So, You Think You Know A Default       back to articles
When You See One?
by Steven Linkon, Esq.
WRIGHT, FINLAY & ZAK, LLP

If a borrower fails to pay their real property taxes or insurance premiums, is this a default that permits the Servicer to start a foreclosure action? Be careful, depending on the language of your loan documents, a borrower's failure to pay taxes and insurance may not necessarily constitute a default. Handling these kinds of delinquencies requires your extra attention, or else you may improperly commence a foreclosure action or conduct a wrongful foreclosure sale.

Typically, the loan documents (i.e. Note and Deed of Trust) require a "default" before the Servicer may commence a foreclosure action. Thus, the Servicer needs to understand how a "default" is defined in the Note and Deed of Trust. Many standard Note forms limit a "default" to the failure to pay the full amount of the monthly payment due each month. You may be surprised to find that the Note is silent about the borrower's failure to pay property taxes or insurance premiums.

Defining "Default"

Most Deed of Trust forms contain provisions requiring the borrower to pay property taxes and similar assessments if non-payment will create a lien senior in priority to the lender's lien. But, if the borrower does not pay the taxes, this is not automatically a "default" that triggers the right to start a foreclosure. Usually, something more must occur before starting foreclosure, such as notice to the borrower and an opportunity to cure. Similarly, a typical Deed of Trust requires the Borrower to maintain proper insurance coverage. Failing this, the lender may obtain insurance to protect its interest in the property.

However, a Servicer's ability to recover for an advance for property taxes and insurance can vary depending upon the language of the Deed of trust. Typically the Deed of Trust will provide a procedure that the Servicer must follow in order to obtain reimbursement of advances for property tax or insurance. Only after this procedure is implemented can the Servicer begin foreclosure. The typical procedure calls for notice to the borrower that the Servicer has made an advance for taxes or insurance and in connection with the notice the borrower is provided a grace period in during which the advance may be repaid.

If the borrower fails to repay the advance after such notice and grace period, a Servicer's options may be limited such that the Servicer still may not be able to declare the loan in "default." For example, some loan documents will permit the lender to add the amount of a property tax or insurance premium advance to the principal amount of the Note so there is interest earned on the advance at the Note rate. But adding the advance to the principal can mean that the advance is not recouped until the loan is repaid. This does not have to be the result, however, if the Deed of Trust contains covenants (i.e. promises) that the borrower will pay the property taxes or insurance, and the Deed of Trust includes the breach (i.e. violation) of a covenant as a "default."

Caution with Payment Applications

Here is where caution is advised: some Servicers desiring to recover an advance for property taxes or insurance may be tempted to apply the next monthly payment tendered by the borrower to reimburse the advance. This diversion of the borrower payment may trigger a "default" under the loan documents. But diverting a regular monthly payment is often improper under many forms of loan documents commonly in use. It is possible to be in a situation where there is no "default" because the borrower is current on the regular monthly payments, even though the Servicer has advanced funds for taxes and insurance.

The solution to this problem is to provide reasonable notice to the borrower of the amount and purpose of the advances before starting any foreclosure action and a warning that the failure to reimburse the Lender for the advance will result in the loan being placed in "default." If the advance is not repaid by the borrower, the entire loan balance can be accelerated because the typical Deed of Trust will permit a Lender to accelerate the loan if the borrower is in breach of any covenant (promise or obligation) contained in the Deed of Trust. The two covenants covered by this discussion include the borrower's covenants to pay the real property taxes and provide for insurance.

Just be sure that the borrower is forewarned that you consider the non-payment of property taxes and insurance to constitute a breach of the Deed of Trust covenants before actually starting a foreclosure action. The borrower may have justification for the non-payment or may repay the advances. A little advance work can prevent unpleasant litigation later.

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