Q: We recently had a fire in our house, and are covered by adequate homeowner's insurance protection. The renovation work is near completion, and the insurance company has indicated that they will send the check directly to the lender. I have heard that lenders have the option to use those proceeds to reduce the amount of the outstanding mortgage, rather than to pay off the construction work. Can you advise?
A: As you have no doubt been reading, lenders are now more than anxious to wipe out their existing low-interest rate mortgages as soon as possible. Indeed, too many lenders have been quite callous in their dealings with homeowners, triggering foreclosures when a mortgage is but a few days in default.
You have to look to the deed of trust that you signed when you first obtained the loan. Generally speaking, there are two different types of clauses. The standard form mortgage (deed of trust) used by commercial lenders contains the following provision:
"Unless lender and borrower otherwise agree in writing, insurance proceeds shall be applied to restoration or repair of the property damage, provided such restoration or repair is economically feasible and the security of this deed of trust is not thereby impaired. If such restoration or repair is not economically feasible or if the security of this deed of trust would be impaired, the insurance proceeds shall be applied to the sum secured by this deed of trust, with the excess if any, paid to borrower."
Under this deed of trust, the lender must apply the insurance proceeds to the renovation, unless they determine that the renovation is not economically feasible or their security in the property is in jeopardy. Clearly, under this type of language, the burden is on the lender to justify using the insurance proceeds for purposes other than the renovation.
But let's look at another form of deed of trust, that which is usually used by individual -- noncommercial -- lenders. There, the following language appears:
"In the event of loss, he the borrower will give immediate notice by mail to the holder of said note the lender . . . and each insurance company concerned is hereby authorized and directed to make payment for such loss directly to and to the order of the holder of said note the lender . And the insurance proceeds or any part thereof may be applied by such holder at his option either to the reduction of the indebtedness hereby secured or to the restoration or repair of the secured property . . . ."
Under this language, the lender has the absolute option to either use the insurance proceeds for the restoration or renovation work, or to reduce or pay off the outstanding mortgage.
The burden is on the borrower to show that the lender is being unreasonable, if the lender wants to use those insurance proceeds to pay off the mortgage, rather than pay the renovation contractor. However, the language is quite clear, and presumably the borrower read -- or should have read -- the standard deed of trust form before it was signed.
In my opinion, unless the security of the property is affected to such extent that the lender would not be able to get its money back on foreclosure, it would be unconscionable if a lender attempted to pay off an old low-interest loan with these insurance proceeds -- even though the lender has the option to do so.
The function of insurance is to pay for the cost of renovation -- not to pay off the mortgage lender.
However, the language of the deed of trust is important, and you should review your documents immediately.
In the past, my experience has been that lenders will generally permit the insurance proceeds to be used for the renovation or repair work. However, in today's marketplace -- with high interest rates and tight money situations -- lenders no doubt would prefer to reduce their own mortgages.
I suggest that you wait until the lender determines what course of action it will take. With luck, your construction contractor will be paid in full. However, if the lender decides to exercise its option to reduce or pay off your mortgage, I suggest you discuss this matter with your lender and let them know that you will fight them if they don't pay your contractor.
Lenders may be difficult to deal with, but they are not insensitive to public opinion.