Second Mortgage & Foreclosure

It’s important to understand the ins and outs of second mortgages because the potential financial consequences of these contracts can be especially hard on already “distressed” borrowers. This article discusses second mortgages in detail. 

Many people take out second or even third mortgages on their homes. This process is essentially obtaining another loan using real estate as collateral. Second mortgages can even cover the down payment on the first mortgage. Home equity lines of credit (HELOC) are the most common.

When you don’t make payments on a second mortgage, second mortgage lenders can foreclose on your property. But because they’re “second” in line to get paid, they could get nothing from the sale. If this happens, depending on state law, these lenders can sue you for repayment.

Read on to learn the difference between first and second mortgages and what you can do if you’re facing foreclosure or other legal action related to your home loan(s). 

What Is Foreclosure?

When you buy a house, the home loan itself is called the “mortgage” or deed of trust. At the same time, you’ll sign a “promissory note” promising to pay the lender back. These two legal documents give lenders a secured debt in the property because the property itself is used to secure the loan. Because of these documents, lenders have the legal right to reclaim the property if you fall behind on your mortgage payments per the unique terms in your contract.

Foreclosure is the process whereby lenders reclaim secured real estate. This process is triggered when a homeowner fails to pay or “defaults” on mortgage payments, whether those payments are due on a first, second, or third mortgage. How many payments you can miss before lenders may start debt collection efforts depends on state law. Lenders will first try to collect the debt by:

• Calling you

• Writing letters

• Sending bills

When these debt collection methods don’t work, mortgage lenders may ask the court to step in. In formal foreclosure proceedings, the lender takes back the home and sells it at a public auction. The proceeds of the foreclosure sale go to paying off the balance of the loan. 

What You Should Know About Second Mortgages

Second mortgages may be used by borrowers in need of funds for an initial down payment on a home. Using these funds to supplement savings for a down payment can give homeowners more favorable pricing for their first mortgage. A larger down payment may also allow them to avoid taking out the property mortgage insurance required by many agencies. 

Other common reasons to take out a second mortgage include:

• Debt consolidation

• Financing college tuition

• Remodeling or home improvements

While first and second mortgages are secured by the same assets, second mortgages bind borrowers to a higher rate of interest. The size of the loan depends on the difference between the home’s current value and the amount owed on the loan. This is known as “equity” and is discussed in greater detail below. 

A second mortgage loan may also have a shorter term. While first mortgages can have terms of 30–40 years, second mortgages can range from 1–20 years. Shorter terms generally mean higher monthly payments. Second mortgage debts are typically drafted in three different ways:

• Home Equity Lines of Credit (HELOC)

• Home Equity Loans (HELs)

• Cash-out refinancing

HELOCs are by far the most popular because they grant borrowers more flexibility and can be used like credit cards. Once you pay them off (usually in 10 years), you can use them again. HELs and cash-outs act like first mortgages because you receive a large sum of money up front. But both charge relatively high interest rates (typically 3–5%).

Remember that first and second mortgages are secured by the same property. This gives both first and second mortgage holders the right to foreclose in the event of default. For both, their legal claim on the property is known as a “lien.” But holding “second position” as a “junior” lien holder completely changes that lender’s prospects of getting paid via the  foreclosure process.

Priority Liens & Junior Liens: What’s The Difference?

There are many types of liens. Liens describe any legal claim to property. Liens can be placed on property for various financial obligations, not just mortgages. Unpaid property taxes and homeowner association dues, for example, may result in liens being placed on a home.

A homeowner who has two or more mortgages has (at least) two liens placed on the property. The first (a first mortgage) is the loan used to buy the home and the second (a second mortgage) is usually a home equity line of credit (HELOC). Like credit cards, HELOCs let you:

• Withdraw money when you need it

• Access a revolving line of credit

• Take out money up to a limit 

• Repay during a set time period

So, you can withdraw money up to a maximum as you would with any bank account. During what is usually a 10- to 15-year “draw” period, you may only have to pay back part of the balance or the interest. But when this period ends, you’ll have to pay back all the balance plus interest. 

HELOCs and HELs

HELOCs make up about 90% of all second mortgages. They’re secured by equity in the home. Equity refers to the portion of the home’s value that you actually “own” at any time. You can use that equity, if available, to secure a HELOC or HEL. Two terms to know when it comes to equity:

• Equity is the value of a homeowner’s interest in the home or the current market value minus any liens on the property (a large down payment and monthly mortgage payments increase equity because they go toward paying down the original or principal mortgage)

• Underwater means that your home’s current market value is less than the principal mortgage balance still owed on the loan (meaning you have “no” or “negative” equity)

HELOCs and HELs require that you have equity in your home. Unlike HELOCs, HELs give borrowers a lump sum of money upfront, which borrowers then repay in fixed-rate monthly installments for 1–20 years. This lack of flexibility makes HELs less popular than HELOCs.

