Are Silent Second Mortgages Legal?
Borrowers obtain second mortgages on their homes to finance large expenses. Medical bills, college fees, and home improvements / remodeling are some of the common expenses borrowers pay when taking out such mortgages. There are some borrowers and sellers who also enter into a “silent second mortgage” agreement. In most cases, this is unethical, and in many cases, it is completely illegal.
What are silent mortgages?
Second mortgages that are created without the knowledge of the first mortgage lender are called a “silent second mortgage.” They are mostly taken because the borrower cannot pay the down payment on the first mortgage.
For example: Borrower Bill takes a first mortgage from Lender L to finance a house worth $ 200,000. The initial payment you must make is $ 20,000. Now, Bill can pay only $ 5,000, and the seller of the house agrees to loan him the remainder of his down payment (that is, $ 15,000). This seller-buyer loan is a mortgage on the home property that is hidden from the first mortgage lender. This is the silent second mortgage.
Why are these mortgages hidden?
The borrower’s ability to make the down payment often plays an important role 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 they can offer up front.
When the borrower pays only a fraction of the actual down payment, their home exposure is drastically reduced. For example, Bill has a 2.5% total exposure to the home with his $ 5,000 down payment. The first mortgage lender believes he has a 10% exposure with a $ 20,000 down payment. The risk of default faced by the first mortgage holder is vastly greater with the lower Bill down payment. This is especially dangerous in scenarios like the housing crisis when home values hit rock bottom. Low-exposure home buyers are likely to simply abandon their loan, leaving the home “under water.”
Risks for the seller
The lender also faces an increased risk of default from the borrower. Also, since this mortgage cannot be documented until the first mortgage is finalized, a silent mortgage is usually an “informal” arrangement. In other words, there is no written legal agreement, which means it is an unsecured loan with no recourse in the event of default.
The question of legality
Silent second mortgages are 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 in which these mortgages can be taken legally.
It can be taken in the form of a subsidized mortgage that is waived once certain conditions are met. An example is the Good Neighbor Next Door program sponsored by HUD. There are also other circumstances in which such a mortgage can be taken in accordance with the law.
A silent second mortgage can seem like a wonderful life saver for a home buyer who can’t afford a down payment. It is very important that both the seller and the buyer understand the legalities of such an agreement before entering into it.