Silent Second Mortgages
April 16, 2007, Revised May 23, 2007
The term “silent second” is used most frequently to describe self-serving or perhaps fraudulent schemes where house sellers accept second mortgages as part of a sale transaction, without the full knowledge of the first mortgage lender. The “silence” refers to the absence of full disclosure to the first mortgage lender.
The smaller of the frauds arises when the second mortgage replaces part or all of a down payment. For example, the buyer and seller agree on a price of $200,000, the buyer has a commitment for a first mortgage loan of $180,000, but doesn’t have the $20,000 required for the down payment. To make the deal work, the seller agrees to accept a silent second mortgage for $15,000. As far as the first mortgage lender knows, the down payment is $20,000, but in fact, it is only $5,000.
The silent second increases risk to the first mortgage lender because it takes only a 2.5% decline in home value to eliminate the borrower’s equity – rather than the 10% decline that the lender counted on. When equity is depleted, some borrowers stop paying on their mortgages.
This silent second is also risky to the seller, because it can’t be recorded at the time of the sale – that would give the game away. This means that the seller has an unsecured loan until the transaction is completed and the lien can be recorded. How long the seller must wait before recording the lien is negotiated between the parties. The longer the seller waits, the greater the risk that other liens will be placed on the property, which will endanger the silent second.
A silent second that replaces the down payment should not be confused with a "piggyback", which is also a second mortgage that replaces a down payment. The difference is that the piggyback is usually offered by the lender making the first mortgage, so no deception is involved.
An even more serious deception of the first mortgage lender arises when the silent second is used to inflate the sale price beyond the true value of the house in order to increase the size of the first mortgage. Assume the same house as before with buyer and seller agreeing on a true price of $200,000, but in this case the buyer has no down payment. They collude to set a fictitious price of $222,200, on the basis of which the first mortgage lender agrees to lend $200,000. This is 90% of $222,200 but 100% of the true value of $200,000. The seller agrees to a second mortgage for $22,200.
In this case, the first mortgage lender knows about the second mortgage. What the lender doesn’t know – where the silence comes in -- is that after the transaction is completed, the seller will forgive the second mortgage. In this way, the lender is deceived into making a 100% loan, believing that it is a 90% loan.
This scheme won’t work unless the higher price is ratified by an appraisal. Lenders base loan amounts on the lower of price and appraised value, so if the appraisal comes in at $200,000, which is the true price, the deal can’t be done. Unfortunately, many appraisers have great difficulty in setting a value below the price agreed to by a buyer and a seller.
The term “silent second” is also used to describe a benign type of transaction in which a government or non-profit agency assists low-income home buyers purchase more costly houses than they could otherwise afford. The “silence” in this case refers to the absence of a payment burden imposed by the second mortgage. Some municipalities in California have such programs.
These second mortgages may carry a zero or low interest rate, or interest may be deferred for some years. Usually, the principal is not repayable until the house is sold. In some cases, the lender may recover part or all of the subsidy on the second mortgage by receiving a share in the house appreciation at sale. See Is This Shared Appreciation Mortgage a Good Deal?
It is a bit incongruous that the term “silent second” is used both to describe deceptions perpetrated on lenders by home buyers and sellers, and subsidy programs to assist lower-income buyers. But English is a very flexible language.
The term “silent second” is used most frequently to describe self-serving or perhaps fraudulent schemes where house sellers accept second mortgages as part of a sale transaction, without the full knowledge of the first mortgage lender. The “silence” refers to the absence of full disclosure to the first mortgage lender.
Silent Second Instead of Down Payment
The smaller of the frauds arises when the second mortgage replaces part or all of a down payment. For example, the buyer and seller agree on a price of $200,000, the buyer has a commitment for a first mortgage loan of $180,000, but doesn’t have the $20,000 required for the down payment. To make the deal work, the seller agrees to accept a silent second mortgage for $15,000. As far as the first mortgage lender knows, the down payment is $20,000, but in fact, it is only $5,000.
The silent second increases risk to the first mortgage lender because it takes only a 2.5% decline in home value to eliminate the borrower’s equity – rather than the 10% decline that the lender counted on. When equity is depleted, some borrowers stop paying on their mortgages.
This silent second is also risky to the seller, because it can’t be recorded at the time of the sale – that would give the game away. This means that the seller has an unsecured loan until the transaction is completed and the lien can be recorded. How long the seller must wait before recording the lien is negotiated between the parties. The longer the seller waits, the greater the risk that other liens will be placed on the property, which will endanger the silent second.
A silent second that replaces the down payment should not be confused with a "piggyback", which is also a second mortgage that replaces a down payment. The difference is that the piggyback is usually offered by the lender making the first mortgage, so no deception is involved.
Silent Second Inflating the Sale Price
An even more serious deception of the first mortgage lender arises when the silent second is used to inflate the sale price beyond the true value of the house in order to increase the size of the first mortgage. Assume the same house as before with buyer and seller agreeing on a true price of $200,000, but in this case the buyer has no down payment. They collude to set a fictitious price of $222,200, on the basis of which the first mortgage lender agrees to lend $200,000. This is 90% of $222,200 but 100% of the true value of $200,000. The seller agrees to a second mortgage for $22,200.
In this case, the first mortgage lender knows about the second mortgage. What the lender doesn’t know – where the silence comes in -- is that after the transaction is completed, the seller will forgive the second mortgage. In this way, the lender is deceived into making a 100% loan, believing that it is a 90% loan.
This scheme won’t work unless the higher price is ratified by an appraisal. Lenders base loan amounts on the lower of price and appraised value, so if the appraisal comes in at $200,000, which is the true price, the deal can’t be done. Unfortunately, many appraisers have great difficulty in setting a value below the price agreed to by a buyer and a seller.
Silent Seconds as a Form of Subsidy
The term “silent second” is also used to describe a benign type of transaction in which a government or non-profit agency assists low-income home buyers purchase more costly houses than they could otherwise afford. The “silence” in this case refers to the absence of a payment burden imposed by the second mortgage. Some municipalities in California have such programs.
These second mortgages may carry a zero or low interest rate, or interest may be deferred for some years. Usually, the principal is not repayable until the house is sold. In some cases, the lender may recover part or all of the subsidy on the second mortgage by receiving a share in the house appreciation at sale. See Is This Shared Appreciation Mortgage a Good Deal?
It is a bit incongruous that the term “silent second” is used both to describe deceptions perpetrated on lenders by home buyers and sellers, and subsidy programs to assist lower-income buyers. But English is a very flexible language.