Mortgages/security devices - Deficiency and surplus

Learning Outcomes

This article explains deficiency and surplus issues in mortgage foreclosures, including:

• How foreclosure sale proceeds are calculated and allocated, from costs of sale through payment of the foreclosing mortgagee, junior lienholders, and any ultimate surplus returned to the mortgagor.
• How lien priority, recording, and purchase-money status determine which interests are paid, which are cut off, and which survive, and how to apply these rules to multi-creditor MBE fact patterns.
• When a deficiency arises, who may seek a deficiency judgment, who is personally liable on the note (original mortgagor, assuming grantee, or subject-to buyer), and how non‑recourse loans change the analysis.
• How surplus proceeds are distributed among junior lienholders and the borrower, and what happens to lienholders who are or are not joined in the foreclosure action.
• How anti-deficiency statutes, fair market value limitations, unconscionably low sale prices, and procedural defects can bar or reduce a deficiency judgment on exam-style questions.
• How credit bids, redemption (equitable and statutory), and election of remedies interact with the existence and size of any deficiency or surplus.
• How to spot and avoid common MBE traps involving senior versus junior foreclosures, mistaken payment of senior liens from the sale, and confusion between in rem effects on liens and in personam liability on the debt.

MBE Syllabus

For the MBE, you are required to understand the consequences when foreclosure proceeds are less than or greater than the secured debt, with a focus on the following syllabus points:

• Identify what happens when foreclosure sale proceeds are insufficient to pay the secured debt (deficiency)
• Explain the process for obtaining a deficiency judgment and who can be held personally liable
• Determine how surplus proceeds from a foreclosure sale are distributed and in what order
• Analyze the priority of claims among multiple creditors, including purchase-money mortgages and junior liens
• Recognize limitations (such as anti-deficiency statutes and fair market value rules) 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.
4. A buyer takes title to Blackacre “subject to” the seller’s mortgage but does not assume it. After foreclosure, the sale price does not cover the full debt. Who can the bank sue personally for the deficiency (absent special statutes)?
   1. Only the buyer.
   2. Only the seller.
   3. Both buyer and seller.
   4. Neither buyer nor seller.

Introduction

When a mortgage or other security device is foreclosed, the property is sold and the proceeds are used to pay off the secured debt. Sometimes the sale proceeds are not enough to cover the outstanding debt (a deficiency), and sometimes there is money left over after all secured debts and costs are paid (a surplus). The MBE tests not only what happens in each situation, but also how lien priority, personal liability, and state-specific limitations affect the outcome.

Key Term: Foreclosure
The legal process by which a mortgagee or other secured creditor forces the sale of collateral (usually real property) after a default, in order to apply the sale proceeds to the debt.

Foreclosure can be judicial (through a court action) or nonjudicial (under a power of sale in the mortgage or deed of trust). The precise procedure varies by state, but the core MBE rules on deficiency and surplus are the same.

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, and sometimes from other parties who are personally liable on the debt.

Key Term: Deficiency
The unpaid balance of the mortgage debt remaining after foreclosure sale proceeds have been applied to the debt and sale costs.

Key Term: Deficiency Judgment
A court judgment allowing the lender to recover the unpaid balance of a mortgage debt from a party who is personally liable after a foreclosure sale fails to satisfy the full debt.

A deficiency judgment is an in personam judgment on the note, not on the property. Once obtained, it can be enforced like any other money judgment (e.g., by garnishing wages or levying on other assets).

Surplus: When Sale Proceeds Exceed the Debt

If the foreclosure sale brings in more than the total amount owed on the foreclosing mortgage and any other liens that are part of that proceeding, the extra money is called a surplus.

Key Term: Surplus
The amount remaining from a foreclosure sale after paying sale costs and all debts and liens that are satisfied by the sale.

Surplus proceeds are not a windfall to the foreclosing lender. They are held in trust and paid out to other claimants according to priority, with any ultimate remainder going back to the mortgagor.

Priority and the Order of Distribution

Foreclosure proceeds are distributed according to a strict order of priority.

Key Term: Priority
The ranking of competing liens or claims to the property or its sale proceeds, generally determined by time of creation and recording, or by special priority rules (such as for purchase-money mortgages).

A typical order of distribution is:

• (1) Costs of the sale and foreclosure (court costs, trustee’s fees, attorney’s fees, advertising costs)
• (2) The debt owed to the foreclosing mortgagee or security holder
• (3) Junior lienholders whose liens are cut off by the foreclosure, paid in order of priority (earliest properly recorded first)
• (4) The mortgagor (borrower), who receives any remaining surplus

Note that liens senior to the foreclosing mortgage are generally not paid from the sale proceeds; instead, they survive the foreclosure. The buyer at the foreclosure sale takes the property subject to those senior liens, and the sale price is usually lower to reflect that burden.

