Most commonly issued in the form of home equity loans and home equity lines of credit, a second mortgage can serve as a good way to access the equity in your home. Once in hand, you can use this money to fix your home, buy a new car or pay off high-interest credit cards. While getting this money when you need it is often a blessing, it can become a curse if you fall behind on your loan payments.
Your lender has the legal right to foreclose on your home if you default on a second mortgage. Even if he chooses not to, there are other ways he can collect the debt.
Second Mortgage Foreclosure Basics
When you take out a mortgage, you agree to use the home you're buying as collateral for the debt. If for some reason you default on the mortgage, the bank has the right to take possession of the home, remove you from it and sell the house at auction to recoup their costs. This holds true for second mortgages as well as first mortgages, but things do get a bit more complicated when there are multiple mortgages.
When you take out a loan against your home, lenders aren't given rights at random. There is a specific pecking order that dictates which liens get paid first in a foreclosure. Typically, lenders get paid in chronological order. Let's say, for example, that you bought a house and took out a mortgage to do so. You then fell behind on your homeowners' association dues, so your HOA put a lien on your house. Sometime after that, you took out a second mortgage to fix your leaky roof. If you default on your second mortgage and the lender forecloses, that lender must use the money he makes selling the home to pay off your first mortgage and your HOA lien before keeping any of these proceeds for himself.
There are, of course, exceptions to the chronological rule. State laws can change the pecking order of lenders and can prioritize some debts over others. A state may, for example, rule that state tax liens on a property take priority over and get paid before an HOA lien or mechanic's lien.
To Foreclose or Not to Foreclose
Because debts get repaid in a very specific order, your lender will carefully weigh the pros and cons of taking your home into foreclosure. If your home is worth more than what you owe on it, a lender is likely to foreclose if you default on a second mortgage. Though it seems counterintuitive, the less you owe on your home, the more likely foreclosure becomes. If your debt is small, your lender can likely sell your home for more than you owe. After the sale, the lender will have enough money to cover all or most of your debt, even after paying off your first mortgage or other liens.
Your lender may think twice about foreclosure, however, if you're upside-down. Being upside-down means that you owe more than what your home is worth. In this case, your second mortgage lender still has the legal right to foreclose on your home, but it may not do her any good. If you owe $200,000 on a home that is only worth $150,000, your second mortgage holder won't benefit from the foreclosure. Even if she sells your home for the full $150,000 value, all of that money would go toward paying off your first mortgage of $200,000. There would be no money left for the second mortgage holder, making the foreclosure process a waste of her time and money.
Alternatives for Your Lender
Even if you're upside-down and your lender opts against foreclosure, a default on a second mortgage has consequences. Your lender may sue you. If he wins, the court can order you to pay back the money you owe. If you can't, the court may allow your lender to take possession of your savings account or your future tax refunds. If you have a job, the court could force your employer to pay some of your wages to your creditors. The same is true of disability payments or other financial benefits you receive.
Alternatives for You
Clearly, you'll want to do what you can to avoid foreclosure or the other unpleasant consequences of defaulting on a second mortgage. Fortunately, you do have options. One is to reinstate your mortgage and stop foreclosure and collection actions. To do so, you can pay off your past due balance in full and then keep making your payments. If you can't find the cash to bring your loan current, contact your lender and work out a repayment plan. Under this arrangement, you agree to begin making your mortgage payments as agreed plus a bit extra until your past due balance is paid off. When it is, you can again lower your monthly payment. Most lenders allow repayment plans of three, six or nine months.
Similar to the repayment plan is the forbearance. Under a forbearance agreement, your lender agrees to lower your mortgage payments or let you skip them for a time. When you begin making them again, you agree to pay some extra money every month to make up for the missed payments. The primary difference between a repayment plan and a forbearance agreement is that a repayment plan comes into play after you've become delinquent. You would negotiate a forbearance agreement before you miss payments. Forbearance agreements typically help people who get temporarily laid off or sent for active military duty.
If your financial situation changes and you simply can't afford your second mortgage any longer, ask your lender for a loan modification. A loan modification lets you renegotiate the terms of your mortgage. Doing so may allow you to reduce your monthly payment by extending the life of the loan or getting a lower interest rate. The sooner you reach out to your lender, the more likely she is to work with you, so contact her as soon as you realize you're struggling.
When researching options for avoiding foreclosure, you'll see short sales mentioned often. Note, however, that this option is very rarely available as a remedy for a second mortgage. In a short-sale arrangement, your lender agrees to let you sell the home and use the proceeds to satisfy the debt in full, even if the house sells for less than what you owe. A short sale is only permissible with approval from all of your lenders. Because they won't get paid until your first mortgage is satisfied, second mortgage holders rarely agree to a short sale. It never hurts to ask, but your lender isn't likely to agree.
When the Dust Settles
If you do lose your home to foreclosure on your second mortgage, know that you could still owe. In some states, a foreclosure is the end of the line. Your lender can sell your home and use the money to repay your loan, but it's game over after that. If you still owe $10,000, the lender must take the loss and move on. Other states, however, allow for deficiency judgments. In these states, a lender who comes up short after a foreclosure can sue you to collect the remaining balance. In this case, a lender who comes up $10,000 short after a foreclosure sale can force you to pay it.
As of 2018, lenders can't collect from borrowers after a foreclosure in Alaska, Arizona, California, Connecticut, Hawaii, Minnesota, Montana, Nevada, New Mexico, North Carolina, North Dakota, Oregon, Washington or Wisconsin. Nevada lenders can collect, but only if the mortgage originated before October 1, 2009. Iowa, too, has special rules. In all other states, lenders can and do sometimes pursue borrowers for payment if any loan balance remains due after a foreclosure sale.