Should the Buyer Default on Their Second Mortgage?
Sunday, January 9, 2011 at 6:28PM Nash Law Firm, PLLC
By: Stephen J. Nash
nash@nash-law.com
Should the borrower continue to pay the second the second mortgage on an upside down property? As the financial problems keep moving up the economic scale, more and more of the troubled borrowers have multiple mortgages on the home. As a result, we are often asked whether the borrower should default on their second mortgage.
Background
When the borrower has multiple mortgages on their home, the following are considerations if their home is located in Minnesota:
- If the borrower defaults on the first mortgage, the lender inevitably will foreclose the mortgage, the only question is what type of foreclosure they will bring.
- If the borrower defaults on the second mortgage, the lender often will not foreclose because there is no equity for them to go after.
- If the first mortgage is foreclosed, most likely in residential situations, the lender will foreclose by advertisement and will not be able to pursue the borrower for a deficiency.
- If the first mortgage is foreclosed, the second lender will not participate since there often is no equity and, therefore, can still sue the borrower for the deficiency on the second lien.
The Strategic Default
A "Strategic Default" is where a borrower technically has the ability to pay the debt but chooses to default. Why would a borrower choose to default if they can make the payment?
They owe more than the collateral is worth or they have to sell the collateral but cannot do so without lender approval (i.e. a short sale).
With declining real estate values, every time the value drops, more borrowers become underwater and those that are already underwater sink further and further under. When the borrower loses hope that the collateral's value will return to a point of equity any time soon, the more likely they will strategically default.
There is a great deal of debate over whether it is morally right to strategically default; however, in my experience, once borrowers are significantly underwater, the debate in their mind dissipates quickly. This is especially true if they have spent a great deal of money keeping all of their debts current while they see the values to continue to fall; if they have run into road block after road block to negotiate a loan modification; and/or if it locks them into a situation that they can't stay in.
Basically, if the borrower has to sell the property for any reason before the value of the property returns to at least equal the debt against it, the borrower has a problem. The worst case scenario for this borrower is that they keep making the payments but then lose their ability to pay or have to sell the property down the line at a time when the country has finally started to recover. If you think the lenders are difficult to deal with during an unprecedented economic crisis, can you imagine how responsive they will be when they can start loaning money again? What happens to the borrower when the loss mitigation department goes away or significantly shrinks? What happens to the borrower when the governmental initiatives go away? What happens to the borrower when the special tax provisions go away? Same problem as today but a much more difficult situation.
When Should the Borrower Default on the Second?
The first situation is obvious: the borrower cannot afford to pay the first or the second.
The second situation is where the borrower wants to stay living in the home but cannot afford both the first and the second payment. The borrower may gamble that by paying the first and not the second, that the second lender will not foreclose. Of course, the borrower will have to expect that the second will bring a lawsuit to recover on the promissory note. In this scenario the borrower should consider negotiating with the second to either obtain a satisfaction of the note for a lump sum payoff (with a discount based upon the borrowers financial shape) or a loan modification that the borrower can afford.
The third situation is that the borrower cannot pay the first, but can pay the second and chooses not to because the property is so far underwater. This truly is a strategic default. The borrower in this case knows the property is going to be lost by a foreclosure of the first so they will never have a chance for the value to recover enough to cover the second, and the borrower believes that they can negotiate a better deal with the second. Like the second scenario, the borrower has to expect to be sued on the promissory note and should consider negotiating with the lender to arrive at a negotiated settlement on the second. Ironically, lenders encourage the strategic default in that it is almost impossible to negotiate with them on a debt that is current.
The final situation is where the borrower can afford to pay both the first and the second but determines that they are going to strategically default on the first mortgage. Like in scenario three, if the borrower believes that they can negotiate a better deal on the second mortgage, they will also strategically default on this loan as well.
What Are Borrowers Doing on Their Seconds?
Julapa Jagtiani and William W. Lang of the Philadelphia Federal Reserve, as reported in HousingWire, have studied the data and determined that 20 percent of the borrowers whose first mortgage was in foreclosure continued to pay the second mortgage. Eighty percent of the borrowers who defaulted on the second mortgage also defaulted on their first mortgage.
This result is surprising in that most would assume that borrowers would first do whatever they could to save the home (i.e. pay the first and not the second to lower their housing cost) and if they couldn't save the home, that they would have no incentive to pay the second.
The authors of the study speculated that homeowners continued to pay the second to keep open a HELOC line of credit. They point out that even if the first is foreclosed the lender on the second often does not close down the credit line. They also point out that the larger the second, the less likely the borrower was to default.
Based on the many clients that I have seen in this situation, I have come across a few that continue to pay the second because they still have an open credit line. Most do not have an open credit line to preserve and most seconds were not credit lines but were the second loan used to originally purchase the property.
In my experience, many borrowers continue to pay the second because they do not want to be sued. In some cases, they have assets that the lender can go after to pay off the debt, in other cases they are afraid of losing their job if their wages are garnished and/or they don't qualify for bankruptcy or simply don't want to file bankruptcy.
Conclusion
Determining if and when a borrower should default on a second is tricky business that has to factor in many different factors as well as the goals and fears of the borrower. What is clear however, is that the borrower has to make a well-informed decision on whether to pay the second or not since that decision for better or worse is going to a have a great effect on their lives for quite some time.