What Happens to Home Equity Loans in Foreclosure?

If you are going through foreclosure and have both a first mortgage and a home equity loan, you are likely wondering what happens to your home equity loan after foreclosure. Keep in mind that a home equity loan or the similar but not exactly synonymous home equity line of credit, or HELOC, are second mortgages. They are subject to foreclosure lien priorities.

While the two terms are often used interchangeably, there are important differences between a home equity loan and a HELOC. Home equity loans are based on the equity you have built up in your house, and this equity is used as collateral for the second mortgage. As an example, if your home is valued at $400,000 and you owe $150,000 on your first mortgage, you have equity of $250,000 in the house. The lender arranges the home equity loan for a specific time period, perhaps 15 years, at a fixed rate. In that way, the home equity loan is similar to a first mortgage.

With a HELOC, you can use your home equity as needed in the form of a line of credit, and you decide the amount you want to use. It’s akin to a credit card. If your lender agrees to give you a $75,000 line of credit, for example, but you only need half that amount for your intended purposes, you just take out the amount you need, not the entire $75,000. These loans have variable rather than fixed rates, and the draw down period is usually 10 years. As you make your payments during this time, the remitted funds are added to your line of credit, so you can actually add more money to the amount you want to borrow. However, many draw-down period repayments are interest only, with none of the monies going toward the principal. Once the draw-down period ends, the repayment period starts, and that is generally for 20 years. Just as with a first mortgage or a home equity loan, if you fail to keep up with your payments, you could face a home equity line of credit foreclosure.

When it comes to foreclosure, all liens are not created equal. There is a priority level for creditors, with property tax liens owed to the municipality at the head of the line. Next on the list, if applicable, are any special assessment liens. Special assessments are levied by your city or a board or district as a tax for specific projects. These may include road, water, sewer and other infrastructure improvements and fire protection districts. Fail to pay these special assessment taxes, and a lien is placed on your home.

After that, priority generally depends on when the lien was recorded, with earlier liens taking precedence over later liens. Mortgages, whether first or second, are a form of lien. A first mortgage takes priority after property tax liens, while a second mortgage or home equity loan is usually next on the list. However, much depends on whether there are liens on the property placed after the first mortgage and before the second mortgage. That’s known as the "first in line, first in right" rule.

The rights of the second lien holder in foreclosure depend on what other judgements or liens are on the property. If a homeowners' association has placed a lien on the house, that lien may take priority over a home equity loan, although state laws vary regarding this prioritization. Perhaps you were sued by a creditor, and a judgement lien was placed on the property. If the judgement lien was recorded prior to the home equity loan, it would take priority. The same holds true for mechanic’s liens, which a contractor may place on your home if you haven’t paid the bill for construction or remodeling.

What happens to your home equity loan after foreclosure depends on state law. In many states, if the sale of the house doesn’t bring enough money to pay off the home equity loan, the lender may sue you for whatever is owed, known as the deficiency. For example, if you owe $250,000 on your first mortgage and $50,000 on your second mortgage with no other liens on the property, and the house sells at a foreclosure sale for $275,000, that’s a $25,000 deficiency on your second mortgage. When someone loses his home to foreclosure, it’s likely that he doesn't have much in the way of cash to pay a judgement, but the lender may still seize bank accounts, garnish wages or place a lien on any other properties he may own. If there’s a third priority lien on the home, that creditor may not receive anything. Even if a state does not allow deficiency judgements per se, the lender may still sue the homeowner personally for the amount owed.

It’s possible that after the foreclosure, you will receive Form 1099-C from the lender if the home equity loan has a deficiency. This means your lender has reported the debt you owe to the IRS and considers the debt uncollectable. For a foreclosure, Code B is used on the form. The fact that the lender considers the debt uncollectable and reports it to the IRS is not really good news for you. The IRS considers the cancellation of such a debt as ordinary income and will tax you accordingly. For example, if the lender is cancelling a $10,000 debt and you are in the 24 percent bracket, you owe Uncle Sam $2,400 on the cancellation. If you can’t pay the IRS the amount due, you can set up a payment plan, but you’ll pay setup fees for the agreement as well as accrue interest and penalties until the amount is paid off.

A lender can only file a Form 1099-C if your home equity loan is a recourse loan. If it is a nonrecourse loan, the only remedy for the lender if you default is repossession of the property. In such cases, the lender cannot pursue you personally for the amount owed on the loan.

There is another alternative for those facing foreclosure with a HELOC, and that’s declaring bankruptcy. Because of the different structure of the HELOC and the home equity loan, after Chapter 7 bankruptcy, this does not pertain to the latter. When you file Chapter 7 bankruptcy, most of your debts are discharged. That means your personal liability for the HELOC is gone, but because the lender has a lien on your home in the form of the HELOC, it can still foreclose. However, if there is a foreclosure and a deficiency balance exists, you are no longer liable for that balance. While the lender can still foreclose in theory, for practical purposes it rarely happens. That’s because if you also have a first mortgage, that lien takes priority, and odds are there is nothing left for your HELOC lender. It doesn’t make sense for a lender to go through the expenses of a foreclosure if there is no chance they will receive their money. Much depends on the amount of equity in your home.