How Does A Second Mortgage Work?

Second mortgages have unfortunately become very common over the past decade. As real estate prices skyrocketed, buyers were forced by borrow more and more money to afford a decent home in a nice neighborhood because, by and large, their incomes weren’t keeping up with real estate prices. This sucked for homeowners but it wasn’t so bad for lenders because a.) there were now twice as many opportunities to charge underwriting fees to go around for the same number real estate transactions and b.) second mortgages carry significantly higher interest rates. Of course, a second mortgage default has always been more likely than a first mortgage default, but so long as real estate prices kept climbing, that wasn’t an issue: homeowners could just keep refinancing forever! Well, that was the theory, at least.

What Is A Second Mortgage?

A second mortgage is a subordinate mortgage loan, meaning it’s not the first in line to be paid in case of a default. For example, say you are defaulting on a property which you owe $100,000 on. You owe $80,000 on the first (non-subordinate mortgage) and $20,000 on the second mortgage. Now assume that, due to the real estate crash, your property is only worth $70,000. In this case, the holder of your primary mortgage loan will receive the full $70,000 of the sale (but still less than the $80,000 they are owed). In this case, the owner of the 2nd mortgage would receive nothing because it is a subordinate loan. The second mortgage holder only gets paid after the first mortgage holder is paid in full. Second mortgage loans are thus riskier and hence sport higher interest rates to compensate.

How Does A 2nd Mortgage Work?

Second mortgages work much the same as any other mortgage. You generally agree to borrow money for a specified period of time (5 years, 10 years, 15 years, 30 years, etc), with a few important variations. Like first mortgages, you will pay back the 2nd mortgage monthly on a schedule calculated in advance by your lending institution (perhaps with known adjustment dates). Also like first mortgages, second mortgages can have fixed or adjustable rates, and there are even interest-only options available. In fact, it’s probably the case that interest-only mortgages and ARMs were (are) even more common with second mortgages than with first. This is because many homeowners are, almost by definition, stretching themselves to the limits to afford the monthly payments on their new properties. If they weren’t, they’d probably just go the traditional route by making a 20% down payment and taking out a single 30 year fixed rate mortgage.

Unfortunately, the consequences of defaulting on your 2nd mortgage are every bit as severe as those for defaulting on any other mortgage. If you miss too many payments, your lender will initiate foreclosure proceedings. In the event of a foreclosure, your second mortgage lender will most likely buy your first mortgage from the other lender (if they don’t own it already) and start the foreclosure process. At this point, you’re probably screwed unless you can bring your payments up to date or unless you qualify for one of the loan-modification programs enacted after the crash.