Part I: Assessing the Damage and Applying the Proceeds

Following the recent hurricanes that have damaged many homes beyond repair, borrowers may seek to apply any available insurance proceeds to satisfy the outstanding balance on their loans rather than repair the property. Servicers should take certain precautions to ensure they comply with the terms of mortgage agreements to protect against liability.

Fannie Mae’s and Freddie Mac’s standard mortgage agreements contain the same clause regarding application of insurance proceeds to the balance on a loan:

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 . . . . If the restoration or repair is not economically feasible . . . the insurance proceeds shall be applied to the sums secured by this Security Instrument, whether or not then due.

As interpreted by courts, this language requires lenders to apply insurance proceeds to an underlying loan within a reasonable time after discovering that repair of the mortgaged property is not economically feasible. Servicers who routinely place insurance proceeds in a suspense account should take the following steps to ensure proper application of these funds:

  1. Pay attention to communication from the borrower, especially if it is in writing. If borrowers advise they do not plan to repair the mortgaged property or request that insurance proceeds be applied directly to their loan, servicers and their insurance vendors should treat this request as potential notice that repair is not economically feasible. Courts have indicated that even unilateral written communication from the borrower may start the clock ticking for the “reasonable time” analysis.
  2. Reach out to the insurance company for a repair estimate. While servicers or their insurance vendors are not necessarily expected to conduct their own investigations into whether repair is not feasible, proactively seeking an estimate from the insurer can help servicers and their vendors stay on top of how to apply the proceeds. If the estimated repairs surpass the insurance proceeds, lenders should expect to apply those proceeds to the loan.
  3. Monitor accruing interest on the underlying loan while proceeds are in suspense. If the feasibility of repair is unclear, insurance proceeds may be kept in suspense for a limited time. Since courts seem concerned with loans accruing interest while a borrower’s proceeds sit unapplied in suspense, however, maintaining accurate records on the accounts and monitoring the length of time the funds remain unapplied may help demonstrate good faith on the part of the servicer.

By implementing the above practices, servicers should be able to ensure they are applying hazard insurance proceeds in compliance with mortgage agreements.