SB 1178 to protect a borrower on a refinanced purchase money second mortgage

SB 1178 to protect a borrower on a refinanced purchase money second mortgage

The Purchase Money Rule

Most people now know that lenders can't come after borrowers for losses on purchase money loans. Unfortunately, many folks lost that protection when they refinanced as the law, Civil Code of Procedure 580b, only applied to the original loan. Senate bill 1178 intends to fix that by extending 580b, the "purchase money rule" to any refinance of that original amount. Note that the protection would still NOT extend to owners that did cash-out refinances, and that makes sense.

The whole idea behind the purchase money rule is that the borrower would not have been able to buy the home without the lender, that lenders are more sophisticated than borrowers, and therefore lenders should bear the risk if they make too large a loan for a given property... basically eliminating the lenders' ability to come after the borrower personally should the borrower default, and there not be enough value left in the property to cover the loan.

With the likely enactment of SB 1178 right around the corner, it seems a good time to revisit the issue of whether the lender on a purchase money 2nd deed of trust can go after a borrower when the lender on the 1st deed of trust forecloses “wipes out” the 2nd deed of trust. The answer is “No” and the enactment of SB 1178 amending CCP section 580b does not change that. On the contrary, SB 1178 will broaden the borrower's protection. To begin, the California Supreme Court decided in Brown v. Jensen (1953) 41 Cal 2d 193 that CCP section 580b applies to a junior purchase money mortgage when the security has been rendered valueless by the foreclosure of a senior mortgage.

In Brown v. Jensen the defendants bought their home from the plaintiff with purchase money borrowed from Glendale Federal Savings & Loan secured by a 1st Deed of Trust and the plaintiff carried back a portion of the purchase price secured by a 2nd Deed of Trust. Glendale foreclosed and the property went back to Glendale at trustee sale for the opening bid. The trustee’s deed was recorded in favor of Glendale and the 2nd Deed of Trust held by the plaintiff was wiped out. Plaintiff unsuccessfully argued that security on the debt (the second trust deed) had become valueless because it had become exhausted by the sale under the first trust deed so she was not limited by the “one action rule” of the California Code of Civil Procedure section 726.

In denying the plaintiff relief the Court asked the question; did the plaintiff take a purchase money trust deed on the property when it was purchased? If she did, then Civil Code section 580b was applicable and she could look only to the security because by taking such a trust deed she knew the value of his security and assumed the risk that it may become inadequate.

The Court pointed out that the rationale was especially true when the lender knowingly takes on a 2nd deed of trust, which has a greater risk that the security could become insufficient. SB 1178 serves to broaden 580b with the following “new and improved” additional language: "For purposes of this section, a loan used to pay all or part of the purchase price of real property or an estate for years shall include subsequent loans, mortgages, or deeds of trust that refinance or modify the original loan, but only to the extent that the subsequent loan was used to pay the debt incurred to purchase the real property. (Emphasis added.)"

So SB 1178 applies to the refinancing of “a loan” used to purchase the property, regardless of whether the loan has senior or junior status, most commonly a 1st deed of trust and a 2nd deed of trust. Assuming the law is enacted in a similar form as is now being considered in Sacramento, folks can feel comfortable that they are not exposing themselves to personal liability by refinancing any or all of their purchase money loans, regardless of the loan’s seniority.

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