No Anti-Deficiency Protection for Home Improvement Loans

Question: Last March we bought a home in the “Arcadia Lite” area of Phoenix. We borrowed a high-interest $250,000 second mortgage (“Second Loan”) to “fix and flip” the home. We tore down two of the smaller bedrooms to make a large covered patio surrounding the swimming pool. We completed this construction six months ago and listed the home for sale. We have not had any serious buyers, and last week we reduced the list price again. If we don’t sell the home in the next few months, however, we will be unable to continue making payments on the Second Loan. The Second Loan will probably foreclose on the home for less than the amount of the Second Loan, and we will probably owe a deficiency to the Second Loan. Will the anti-deficiency statutes protect us from personal liability for the amount of deficiency still owed on the Second Loan?

Answer: By way of background, the anti-deficiency statutes generally provide for no personal liability of a borrower who uses the loan to construct a new home. In other words, if the borrower defaults on a construction loan, and there is a foreclosure by the lender, the borrower has no liability to the lender for any deficiency. The anti-deficiency statutes, however, do not protect deficiencies on home improvement loans. Bottom line: If the Second Loan was a construction loan, there should be deficiency protection. If the Second Loan was a home improvement loan, however, there would be no deficiency protection. The Arizona Court of Appeals recently listed five factors to distinguish between a construction loan and a home improvement loan. 470 P.3d 160. For example, a construction loan does not require that the construction of the new home be “scrape and build” construction. In other words, a loan for the substantial demolition of an existing home that was replaced by new construction should probably qualify as a construction loan, not a home improvement loan.