Can a Mortgage Lender Profit From Foreclosure?

December 7, 1998, Revised January 30, 2004

"I have lost my home! The second mortgage lender foreclosed after buying the first mortgage, which was current under a forbearance agreement. The first mortgage lender informed me that the buyer was obligated to honor the forbearance agreement, but this didn't stop the foreclosure. I lost the house I had lived in for 22 years, and which was worth more than the two mortgages combined…Can this be legal?"

Yes it is legal. It is unfortunate you didn't get informed advice 6 months ago, when there was still time to save your house. With second mortgages becoming increasingly common, I'm afraid that this problem is going to emerge with increasing frequency in the years ahead.

Here is the sorry sequence of events.

* Homeowner with 2 mortgages suffers a financial setback and can't make the required two payments.

* Homeowner pleads case to first mortgage lender, who agrees to a reduced payment schedule for a specified period. This is the "forbearance agreement."

* Homeowner stops paying on the second mortgage, on the erroneous assumption that so long as the first mortgage remains in force, there isn't anything the second mortgage lender can do about it.

* Second mortgage lender crosses up homeowner by purchasing the first mortgage, acquiring the right to foreclose in the event the borrower fails to pay as stipulated in the forbearance agreement.

* With the property value high enough to cover both mortgages, the lender holding both mortgages now has a powerful incentive to foreclose because that is the only way to get repaid on the second mortgage.

* Homeowner is a day late on the payment and the blade falls.

While any difference between the sale price at a foreclosure auction and the balance of the mortgages would go to the owner, in many cases the lender is the only bidder in the auction and they bid only the amount of the mortgages. But once the lender acquires title, he can sell for whatever he can get.

What were the alternatives? Had the homeowner sold the house and repaid the mortgages, she would have retained both the residual equity in her property and her credit rating. That would have been the smart thing to do.

Pressing the first mortgage lender into a forbearance arrangement, while stiffing the second mortgage lender, was the riskiest course of action. It made the first mortgage much less valuable to the originating lender than it was to the second mortgage lender, precipitating the sale. The result was that she lost it all: house, residual equity and credit rating.

The result probably would not have been much different if she had kept current on the first mortgage but stopped paying the second. In this scenario, there would have been less reason for the first mortgage holder to sell. However, the second mortgage holder could have initiated foreclosure proceedings, and probably would have because there was enough equity to cover his claim. What would have happened after that is hard to say, but the chances are that one of the lenders would have bought out the other and taken the house in a foreclosure.