Anyone who has seen a horror movie is familiar with this scenario. A fierce battle ensues between the main characters and the antagonist (typically wearing a mask) that results in the slasher’s apparent demise. A few moments of quiet go by before the villain comes back to life for a final battle.
A similar situation has proven to be the case for second mortgages. As the name suggests, a second mortgage is a loan secured by real estate, but it is in second position to the first mortgage in terms of lien priority. Back in the early 2000s, it was common for homeowners to take out “80/20” mortgages. A lender would loan 80% of the purchase price of the home and a second mortgage would be taken out for the other 20%. This allowed homeowners to sidestep private mortgage insurance (“PMI”). This also led to home purchases with no down payment.
The Great Recession saw real estate values drop to the point where second mortgages no longer attached to any equity in the collateral real estate. For example, let’s assume that a home was purchased for $200,000 in 2007 with an 80/20 loan.1 This would result in a first mortgage for $160,000 and a second mortgage of $40,000. A few years pass and the real estate crash causes the value of the house to drop to $150,000. In this situation, the second mortgage effectively has no value. In fact, a second mortgage can be entirely avoided and paid as a general unsecured creditor2 in a Chapter 13 bankruptcy when it attaches to no equity in the home. If the last payment on the loan comes due during the life of a Chapter 13 bankruptcy, the loan can be bifurcated. More on that later.
When home values plummeted, the second mortgage holder was left with little recourse against the property owner. If the second mortgage holder forecloses, they are only doing the first mortgage holder’s job for them. If a mortgage creditor successfully brings a foreclosure action and the property is auctioned through a sheriff’s sale, first priority liens still need to be paid before the second mortgage holder gets any distribution from the sale proceeds.3 As a result, many of these second mortgages appeared to have died over the past decade…or so it would seem!
One of the unforeseen consequences of this real estate market is the reanimation of “zombie” second mortgages. As I mentioned in a recent blog post4, home values reached an all-time high this year. Since home values have increased, second mortgages that were previously valueless may now attach to significant equity in the property. This is especially true if the first mortgage has been paid down through regular monthly payments over the past ten years. A second mortgage that has been unpaid will have accrued significant interest and late fees for non-payment.
I have met with two separate clients this summer who received foreclosure complaints initiated by second mortgage holders. One of these mortgage balances has nearly doubled in size since it was last paid! Additionally, the parties that are filing these foreclosures may look unfamiliar to the homeowner. These second mortgages may have been bought and sold multiple times prior to reaching their final holder.
These second mortgage loans can be very old (at least, old for mortgages). One of the loans that is owed by one of my clients came due in 2019. As I mentioned earlier, a second mortgage that attaches to no equity in a home can be entirely avoided through a Chapter 13 bankruptcy. However, if a loan has fully matured, or if it will mature during the life of a Chapter 13 bankruptcy, it can be modified into secured and unsecured claims.5
For example, let’s say that a house is worth $200,000, there is a first mortgage for $190,000 and a second mortgage for $30,000. This means that the second mortgage attaches to $10,000 worth of equity in the home and $20,000 is unsecured. In these circumstances, if the loan has matured (based upon the date of maturity on the promissory note) or if the loan will mature during the life of a Chapter 13 plan, the second mortgage can be repaid $10,000 as a secured claim and $20,000.00 as an unsecured claim. The second mortgage lien is then released from the property upon completion of the Chapter 13 bankruptcy.
Considering these circumstances, it is more important than ever for attorneys to do their due diligence when they encounter a client with real estate. For example, in a divorce, the perceived equity in the property could be significantly reduced if the husband and wife forgot about the old mortgage. It is worth conducting a preliminary title search whenever property is involved to ensure that any possible debts associated with the property are uncovered.
If you or someone you know has received a letter or a pleading from an unfamiliar creditor asserting a claim against their real estate, don’t ignore it! I would be happy to talk with you about how this loan can be addressed and what possible defenses may exist against a foreclosure. At a minimum, the debt can be restructured and repaid over a five-year timespan in a Chapter 13 bankruptcy.
Zingarelli is an associate attorney with The Law Firm of Droder & Miller. He has been practicing law since 2005 in the areas of bankruptcy and general civil litigation. Zingarelli is licensed to practice in Ohio, Kentucky and Missouri. Reach him at nzingarelli@drodermiller.com.
1 For more information on 80/20 loans, see https://www.businessinsider.com/personal-finance/80-20-loan.
2 In Chapter 13, general unsecured debts (like credit cards and medical bills) are paid back at a percentage of what is owed (sometimes as little as a penny on the dollar) with the unpaid balance discharged upon completion of the repayment plan.
3 There are exceptions to this rule. If the first mortgage holder does not file an answer to a second mortgage holder’s foreclosure complaint, the property can be sold at auction free and clear of the first mortgage holder’s lien. What happens when there are excess proceeds in this situation can be the subject of debate. See Villas at East Pointe Condo. Ass’n v. Strawser, 2019-Ohio-3554 (10th Dist. 2019).
4 https://www.zingarellilaw.com/blog/2022/07/08/protect-the-equity-in-your-home/
5 See In re Eubanks, 219 B.R. 468 (6th Cir. B.A.P. 1998).