How do foreclosures work for homes with a first and second mortgage?

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Question:

I have two loans on my house, a primary mortgage and a secondary mortgage, each from a different bank. We did an 80/20 combo and financed the entire purchase price when we bought the home almost four years ago. Our home's value has gone below the amount we owe on our mortgages. We are defaulting on the first mortgage but not the second. How does the foreclosure process work in a situation like this? We are in Georgia.

Answer:

Whether you live in Georgia or any other state, if you have more than one loan on your home and you default on any one of those loans, the lender holding the defaulting loan has the right to foreclose according to the process set out in your state's laws. (To find out what the foreclosure process is like in your state, find your state in our State Foreclosure Laws section.) But just because the lender has the right to foreclose doesn't necessarily mean the lender will foreclose. It all depends on whether the lender believes that it will recover any money through the foreclosure. And that depends on the current value of your home and your outstanding mortgage balances.

Let's say your home was worth $500,000 when you purchased it. You mention that you took out a primary loan for 80% of the house's value, which is $400,000. Your second loan, for 20% of the house's value, is $100,000. For the sake of simplicity, let's assume that in the four years you've owned your home you've been making interest-only payments on your mortgage, so you still owe $400,000 on your first mortgage and $100,000 on your second mortgage. Now let's also assume that the value of your home has dropped to $400,000. If you stop paying your first mortgage and continue paying your second, as you have been doing, your first lender will likely go forward with foreclosure because it stands to recover the outstanding debt--$400,000--in full when the house is sold at a foreclosure auction for its current value--$400,000. Even if your home drops in value to $300,000, $200,000, or even $100,000, your first lender still has an incentive to foreclose because it will recover something in the foreclosure sale.

What about your second lender? The second lender won't receive any money from a foreclosure sale until the first lender is repaid in full. That means your second lender has no incentive to foreclose unless the value of your home is greater than the amount of your first mortgage--$400,000. If the value of your home has dropped below the outstanding balance on your first mortgage, even if you default on your second mortgage, your second lender will probably not foreclose.

Because you've stopped paying your first mortgage, it's likely that your first lender has or will start the foreclosure process. You don't mention why you chose to pay your second mortgage over the first, but as a general rule, if the goal is to keep your home, you should always pay the first mortgage over the junior second or third mortgage.

For more on this subject, read Nolo's article Reduce Your Mortgage Obligations to Avoid Foreclosure.

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