Borrowers take out second mortgages against their homes to fund large expenses. Medical bills, college fees and home improvement/remodeling are some of the common expenses that borrowers pay off by taking such mortgages. There are some borrowers and sellers who also enter into a ‘silent second mortgage’ agreement. This is most often unethical and in many cases outright illegal.
What are silent mortgages?
Second mortgages that are created without the knowledge of the first mortgage lender are called ‘silent second mortgage’. They are mostly taken because the borrower cannot afford the down payment of the first mortgage.
For example: Borrower Bill takes a first mortgage from Lender L to finance a house worth $200,000. The down payment he needs to make is $20,000. Now, Bill can afford only $5000 and the seller of the house agrees to loan him the rest of his down payment (i.e., $15,000). This seller-buyer loan is a mortgage on the house property that is concealed from the first mortgage lender. This is the silent second mortgage.
Why are such mortgages concealed?
· The capacity of the borrower to make the down payment often plays an important part in determining the total loan amount. The first mortgage lender’s calculation of the borrower’s repayment capacity also takes into account the amount of cash he can offer up upfront.
· When the borrower pays only a fraction of the actual down payment, his exposure in the home is dramatically reduced. For example, Bill has a total exposure of 2.5% in the home with his $5000 down payment. The first mortgage lender believes that he has a 10% exposure with $20,000 down payment. The risk of default faced by the first mortgage holder is immensely higher with Bill’s lower down payment. This is especially dangerous in scenarios such as the housing crash crisis when home values hit rock bottom. Home buyers with low exposure are likely to simply walk away from their loan leaving the home ‘underwater’.
Risks for the seller
The lender also faces a higher risk of default by the borrower. In addition, as this mortgage cannot be documented until the first is finalized, a silent mortgage is often an ‘informal’ agreement. In other words, there no written legal agreement, meaning that this is an unsecured loan with no recourse in the case of a default.
The question of legality
Silent second mortgages are most often illegal for the above reasons. The borrower deliberately misleads the first lender about his financial circumstances by hiding the loan. But there are some situations where these mortgages can be taken legally.
It may be taken in the form of a subsidized mortgage that is waived once certain conditions are fulfilled. One example is the Good Neighbor Next Door program sponsored by the HUD. There are also other circumstances where such a mortgage can be taken in line with the law.
A silent second mortgage may seem to be a wonderful lifeline to a home buyer who cannot afford a down payment. It is very important for both seller and buyer to understand the legalities of such an agreement before entering into a deal.