Second Mortgage

Mortgages are often classified by their priority in the event of the borrower's default and, subsequently, foreclosure. The priority is important because it indicates which claim is to be satisfied in which order. It is especially important when there are insufficient resources to cover all of the debt claims, as is typically the case when a borrower defaults.

The permanent, long-term mortgage, traditionally a fixed-rate mortgage (FRM), is generally the first (or primary) mortgage in most residential financing arrangements. This legal agreement is achieved by a contractual arrangement between borrower and lender using the mortgage document. The mortgage dates back to medieval times and, unlike contracts, originally was viewed as a conveyance of property for the duration of time that the promissory note was outstanding. In the mortgage, the parties agree that subsequent to a default by the borrower, the lender has the first claim (with a first mortgage) to the liquidation value of the asset in order to recover the lender's outstanding balance on the note. For the lender, the establishment of a priority claim against the property owner helps to secure collateral for the loan, which lowers the riskiness of the agreement. For the borrower, the acceptance of the claim against the asset permits the borrower to repay the promissory note over a very long period of time (as much as 30 years in most states) despite unanticipated changes in the economy during the repayment period and, in some cases, in the borrower's life. Without the first mortgage as security, the note could not be used, at least, not at the typical terms of mortgage loans.

However, sometimes a first mortgage may be insufficient. Additional financing may be desired or even required by the borrower, but because of lending policies at the first mortgage holder's institution, a higher amount of money is not available. Alternatively, a buyer in a real estate transaction might not be able to produce a sufficient down payment to complete the financing arrangements of the transaction. Sometimes, the seller is willing to supplement the institutional loan arrangements with so-called seller financing to fill the gap and complete the transaction. A borrower might also want to use some of the equity in the house by refinancing a portion of the equity and withdrawing the funds without disturbing the first mortgage. During periods of rapidly rising mortgage interest rates, taking out a second mortgage might be preferable to refinancing in order to preserve the low interest rate on the existing first mortgage. Finally, a high-leverage strategy might be to supplement the first mortgage loan with one or more additional mortgages so as to reduce the required down payment and increase the returns to equity due to financial leverage. In all of these situations, second mortgages are employed.

Second mortgages are supplementary financing instruments used to achieve one or more of the financing objectives of the borrower. Some second mortgages originate in financial institutions, but many do not. Some modern arrangements take the form of a line of credit, whereby the borrower can draw upon a set aside amount as needed. Some mortgages are marketable such that they may be sold in the secondary mortgage market, but many are not. In the 1950s and 1960s, some small investors used to buy and sell second mortgages as investments. As markets developed more broadly in more recent decades, institutions moved in to capture the demand for second mortgages. Most second mortgages are shorter in duration than primary mortgages, often for as little as 3 to 7 years.

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