First Mortgages Get Priority Over Junior Liens 

Generally, the “first in time is the first in line” to get paid if a house gets foreclosed. So, the first recorded mortgage has priority over the second. The second lienholder is “junior” to the first. 

Some debts like unpaid property taxes even take priority over first mortgages. This means that in a foreclosure sale, the IRS gets paid first. The first mortgage lender takes “second place.”

Holding a priority lien over a junior one makes the second mortgage lender:

• More likely to foreclose the more equity you have

• Less likely to foreclose if your home is underwater

More equity increases the likelihood that the second mortgage lender will be able to recoup something from the foreclosure process. If your mortgage is underwater, the senior lender reaps all the benefits. Junior lien holders aren’t likely to get paid in first mortgage foreclosures on underwater homes.

Subordination Agreements

If you’re allowed to pull value from the house, sell it, or modify loan terms to prevent foreclosure, these actions will be recorded after the priority assumed by the second mortgage. This gives the second mortgage priority over your ability to take advantage of your interest in the property. This happens in a subordination agreement.

To avoid giving priority to the second mortgage holder in an event to prevent foreclosure, the first mortgage holder will likely ask the second mortgage holder to subordinate its loan to the newer one. That way, the first lender skips ahead of the second and keeps its priority in line. In general, it’s hard for junior lien holders to gain priority over the first.

Because of the “first recorded” rule, any change to your first mortgage will affect the second. Changes that require subordination include:

• Refinance

• Short sale

• Loan modification

A first mortgage foreclosure on an “underwater” home may wipe out foreclosure possibilities for second mortgage lenders. They lose their security interest in the real estate and become unsecured creditors. Because filing for foreclosure could be a waste if there isn’t enough equity in the property available to repay all interested lien holders, junior lien holders in some states may sue you directly for what you owe on your second mortgage loan. 

How and when they can personally sue depends on state law. In some states, second mortgage holders don’t have to wait until after a first mortgage foreclosure to pursue their interests. 

Deficiency Judgments

If the foreclosure sale price isn’t enough to cover what you owe on the second mortgage, junior lien holders can use their promissory note to hold you personally responsible for repayment. They must first serve you with a summons to appear in court. 

If you don’t appear, the judge will treat the second mortgage holder as the winner of the lawsuit and enter a default judgment against you. A deficiency judgment in the lien holder’s favor allows the lender to use more aggressive means of collection. These methods are discussed below.

Second Mortgage Collections

If a borrower defaults, the second mortgage holder may choose to foreclose depending on:

• How much equity is in the home (is it worth more than what you owe) and

• What sale price they may be able to get for the home at auction (to pay off the balance of the loan)

If the first mortgage foreclosure isn’t enough to pay off the debt, the second mortgage holder may decide to sue and try to collect the money owed in court. If the second lender wins a money judgment against you, it can collect by:

• Garnishing wages

• Levying bank accounts

• Placing a lien on other property

If you’re facing a lawsuit from a second mortgage holder, you will be served with a summons. You should answer the summons and appear in court. But before court, you can also:

• Try to settle the debt for less than what you owe (by agreeing to a one-time, lump-sum payment)

• Request a short sale if both the first and second lien holders agree to this plan of action

• File for bankruptcy to help manage your debts and avoid money judgments

Second mortgage holders are unlikely to get much from foreclosure of an underwater home with no equity. That gives you some bargaining power. It’s better to get some payment than none. A foreclosure attorney can give you more legal advice about these options.

If you’re thinking of filing for bankruptcy, remember that you’ll still need to pay off your secured debts to keep that property. Filing for Chapter 13 bankruptcy can help you catch up on overdue debts over time. If you have many liens on your property, both Chapter 13 and Chapter 7 bankruptcy can reduce or alleviate these debts. You can learn more about Chapter 7 versus Chapter 13 bankruptcy using Upsolve’s free library. 

Let’s Summarize…

Like first mortgages, second mortgages are secured by real estate. But because they are “junior” to first liens, second mortgage holders are second in line to get paid. The more equity you have in your home, the more likely second mortgage lenders are to foreclose on your residence. They can only recover money if the home’s value is greater than what you owe. If you’re underwater, money from the foreclosure won’t be enough so second mortgage holders can personally sue you in court for the balance. 

If you’re facing foreclosure or other legal action from a mortgage creditor, get help from a private foreclosure attorney or HUD-approved housing counselor. You can also try to settle with the second mortgage holder, ask both lien holders to agree to a short sale, or file for bankruptcy to alleviate debts. Before filing for bankruptcy, see if you’re eligible to file Chapter 7 yourself using Upsolve’s free web tool or let Upsolve help you find a local bankruptcy attorney to consult for free.