“When does it make sense for a home seller to take back a second mortgage?”

Most sellers who take back second mortgages from buyers view them as investments that can yield an attractive rate of return. However, I don’t view them as very good investments unless a seller can obtain a higher price on the sale. While the promised rate may be high, second mortgages are riskier than first mortgages, and few sellers are qualified to assess the risk.

Borrowers who get into payment trouble sometimes stop paying on the second while continuing to pay on the first mortgage, gambling that the second mortgage lender won’t do anything about it. Forcing a borrower into foreclosure is costly, and because the second mortgage lender gets paid only after the first mortgage lender has been paid in full, there may be nothing left.

A second problem is that mortgages must be serviced, which few sellers are equipped to do effectively. A moderately intelligent seller can learn to keep track of payments and balances using a spreadsheet because this requires following only a few simple rules. The fun begins when the borrower becomes delinquent, and the seller realizes he hasn’t a clue as to how to adjust the books. 

In addition, unlike institutional investors, the seller-investor is not diversified. Even if he does a great job of risk assessment, reducing the probability of default to 1 in 100, he might be unlucky enough that the one borrower who defaults turns out to be his.

A higher price on the sale might overcome these negatives. A critical number is the ratio of the increase in price relative to the risk of loss, which is measured by the size of the second mortgage. For example, if a seller can raise the price to $410,000 from $400,000 by providing a 15-year, 7 percent second mortgage for $20,000, the ratio is 50 percent, which is a great investment if the buyer repays the mortgage as scheduled. If not, the seller stands to lose up to $10,000.

The seller-investor has access to three critical pieces of information that can be used to determine whether the risk is worth taking: the ratio of price increase to loss exposure, as explained above; the buyer’s credit score (FICO); and the buyer’s down payment. Here are some rules of thumb I would use if I made second mortgages. I wouldn’t do it unless the price increment was 30 percent of the second mortgage or more. If that condition were met but the buyer puts nothing down, I would require a FICO score of 750 or more. If the buyer put 10 percent down, I would accept a score of 675.

Some sellers who purchased at or near the peak of prices in 2005-06 with little or no down payment now find that the sale proceeds don’t cover the balance on their mortgage. Desperate for a way to obtain a better price, they may be lured into accepting a second mortgage as part of the deal. This doesn’t help them with their problem, however, unless the price increment exceeds the second mortgage.

For example, if the best price obtainable is $380,000 without a second, and $400,000 with a second of $20,000, the seller nets cash of $380,000 in both cases. If his own mortgage plus selling costs is $390,000, he is $10,000 short in both cases. He needs a price of $410,000 with a first mortgage of $390,000.

It may be possible to up the price by more than the amount of the second mortgage if the first mortgage lender is unaware of the second. In the example, the first mortgage lender, assuming that the $20,000 difference is the buyer’s down payment, might view a $390,000 loan on a $410,000 property as safe. If the first mortgage lender knows that the $20,000 is a second mortgage rather than a down payment, however, he probably will decline the loan as being excessively risky because the buyer has a larger payment burden and no equity.

In short, the second is not an answer to the seller’s predicament without colluding with the buyer and probably the Realtor to deceive the first mortgage lender. Don’t write me to ask how to do this because I won’t reply.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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