Deficiency Judgment Procedure

If the sale proceeds are less than the outstanding mortgage balance, the lender may seek a deficiency judgment against any party who is personally liable on the note. Procedure varies by jurisdiction:

• In a judicial foreclosure, the court often determines the deficiency and enters judgment in the same action.
• After a nonjudicial foreclosure, the lender may need to file a separate lawsuit on the note to obtain a deficiency judgment, and some states bar or limit this remedy entirely.

Key Term: Personal Liability
A borrower’s or other obligor’s responsibility to pay the debt from personal assets, beyond the value of the mortgaged property.

Who Can Be Sued for a Deficiency

The key exam question is: who is personally liable?

• The original mortgagor is personally liable on the note unless it is expressly non-recourse or a statute says otherwise.
• A subsequent grantee who assumes the mortgage becomes personally liable in addition to the original mortgagor.
• A subsequent grantee who takes title subject to the mortgage does not become personally liable; only the land remains security for the debt.

Key Term: Assumption of Mortgage
An agreement by a grantee of the property to become personally liable on the existing mortgage debt, in addition to the original mortgagor.

Key Term: Subject-To Mortgage
A transfer in which the grantee takes title “subject to” an existing mortgage, meaning the mortgage remains on the property but the grantee does not assume personal liability for the debt.

Key Term: Non-Recourse Loan
A loan in which the lender’s sole recourse is to the collateral; the borrower has no personal liability for any deficiency.

On the MBE, unless the facts mention a non-recourse loan or a specific statute, assume the note is recourse and personal liability exists according to these assumption/subject-to rules.

Limitations and Defenses

Some states limit or prohibit deficiency judgments, especially for residential or purchase-money mortgages. Others allow deficiency judgments but reduce the amount.

Key Term: Anti-Deficiency Statute
A statute that bars or limits deficiency judgments, often for certain residential or purchase-money mortgages, or after nonjudicial foreclosure.

Common defenses to a deficiency claim include:

• Anti-deficiency protection: The loan falls within an anti-deficiency statute (e.g., a purchase-money mortgage on an owner-occupied single-family home).
• Fair market value rules: The statute requires the court to credit the fair market value, not the (possibly low) sale price, when calculating the deficiency.
• Procedural defects: The lender failed to give proper notice of the sale, failed to advertise as required, or did not conduct the sale in a commercially reasonable manner.
• Unconscionably low sale price: The sale price is so low as to shock the conscience, suggesting unfairness or collusion.

Key Term: Fair Market Value Limitation
A rule that limits the deficiency to the difference between the debt and the property’s fair market value at the time of foreclosure, rather than the (possibly much lower) sale price.

The mortgagor’s insolvency (answer choice c in Question 3) is never a defense; it is the very reason a lender might want a deficiency judgment.

Surplus Distribution in Detail

When there is a surplus, it is distributed to junior interests in order of priority, then to the mortgagor.

If a junior lienholder was properly joined and given notice, its lien is cut off by the foreclosure; it must assert a claim to the surplus or lose its secured position. Junior lienholders who are not joined are generally not cut off; their liens remain on the property, and they may still foreclose later. In that case, they do not share in the surplus from the earlier foreclosure.

Special Case: Purchase-Money Mortgages

Key Term: Purchase-Money Mortgage
A mortgage given to secure a loan that is used to acquire the property itself, either to the seller (vendor) or to a third-party lender, and made as part of the same transaction as the purchase.

Purchase-money mortgages (PMMs) have special priority rules: as between a PMM and most other liens created by the buyer, the PMM has priority. As between two PMMs, a vendor PMM usually has priority over a third-party PMM, and between two third-party PMMs, the one recorded first wins.

On deficiency, many states treat PMMs more favorably to borrowers. Some anti-deficiency statutes specifically bar or restrict deficiency judgments on purchase-money loans, especially when the lender elects a nonjudicial foreclosure. On the MBE, apply the general rule that deficiency judgments are allowed unless the problem explicitly introduces a local anti-deficiency statute.

Fair Market Value and Credit Bids

At foreclosure, the lender often bids using a “credit bid.”

Key Term: Credit Bid
A bid by the foreclosing lender at the foreclosure sale in which the lender bids some or all of the debt owed, instead of cash.

If the lender credit-bids the full amount of the debt and wins, the debt is treated as fully satisfied, so there can be no deficiency. If the lender credit-bids less than the debt, a deficiency may still be available, but in fair market value jurisdictions the court may reduce or eliminate the deficiency by crediting the property’s fair value rather than the bid price.

Redemption and Its Relationship to Deficiency and Surplus

Key Term: Redemption
The mortgagor’s right to reclaim the property by paying the full amount owed, either before the foreclosure sale (equitable redemption) or, in some states, within a statutory period after the sale (statutory redemption).

Redemption affects deficiency and surplus:

• If the mortgagor redeems before the sale, there is no sale, so no surplus or deficiency.
• Where statutory redemption is allowed after the sale, the mortgagor typically must pay the foreclosure price plus interest and certain costs; this extinguishes the debt and thus any deficiency.

