Why Collateral?

Why collateral?

As described in previous Y-blawgs, Vermont’s foreclosure laws were designed to protect the homeowner from losing their home too quickly by giving the homeowner a chance to halt the process, if possible, in order to modify, reinstate or perhaps even file for Chapter 13 relief.  To understand the process more fully, we have to start with the originating documents: the Note and Mortgage.  Most people are unaware of the subtle differences between all of the documentation they sign at a mortgage closing.  That event itself is overwhelming.  The two main documents being signed are the Note and Mortgage.  The Note is a promissory note saying that the homeowner is borrowing money and owes the lender x dollars.  The Mortgage secures that obligation by basically pledging the home as collateral for the money borrowed.  Both components are necessary to complete the transaction and to give the lender the later right to foreclose if payments are missed.

When a lender forecloses, the lengthy procedure gives the lender the ultimate right to do two things if certain steps are followed:  One, take ownership of the property in order to sell; Two, collect any deficiency IF the property doesn’t sell for enough to pay what’s owed.  These are two separate remedies; the first being a right under the Mortgage and the second being a right under the Note.  In the vast majority of cases, particularly with large out-of-state lenders, the bank only seeks ownership of the property, and will not sue the borrower to collect on any deficiency.  Recently, however, some lenders have sought deficiencies against borrowers in Vermont, so it is important to review the paperwork thoroughly.  To collect on a deficiency, a lender must ask for it initially and also seek to recover the specific amount at confirmation of any foreclosure sale that didn’t make them whole.

It is important to recognize the difference between the Note and Mortgage and their separate remedies, particularly when a bankruptcy is involved.   All transactions involving the pledging of collateral have these components—one showing the amount borrowed, and one pledging the collateral.  When a person files for bankruptcy relief, that person is seeking to discharge debt.  If a Chapter 7 discharge is received, for example, all dischargeable debts such as an amount owing under the Note will be eliminated.  The borrower no longer owes the lender any money.

A bankruptcy, however, does not affect a properly recorded Mortgage.  This is why so many people are able to file for Chapter 7 bankruptcy relief and keep their homes.  The Mortgage stays put, and so long as the debtor continues to pay their mortgage payments, they keep the home.  If they are later unable to afford the home, a lender can commence a foreclosure action.  Post-discharge, however, a lender can never collect on the Note (unless the debtor “reaffirmed” in their bankruptcy case, which warrants its own blawg entry), it can only recover from the property itself.  Absent a new contract within the bankruptcy case, called “reaffirmation” the mortgage lenders would never be able to collect from the borrowers after a discharge.  This benefit of bankruptcy can be huge, especially when dealing with property that may be upside-down in terms of loan to value.

It is important to know, when borrowing money, what, if anything, is being pledged as collateral and what rights you have under the agreements.  Collateral gives lenders greater rights both inside and outside the bankruptcy world and significantly impacts a borrower’s options.  Lenders have to follow certain procedures to validate the Mortgage.  Understanding how a bankruptcy discharge affects a Note but not a Mortgage is extremely important when considering bankruptcy or even when considering whether to enter into a deed in lieu of foreclosure with a lender.  Giving property back to the lender does not necessarily eliminate the Note obligation, so it is important to read any agreement carefully. 

Merely having some understanding of the two essential components of a mortgage lending transaction gives a borrower the ability to retain some control in an otherwise overwhelming process.  If you are unsure of your rights and obligations with respect to your home, a consultation with an attorney concentrating in debtor-creditor relations may be beneficial, especially if you are having financial difficulties.  We at OEBlaw will take the time to review your situation and any loan documents carefully to best advise you as to your options.