sale brings in less than the amount owed on the mortgage, what is the mortgagee’s typical remedy?
   1. The mortgagee must accept the loss.
   2. The mortgagee may seek a deficiency judgment against the mortgagor.
   3. The mortgagee may foreclose again.
   4. The mortgagee may seize unrelated property of the mortgagor without court order.
2. When a foreclosure sale yields more than the total debt secured by the mortgage, who is entitled to the surplus?
   1. The mortgagee.
   2. The mortgagor.
   3. The junior lienholders, then the mortgagor.
   4. The state.
3. Which of the following is NOT a valid defense to a deficiency judgment?
   1. The foreclosure sale price was unconscionably low.
   2. The mortgagor was not given notice of the sale.
   3. The mortgagor is insolvent.
   4. The mortgagee purchased the property at the sale for less than fair value.

Introduction

When a mortgage or other security device is foreclosed, the property is sold and the proceeds are used to pay off the debt. Sometimes the sale proceeds are not enough to cover the outstanding debt (a deficiency), and sometimes there is money left over after all debts are paid (a surplus). Understanding how deficiency and surplus are handled is essential for the MBE.

Deficiency: When Sale Proceeds Are Insufficient

If the foreclosure sale does not generate enough money to pay the full amount owed on the mortgage or security device, the remaining balance is called a deficiency. The lender may seek to recover this amount from the borrower.

Key Term: Deficiency Judgment A court order allowing the lender to recover the unpaid balance of a mortgage debt from the borrower after a foreclosure sale fails to satisfy the full debt.

Surplus: When Sale Proceeds Exceed the Debt

If the foreclosure sale brings in more than the total amount owed on the mortgage and any other secured claims, the extra money is called a surplus. The law sets out who is entitled to receive this surplus.

Key Term: Surplus The amount remaining from a foreclosure sale after all debts secured by the property and related costs have been paid.

Order of Distribution

The proceeds from a foreclosure sale are distributed in a specific order:

1. Costs of the sale (including court costs and fees).
2. The debt owed to the foreclosing mortgagee or security holder.
3. Junior lienholders, in order of priority.
4. The mortgagor (borrower), if any surplus remains.

Key Term: Priority The order in which creditors are paid from the proceeds of a foreclosure sale, determined by the time and manner in which their interests were recorded or attached.

Deficiency Judgment Procedure

If the sale proceeds are less than the debt, the lender may seek a deficiency judgment against the borrower for the difference. This usually requires a separate court action, unless the foreclosure was by judicial sale and the court enters the judgment as part of the foreclosure.

Limitations and Defenses

Some states limit or prohibit deficiency judgments, especially for residential property. Common defenses include:

• The sale price was so low as to be unconscionable.
• The lender failed to give proper notice of the sale.
• The lender purchased the property at the sale for less than fair value.

Worked Example 1.1

A bank holds a mortgage on a property for $200,000. At foreclosure, the property sells for$150,000. There is a junior lienholder owed $30,000. How are the proceeds distributed, and what remedies are available?

Answer: The sale proceeds first pay the costs of sale. The remaining funds go to the bank (the foreclosing mortgagee) up to $200,000. Since only$150,000 is available, the bank receives all $150,000. The junior lienholder receives nothing. The bank may seek a deficiency judgment against the borrower for the$50,000 shortfall, subject to any state law limitations.

Worked Example 1.2

A property is foreclosed and sells for $250,000. The mortgage debt is$180,000. There is a junior lien for $40,000. Who receives the surplus?

Answer: After paying sale costs, $180,000 goes to the mortgagee. The next$40,000 goes to the junior lienholder. The remaining $30,000 is surplus and is paid to the mortgagor (borrower).

Exam Warning

In some states, anti-deficiency statutes or judicial doctrines may bar or limit deficiency judgments, especially for residential or purchase-money mortgages. Always check for local law restrictions in MBE questions.

Revision Tip

Remember the order of distribution: sale costs, foreclosing lender, junior lienholders, then the borrower. Deficiency judgments are not automatic—state law may restrict or prohibit them.

Key Point Checklist

This article has covered the following key knowledge points:

• Deficiency arises when foreclosure sale proceeds are less than the debt; the lender may seek a deficiency judgment.
• Surplus occurs when sale proceeds exceed the total debt; surplus is paid to junior lienholders, then the borrower.
• Foreclosure proceeds are distributed in a set order: sale costs, foreclosing lender, junior lienholders, then borrower.
• Deficiency judgments may be limited or barred by state law, especially for residential property.
• Defenses to deficiency judgments include unconscionably low sale price and lack of notice.

Key Terms and Concepts

• Deficiency Judgment
• Surplus
• Priority