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 from the sale and loses its lien if it was properly joined. The bank may seek a deficiency judgment against any party personally liable (e.g., the original mortgagor, and any assuming grantee) for the $50,000 shortfall, subject to any state law limitations such as anti-deficiency statutes or fair market value rules.

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 foreclosing mortgagee. The next $40,000 goes to the junior lienholder whose lien is cut off by the sale. The remaining $30,000 is surplus and is paid to the mortgagor (borrower).

Worked Example 1.3

Blackacre is worth $300,000. It is subject to a $220,000 first mortgage held by Bank and a $60,000 second mortgage held by FinanceCo. FinanceCo forecloses, properly joining Bank and the mortgagor. At the sale, the property brings $100,000. How are the proceeds allocated, and what claims remain?

Answer:
Sale costs are paid first. The remaining proceeds go to FinanceCo, because it is the foreclosing mortgagee. FinanceCo receives up to its $60,000 debt; any excess (if costs are small) would go to Bank as a partial payment on the senior mortgage. Bank’s lien is not cut off by the junior foreclosure; Bank keeps its lien for the unpaid balance and may later foreclose or sue on the note. FinanceCo can seek a deficiency judgment against any person personally liable for its loan (typically the mortgagor).

Worked Example 1.4

Property is worth $280,000. The outstanding mortgage debt is $260,000. Bank forecloses and purchases the property at the sale with a $180,000 credit bid. The jurisdiction has a fair market value statute requiring the court to credit the property’s fair market value when computing any deficiency. What is the maximum deficiency Bank can obtain?

Answer:
Under a fair market value limitation, the deficiency is calculated as debt ($260,000) minus fair market value ($280,000), not the bid price. Because fair market value exceeds the debt, the debt is treated as fully satisfied and Bank is entitled to no deficiency, even though it bid only $180,000.

Worked Example 1.5

Seller owns Blackacre subject to a $150,000 mortgage to Bank. Buyer agrees to pay Seller $50,000 cash and takes title “subject to” the existing mortgage (no assumption). Buyer later defaults, Bank forecloses, and the property sells for $120,000. Ignoring costs and statutes, who can Bank sue for the $30,000 deficiency?

Answer:
Buyer took title subject to the mortgage and did not assume it, so Buyer has no personal liability on the debt. Bank can sue Seller, the original mortgagor, for the $30,000 deficiency because Seller remains personally liable on the note.

Common Exam Pitfalls

Some recurring traps in MBE questions on deficiency and surplus include:

• Ignoring who is foreclosing (senior vs junior) when deciding which liens are cut off and who gets paid from the sale proceeds.
• Forgetting that senior liens survive a junior foreclosure and are not paid from that sale’s proceeds.
• Treating any low sale price as automatically invalid; an unconscionably low price usually requires both a very low percentage of fair value and some additional irregularity.
• Confusing assumption with subject-to treatment when deciding who is personally liable for a deficiency.
• Overlooking an express anti-deficiency statute or fair market value rule embedded in the fact pattern.

Exam Warning

In some states, anti-deficiency statutes or judicial doctrines may bar or limit deficiency judgments, especially for residential or purchase-money mortgages, or after nonjudicial foreclosure. On the MBE, treat deficiency judgments as generally available unless the problem states a specific statute or rule limiting them. Then apply that local law.

Revision Tip

Remember the distribution order: sale costs, foreclosing lender, junior lienholders (in order of priority), then the borrower. Separate the in rem effect of foreclosure (which liens are wiped out or survive) from in personam liability on the note (who can be sued for a deficiency). Practice distinguishing assumption from taking subject to the mortgage.

Key Point Checklist

This article has covered the following key knowledge points:

• A deficiency arises when foreclosure sale proceeds are less than the secured debt; the lender may seek a deficiency judgment against any party who is personally liable.
• A surplus occurs when sale proceeds exceed all debts and costs satisfied by the sale; surplus is paid to junior lienholders in order of priority, then to the mortgagor.
• Foreclosure proceeds are distributed in a set order: sale costs, foreclosing lender, junior lienholders (cut off by the sale), then the mortgagor. Senior liens generally survive and are not paid from the proceeds.
• Anti-deficiency statutes and fair market value limitations may bar or reduce deficiency judgments, especially for residential or purchase-money mortgages.
• Personal liability depends on the parties’ agreements: assuming a mortgage creates liability; taking subject to does not; non-recourse loans limit the lender to the collateral.
• Purchase-money mortgages enjoy special priority and sometimes special anti-deficiency protection, depending on local law.

Key Terms and Concepts

• Foreclosure
• Deficiency
• Deficiency Judgment
• Surplus
• Priority
• Purchase-Money Mortgage
• Anti-Deficiency Statute
• Fair Market Value Limitation
• Personal Liability
• Assumption of Mortgage
• Subject-To Mortgage
• Non-Recourse Loan
• Redemption
• Credit Bid