NORTH BAY – A new piece of legislation is coming before the California Senate intended to preserve a borrower's protection from a deficiency judgment when home loans are refinanced, as long as the refinance is used to pay debt incurred to acquire, construct or substantially improve the real property.

A deficiency judgment is a judgment for an amount not covered by the value of the home put up for the loan.

The bill was written by Senate Judiciary Committee Chair Senator Ellen Corbett.

“Most borrowers are generally unaware that refinancing their home mortgage causes them to lose the anti-deficiency protection of existing law,” she said. “That anti-deficiency protection is important because it protects the borrower under certain circumstances if the lender forecloses on them.  Senate Bill 1178 seeks to narrowly address that issue by preserving the anti-deficiency protection for borrowers if they choose to refinance their home for purposes of improvement. Borrowers who refinance for personal reasons, such as buying a car, would not be protected.”

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Jeremy Olsan, partner at Perry, Johnson, Anderson, Miller & Moskowitz in Santa Rosa, specializes in real estate issues.

“This would not count for those borrowers who used their homes as a piggy bank. They would still be liable as they are now,” said Mr. Olsan. "But this bill, if passed, would protect the ones that improved the property because they are adding to the value of the property and not refinancing their home to buy a new car or go on vacation.”

Currently, if a homeowner defaults on a mortgage used to purchase his or her home, a “purchase-money mortgage,” the homeowner's liability on the mortgage is limited to the property itself. The law has worked since the 1930s to protect borrowers, ensure the quality of loan underwriting and allow borrowers brought down by financial crisis to get back on their feet.

The original law did not extend the purchase money protection to loans that refinance the original purchase debt, even if the refinance only was to obtain a lower interest rate according to the California Association of Realtors, who is in support of the bill. As it stands, a lender can sue a homeowner facing the possibility of foreclosure for the difference between the value of the foreclosed property and the outstanding balance on the refinanced mortgage loan.

“Some people confuse the Mortgage Forgiveness Debt Relief Act of 2007,” said Elizabeth Weintraub, a Realtor specializing in short sales in the Sacramento area. “That exempts sellers from taxation on deficiencies, with the 1930s California law that allows for deficiency judgments. The two are not the same. The federal government won’t go after a short sale seller who sells an owner-occupied residence, but present California state law allows lenders to pursue sellers who have refinanced.”

Additionally, according to CAR, the majority of these borrowers did not realize that by refinancing they were forfeiting their protections and becoming personally liable for the balance of the loan.

“Most homeowners don’t know that when they refinanced their original loan they lost critical legal protections and now may be personally liable for the difference between the value of their foreclosed property and the amount they owe the lender,” said CAR President Steve Goddard. “If a foreclosed home’s market value is $250,000, and the balance on the refinanced loan is $350,000, the homeowner is personally liable for the $100,000 difference under existing law.”

Of course, said Mr. Olsan, “no one has a crystal ball. There is always some risk if there is a nonrecourse loan, but this bill is hugely important and would give some real relief to borrowers.”