After an insurance company issues payment for property damage, property owners often find themselves navigating the dynamics between insurance claim repairs and mortgage obligations. It is common for insurance payout checks to be issued jointly to both the property owner and their mortgage company. A frequently asked question is whether the mortgage company can direct these insurance proceeds to reduce the mortgage balance instead of funding repairs. The answer depends on the jurisdiction and the specific terms outlined in the deed of trust or mortgage agreement. In some instances, the lender has the right to decide.

Understanding Mortgage Companies’ Discretion

Many deeds of trust and mortgage agreements permit lenders to unilaterally prioritize loan repayment over property repairs. In Edwards v. Bank of America, the lender indicated its intent to apply the insurance proceeds to the loan’s principal balance against the property owner’s wishes.1 The deed of trust between the property owner and mortgage company contained the following provision:

In the event of loss, … [a]ll or any part of the insurance proceeds may be applied by [l]ender, at its option, either (a) to the reduction of the indebtedness under the Note and this Security Instrument, first to any delinquent amounts applied in the order in paragraph [three], and then to prepayment of principal, or (b) to the restoration or repair of the damaged Property. . .

The Maryland court noted that the language used in the deed of trust, specifically the words “may,” “either,” and “at its option,” did not impose an absolute obligation on the lender to repair the property. The use of these terms indicated a degree of discretion afforded to the lender regarding the use of insurance proceeds. This discretion was similarly recognized in Hopkins v. Wells Fargo Bank, where the California court acknowledged the lender’s right to unilaterally allocate some of the insurance proceeds towards the loan’s principal.2

Balancing Interests and Honoring Borrower Preferences

Some jurisdictions require a balancing of interests. In Plymouth Commons Realty Corp. v. Northeast Savings., F.A., the Connecticut court found that the lender did not breach its contract by using its discretion to apply insurance proceeds to the homeowner’s debt.3 However, the court allowed a claim for breach of the implied covenant of good faith and fair dealing to proceed, holding that while a lender may act within its contractual rights, it must also consider the impact of its actions on the borrower.

The Seventh Circuit’s decision in the Illinois case Avila v. CitiMortgage, Inc., further discussed the lender’s discretion when the insured wished to use the insurance proceeds to pay down the mortgage.4 The court noted that the lender’s discretion is intended to protect the lender’s interest, ensuring that repairs are economically feasible and the security is not jeopardized. However, this discretion did not allow the loan servicer to unilaterally decide against the borrower’s wishes, especially when the borrower preferred to use the insurance proceeds to pay down the loan and communicated this preference clearly.

In Denton v. Seterus, Inc., the Oklahoma court clarified that borrowers are not without recourse if a loan servicer receives and retains insurance proceeds but refuses to apply them to pay down the loan. 5 In rendering its decision, the court allowed the property owner’s lawsuit to proceed against the lender for its alleged violation of the Fair Debt Collection Practices Act.

These court decisions reinforce the principle that while lenders have certain discretions, they should not act in ways that fundamentally disregard the interests and intentions of the borrowers.

Potential Implications for Property Owners

Property owners should be aware that opting to use insurance proceeds to pay down a mortgage may lead to the forfeiture of withheld depreciation, which can be a significant portion of the overall payout. This is why it is important to carefully consider the long-term impacts of how insurance proceeds are utilized, balancing the immediate financial relief against the potential loss of benefits designed to aid in restoring the property’s value.

Property owners facing this situation should carefully review their mortgage agreements and consult legal counsel to understand their rights and obligations.

1 Edwards v. Bank of Am., N.A., 2015 WL 9257696, at *5 (Md. Ct. Spec. App. Dec. 17, 2015).

2 Hopkins v. Wells Fargo Bank, N.A., 2013 WL 2253837, at *6–9 (E.D. Cal. May 22, 2013).

3 Plymouth Commons Realty Corp. v. Ne. Sav., F.A., 1994 WL 622009, at *3 (Conn. Super. Ct. Oct. 7, 1994).

4 Avila v. CitiMortgage, Inc., 801 F.3d 777 (7th Cir. 2015).

5 Denton v. Seterus, Inc., 2019 WL 6721643, at *5 (N.D. Okla. Mar. 14, 2019).