If you don’t make the payments on your second mortgage, the lender can foreclose. Whether the lender actually will foreclose, however, depends primarily on how much your home is worth. Read on to learn more.
What’s a Second Mortgage?
Like a first mortgage, a second mortgage is a loan that uses your home as collateral.
You probably took out a first mortgage to buy your home. Sometimes people take out a second mortgage at the same time as the first. But a second mortgage often happens later and is based on the equity in the home. (“Equity” is simply the value of your home minus any debt you owe on it. You can think of equity as the portion of your home that you truly own, which is why a lender would be willing to fork over a loan on a house already encumbered by a mortgage.)
HELOCs and Home Equity Loans
Both a home equity line of credit (HELOC) and a home equity loan are sometimes called second mortgages.
A HELOC is like a credit card. A HELOC is a kind of revolving credit, like a credit card. You get an account with a maximum limit and you can withdraw funds as you need them—up to the limit—during what’s called the “draw period.” While you’re in the draw period, you may pay all or part of the balance off, and you might be required to make payments of only interest. When the draw period ends, you normally have to pay back the outstanding balance plus interest by making regular payments.
A home equity loan is like a first mortgage. Another type of second mortgage is a home equity loan. A home equity loan is like a first mortgage in that the borrower gets a lump sum of money up front and makes standard monthly mortgage payments to repay the loan. This type of second mortgage is less common than a HELOC.
First Mortgage Gets Priority in a Foreclosure
Generally, the date a mortgage is recorded in the county property records determines lien priority. An old common law principle explains this idea simply: “first in time, first in right.” A second mortgage is a junior lien, which means the first mortgage, or senior lien, takes priority if there is a foreclosure sale. The proceeds of any foreclosure sale will first go to the senior lienholder, and only the remaining funds will go towards paying the junior lienholder.
While a junior lienholder can initiate a foreclosure, the senior lienholder still has priority. Usually, the junior lienholder has to pay off the entire first mortgage before foreclosing or foreclose subject to the first mortgage. So, the junior lienholder will normally only foreclose if you have a good deal of equity.
Your Equity Determines the Second Mortgage Lender’s Action
The more equity you have in your home, the more likely the junior lienholder will foreclose if you stop making payments. The simple reason is that after the first mortgage is paid off, there will still be money left from the foreclosure sale to pay the junior lienholder.
Borrowers who are in default often don’t have much equity, so second mortgage foreclosures aren’t that common. If your home is underwater, meaning it is worth less than what you owe on your first mortgage, there is almost zero chance the junior lienholder will foreclose. Without equity, it makes little sense for a junior lienholder to foreclose, so they will usually pursue other avenues, like a personal lawsuit, to collect from you.
Personal Lawsuit: Instead of Foreclosure or After a First Mortgage Foreclosure
Again, home loans usually have two main agreements: a promissory note and a mortgage. When it isn’t in the second lienholder's interest to foreclose, it might instead sue you on the promissory note separate and apart from the mortgage itself. The laws on how and when a junior lienholder can sue you personally for the debt vary by state, so it is crucial to understand your local rules.
A first mortgage foreclosure automatically eliminates junior liens, like a second mortgage lien. But, if allowed by state law, a second mortgage lender might sue you after a first mortgage foreclosure for whatever money it did not recover from that foreclosure.
If a junior lienholder sues you and wins a money judgment, it can collect in a number of ways, such as garnishing your wages, levying your bank account, or even attaching a new lien against some other property you own. Until you pay off the debt, get a bankruptcy discharge, or somehow settle with the lender, the debt will follow you.
Alternatives to Foreclosure
To avoid a foreclosure or a personal lawsuit, you may proactively take steps to resolve your second mortgage debt.
You Can Offer to Settle the Debt
Your lender might accept a one-time, lump-sum payment that is less than what you owe. However, settlements usually only come into play if you are underwater because the lender is willing to take a small amount rather than risk losing everything through a foreclosure. If the lender does agree to settle the debt, keep in mind that settled (“canceled”) debt is ordinarily considered income for tax purposes, subject to some exclusions and exceptions.
You Can Ask for a Short Sale
If your first mortgage is underwater and you’re behind in payments, a short sale might be an option to avoid a foreclosure. A short sale could potentially also resolve your second mortgage delinquency. As the name suggests, a short sale is when the lender allows the borrower to pay off the loan by selling the property for less than the outstanding debt. The lender accepts the "short" payment to satisfy the debt and discharge the mortgage.
Getting one lender to agree to a short sale is hard enough, but with two lenders to negotiate with, the process is even more difficult. Every lienholder must agree to the short sale, so if you are underwater on both of your mortgages, it is unlikely that a junior lienholder will sign off on the deal. Still, sometimes a first mortgage lender will agree to give some of its proceeds from a short sale to the second mortgage lender to avoid having to foreclose.
While a short sale is one way to avoid a foreclosure, unless both lenders agree to waive the difference between the debt and sale proceeds received, you might still face a lawsuit for a deficiency judgment from either lender after the sale. Again, there might be tax consequences if a lender cancels some of your debt.
If you miss a payment on any loan, the lender will likely report it to the credit bureaus, lowering your credit score. Civil judgments, foreclosures, and many collections actions will remain on your credit report for seven years. In general, the longer you go without paying your mortgage, the worse the effect on your credit, so it is important to deal with the issue as quickly as possible. (Learn more about how missed mortgage payments affect your credit.)
If you're behind on your second mortgage payments and have questions about what's likely to happen in your specific situation, consider talking to a local foreclosure attorney.