What Happens to a Second Mortgage in a Home Foreclosure?
UPDATED: June 19, 2018
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The homeowner often takes out more than one mortgage on his home. Once the first mortgage lender forecloses on the property, the lender will sell the mortgage to the highest bidder in a foreclosure auction sale. The sale proceeds will be used to pay down any real estate taxes due. After the real estate taxes are paid, if any funds are left, the first loan must be paid, followed by the second mortgage debt. However, the auction proceeds might not be enough to cover these debts.
Insufficient Funds to Pay First & Second Mortgage Lenders
If the balances in the first and second loans cannot be paid off, both lenders have the right to sue the borrower for balances owed, plus interest and other costs. If both lenders sue the borrower and win, each will be granted a "deficiency judgment". Such a judgment will give both lenders the legal right to garnish the borrower's wages, seize bank accounts, and place a levy against other property not exempted by state law. However, not all states allow deficiency judgments. In that case, the lender's rights to proceed against the borrower are terminated once the property is foreclosed upon. The lender may not pursue further collection activity.
Second Mortgage Holder Buys Back the Property
When the first mortgage lender carries out a foreclosure sale, the second mortgage lender may also bid for the property at the time of foreclosure sale. Even after the property has been sold at auction, the second mortgage lender may pay off the required amount of money to the first mortgage holder and get the property back at the end of the "redemption" period. These last two options are attempts to recover the money the second mortgage holder has invested, although they are rarely undertaken (particularly in a weak housing market).
Collecting on an Unpaid Debt
A second mortgage lender can also charge-off any unpaid debt after getting a part of the sale proceeds when the first loan is paid off. This means the second lender considers the debt uncollectible, but legally the borrower still owes the money. Therefore, if the second mortgage holder charges-off the loan, while it will no longer pursue a borrower, the second mortgage holder can still sell the right to collect on the debt to a third-party collector. The third-party collector has the legal right to make continued attempts to collect the debt. The charge-off will negatively impact the borrower's credit score. In addition, the charge-off may be considered income by the IRS. However, federal law does provide for relief, depending on the circumstances.