Deficiency Balance

What Is a Deficiency Balance?

A deficiency balance is the net difference between the amount a borrower owes on a secured loan and the amount the creditor receives after selling the collateral that secures the loan.

Typical examples of when a deficiency balance might occur include after a lender repossesses a car because the borrower has failed to make payments, or takes possession of a home in a foreclosure.

The lender will then attempt to recover the remaining loan balance by selling the property. However, if the sale does not result in the lender recovering the full loan balance, the resulting shortfall is the deficiency balance. The lender may also add administrative fees and costs associated with selling the collateral to the total deficiency balance.

How a Deficiency Balance Works

A deficiency balance usually occurs in situations where a borrower can no longer afford to make payments. The borrower either negotiates a lower settlement on what is owed or completely defaults on the entirety of the loan. This is sometimes also referred to as being "upside-down" on a loan.

The borrower's remaining responsible balance may be increased by the creditor to cover any additional legal costs that they may have incurred during the process of regaining possession of the collateral. The deficiency balance can either be absorbed by the lender or the lender can pass responsibility for the debt back to the borrower.

With auto loans, this expense is usually passed back to the borrower and is part of the repossession. With mortgages, the party responsible for the balance is usually negotiated between the servicer of the loan and the homeowner. Sometimes it can be negotiated by a third-party agent acting on the homeowner’s behalf. These processes are known as foreclosures or short sales.

How a Deficiency Balance Affects a Credit Report

When the lender enforces the borrower’s responsibility for the remaining debt, the account will continue to report as open on their credit report until it is paid in full. When the amount is not passed to the borrower, and the servicer waives the remaining balance to discharge the debt, the credit report will reflect the manner in which the loan was paid off.

Generally, when a loan is closed satisfactorily, it will show as paid as agreed. When it is closed with a deficiency balance, it can be reported a few different ways but is most commonly known as a charge-off, settlement, or deed in lieu of foreclosure.

Consumers should be aware that the Internal Revenue Service (IRS) may count waived deficiencies as earned income. A certified tax specialist should be consulted to determine a borrower’s potential for additional tax responsibility.

Examples of a Deficiency Balance

Consider a deficiency balance in the example of a short sale. John and Mary own a home with a remaining mortgage balance of $250,000. They can no longer afford to make monthly payments. The value of their home is only $200,000, which is the amount that they can sell it for. This leaves a deficiency balance of $50,000, which doesn’t include any costs or fees associated with executing the sale of the home.

John and Mary have negotiated a short sale with their loan servicer, who has agreed to accept less than what is owed on the property to satisfy the mortgage. After the closing takes place, the servicer writes off the remaining balance of $50,000 and closes the mortgage without further responsibility to the borrower.

An auto lender may take a different approach. Imagine the same situation with the car that John and Mary can no longer afford. The auto lender repossesses the car. John and Mary owe $10,000, but the lender is only able to sell the car for $8,500. The deficiency balance is $1,500 and the auto lender passes this cost back to John and Mary. The auto lender contacts an attorney and they go to court to levy a deficiency judgment against John and Mary for the $1,500 balance remaining and the additional $500 in fees that they incurred as part of the repossession.