J. Patrick Sutton Cases & Issues Blog

No Recourse? A No-Brainer!

Since Texas home equity loans are "no-recourse," which means that a lender may not pursue a borrower for any deficiency following a foreclosure sale, why doesn't everyone who worries that defaulting on their home loan could threaten them at some point in the future go out and get a home equity loan? Borrowers acting in good faith would never be on the hook for a deficiency judgment if they default!
The Texas Constitution, Art. XVI Section 50(a)(6)(C), provides that home equity loans are "without recourse" to the owner and the owner's spouse. That means that if the borrower defaults, the lender forecloses, and the lender does not realize enough cash from the foreclosure sale to cover the entire amount of the loan, the lender loses the deficiency amount.

That's completely the opposite result from traditional purchase-money mortgages, where a borrower is almost always personally liable if the foreclosure sale doesn't pay off the entire loan. I have defended borrowers being chased for a deficiency, and it's not pretty. Once a lender gets a judgment, that judgment can be renewed every ten years or so. The lender can hound the borrower with collection activity for decades.

There's a saying in Texas concerning home equity loans: "once a home equity loan, always a home equity loan." That is, once a lender has transformed a purchase-money mortgage into a home equity loan, the loan can never revert to a traditional mortgage with recourse. There's a one-way trip switch that insulates the borrower from personal liability for the home loan forever, so long as the borrower didn't commit fraud in obtaining the loan.

It therefore seems to me that some people would better off by taking out some equity as soon as they have it, if they feel it's prudent to shield themselves from personal liability for the loan. It doesn't matter how much equity you take out -- it can be $1,000 -- so long as the transformation occurs.

In reality, the transactions costs (closing costs) are pretty high, and the interest rate is higher than for a traditional mortgage, so it may not make sense to engage in this maneuver unless you value the no-recourse protection fairly high. Nevertheless, if all you want is peace of mind in turbulent times, it's not a bad strategy. I think what you would do is take out as little as possible or else take out quite a bit and put it in a high-yield investment.

One thing you cannot do, in light of the exception for fraud, is go get a home equity loan when you already know you're about to go underwater or intend to do so. You would lose the no-recourse exception if the bank could prove you only did it to avoid a personal judgment against you.

When I woke up a few days back and realized this strategy existed, I sort of slapped my forehead. Really? I thought. Why isn't every accountant and tax strategist in town telling their clients' about this? Well, today I called my accountant and asked him about it. He had never heard of the strategy either. (I'm not sure he quite believed me, so he's no doubt looking it up himself even as I write).

The message Section 50 gives? Texan: leverage thine equity!
J. Patrick Sutton Cases & Issues Blog