As homeowners file insurance claims for property damage following Hurricane Ida and with Hurricane Larry threatening the northeast coast, mortgage servicers are facing an influx of insurance proceeds or loss draft funds. To avoid borrower litigation and to protect against potential liability to borrowers and investors, mortgage servicers must ensure that all loss draft activities comply with the terms of property-specific mortgage agreements.

Section 5 of the current Fannie Mae and Freddie Mac standard mortgage agreements, which are being retired in December 2022 (changes to the insurance provisions of the new mortgage agreement will be addressed in a future article), contains the obligations of the borrower and the lender regarding the use of loss draft funds. The standard security instrument generally describes two permissible uses for such insurance proceeds: repair of property or application to amounts due on the loan.

Specifically, the mortgage agreement provides:  “Unless Lender and Borrower otherwise agree in writing, any insurance proceeds . . . shall be applied to restoration or repair of the Property, if the restoration or repair is economically feasible and the Lender’s security is not lessened”   (Security Instrument ¶ 5; emphasis added). Thus, under the terms of the standard security instrument, the default application of loss draft funds should be for repair or restoration of the property.

The standard security instrument further provides that “[i]f the restoration or repair is not economically feasible and the Lender’s security is not lessened the insurance proceeds shall be applied to the sums secured by this Security Instrument, whether or not then due” (Security Instrument ¶ 5; emphasis added). There is very little guidance on what constitutes “economically feasible” repair or under what circumstances the lender’s security would be lessened. Factors to consider in making this determination could include the extent of the property damage, the amount of insurance proceeds available, whether repair or rebuilding in a particular area may be precluded by government action, and the delinquency status of the loan prior to the insured loss.

Even where repair or restoration is economically feasible, however, the lender and borrower may otherwise agree in writing that the insurance proceeds will be applied to the loan balance. For instance, a borrower who has sustained repeated property damage losses as a result of successive hurricanes in Louisiana may desire to relocate rather than rebuild the property and may request to have the proceeds applied to the loan balance.

When loss draft funds are being applied to the loan balance, the standard security instrument specifies that proceeds “shall be applied to the sums secured by this Security Instrument, whether or not then due, with the excess, if any, paid to Borrower” (Security Instrument ¶ 5).  Furthermore, the “insurance proceeds shall be applied in the order provided for in Section 2,” which, in turn, requires application in the following “order of priority: (a) interest due under the Note; (b) principal due under the Note; (c) amounts due under [escrow items]” (Security Instrument ¶ 5).

Importantly, the security instrument’s binary options regarding either repair or application to the loan do not allow a servicer to place proceeds in a suspense account indefinitely or condition application of proceeds to the loan on whether the proceeds will satisfy all amounts due on the loan. By its express terms, the homeowner policy will provide coverage only for the improvements on the property and not the land itself. As a result, a policy limit payment may often be insufficient to satisfy all amounts due on the loan. In any situation where loss draft funds will be applied to the amounts due on a loan in lieu of repair or restoration, the servicer must take steps to ensure that the borrower is provided clear notice that application of the proceeds to the loan may not relieve the borrower of all obligations under the loan agreements.

As servicers and their vendors prepare for an influx of loss draft claims throughout hurricane season and into the winter, it is critical that servicers comply with the contractual obligations contained in the security instrument that govern servicing of the loan and the application of loss draft funds either to repair and restoration of the property or to amounts due on the loan.