We recently had a fire in our house, and have adequate homeowners' insurance. The renovation work is nearing completion, and the insurance company has indicated it will send a check to the lender.

I have heard that lenders have the option of using those proceeds to reduce the amount of the mortgage, rather than paying off the construction work. Can you clarify?

You have to look to the deed of trust you signed when you obtained the mortgage loan.

Generally speaking, there are two 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 insurance proceeds must be applied to the renovation, unless the lender determines the renovation is not economically feasible or that its security in the property is in jeopardy.

In this case, the burden is on the lender to justify using the insurance proceeds for purposes other than the renovation.

Let's look at another form of deed of trust, that is usually used by individual, or noncommmercial, lenders.

In the other form, 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 option of using the insurance proceeds for the restoration or renovation work, or reducing or paying off the outstanding mortgage.

The burden is on the borrower to show that the lender is being unreasonable if the lender wants to use the insurance proceeds to pay off the mortgage rather than paying 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 the lender attempted to pay off an old low-interest loan with the 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 lenders no doubt would prefer to reduce their own mortgages.

I suggest 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 the lender and make it known that you will fight it in court if the insurance funds are not used to pay the contractor.

Lenders may be difficult to deal with, but they are not insensitive to public opinion.

Benny L. Kass is a Washington attorney. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.