In our view, this practice could be questionable. Based on the specific facts in this case (which we do not have), it may be possible for the customer to argue that the use of the insurance proceeds to reduce the loan principal is not contractually permitted. On the other hand, it is not uncommon for mortgage documents to include a provision that addresses situations similar to this, in which the lender could rightfully apply the excess insurance proceeds to the loan principal, rather than returning them to the borrower.

In addition, if the loan was sold to Fannie Mae or Freddie Mac, or to other secondary market investors, the investor’s requirement might dictate how insurance proceeds are handled. For example, Fannie Mae servicers are required to establish “written procedures for application of any insurance loss proceeds in excess of the cost to repair” in the case of a borrower who is “31 or more days delinquent at the time the servicer receives notification of damages.” It could be that the lender in this case has such a policy, which likely would entail applying excess insurance proceeds to the loan principal, and that it was mistakenly adhering to this policy even though the borrower had not been delinquent.

For resources related to our guidance, please see:

• Fannie Mae, Servicing Guide Announcement SVC-2014-19 (October 17, 2014) (“The servicer must take the actions described in the following table for a mortgage loan that is 31 or more days delinquent at the time the servicer receives notification of damages. The servicer must  . . . have written procedures for application of any insurance loss proceeds in excess of the cost to repair.”)

• Avila v. CitiMortgage, Inc., 801 F.3d 777, 787 (7th Cir. 2015) (“Here, Avila's claim is that CitiMortgage’s use of the insurance proceeds to reduce his loan was not a contractually permitted response . . . .”)