A second mortgage is a loan taken out on a property that already has an existing mortgage. The second mortgage lender holds a secondary lien position after the first (primary) mortgage lender. This matters in a foreclosure sale.
In This Article
What is Lien Priority and why does it matter?
Lien priority determines the order in which different mortgages or liens on a property are paid off in the event of a foreclosure or sale. The lien with the highest priority is the first mortgage and paid first, followed by subsequent liens that could be a second mortgage or even third or fourth mortgages in order of priority.
Defining a Second Mortgage
For example, let’s consider a property with a first mortgage, a second mortgage, and a home equity line of credit (HELOC). If the property goes into foreclosure and is sold, the proceeds would first go towards paying off the first mortgage in full. Any remaining funds would then be used to satisfy the second mortgage, and finally, the HELOC.
To illustrate further, if a borrower defaults on their mortgage and the property is sold for an amount that does not cover the outstanding loan balances, the lien priority determines which lenders are paid first and how much each receives from the sale proceeds based on their lien position. Understanding lien priority is crucial for both lenders and borrowers to assess their risks and potential recovery in case of default.
Implications of First Mortgage Foreclosure
Let’s consider a scenario to better understand the implications of a first mortgage foreclosure. Assume the property is worth $100,000, with a first mortgage of $80,000 and a second mortgage of $10,000. Now, imagine you own the second mortgage. If the borrower stops making payments on the first mortgage and the lender decides to foreclose, the first mortgage balance could increase to $90,000 by the time the legal process concludes. Additionally, the condition of the house may not be in great shape.
Eventually, the house will be sold by the court or a trustee, depending on the state. As the holder of the second mortgage, you have the right to bid at the sale and pay off the first mortgage to retain ownership of the property. However, would you want to do so considering the increased first mortgage balance and the potential deterioration of the house? Another possibility is that someone else may bid on the property, and if their bid is high enough, you will be next in line to receive payment after the first mortgage is paid off (up to the balance of what you are owed). However, it’s not likely to happen.
Alternatively, you could choose to keep the first mortgage current and foreclose on your second mortgage. While most lenders may agree to this arrangement, they may not be legally obligated to do so. It’s essential to read the legal ruling on this subject to understand the specific requirements and possibilities in your jurisdiction. However, the chances are that you may end up getting wiped out.
Should You Make or Own a Second Mortgage?
Given the risks associated with second mortgages, you might wonder if it’s wise to make or own one. The answer is not straightforward. Commercial lenders do offer second mortgage loans, but typically only to borrowers with good credit. Additionally, you can reduce your risk by ensuring that the combined loan-to-value (CLTV) ratio is lower.
For example, let’s say the property is still worth $100,000, but the first mortgage is only $70,000, and the second mortgage is $10,000. In this case, the CLTV is 80% ($70,000 first mortgage + $10,000 second mortgage divided by the property value of $100,000). It’s worth noting that interest rates on second mortgages are typically 2-4% higher than those on first mortgages.
Some individuals may be willing to take on the extra risk, hoping that the profits from the good mortgages will outweigh the losses from the few bad ones. However, others may prefer to avoid such risks altogether. Ultimately, the decision is yours to make.
If you do decide to originate a second mortgage, we recommend that it should be for at least 50% of the value of the property.
Let’s consider two scenarios to understand why this is important:
Scenario 1: The house is worth $130,000 and sells for $100,000. The buyer puts down $10,000 and borrows $40,000 from the bank. You lend a second mortgage for $50,000.
Scenario 2: The house is worth $130,000 and sells for $100,000. The buyer puts down $10,000 and borrows $80,000 from the bank. You lend a second mortgage of $10,000.
In this case, Scenario 1 is safer for you than Scenario 2. If the buyer defaults, it is easier for you to make payments on a $40,000 first mortgage than on an $80,000 first mortgage. Additionally, it may not be worth the hassle of creating a second mortgage that pays you only about $140 a month.
Ultimately, the decision to make or own a second mortgage should be carefully considered, taking into account the potential risks and rewards involved.
Further Reading on Foreclosure:
- Foreclosure: What Private Lenders and Hard Money Lenders Need to Know
- Expert Guide to the Non-Judicial Foreclosure Process
- Expert Guide to the Judicial Foreclosure Process
- What you need to know to Evaluate Foreclosure Losses
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