February 7, 2007, Revised May 14, 2007, May 21, 2007

"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 a way to facilitate the sale and, hopefully, get a better price. In the process, they become investors in a risky asset which they often are not in a position to manage effectively.

The Second Mortgage Might Result in a Higher Sale Price

One useful way to think about the question of whether or not to provide a second is to estimate 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 10% second mortgage for $20,000, and the appraisal comes in at least at $410,000, the ratio is 50%.

This is a great investment if the buyer repays the mortgage as scheduled. If not, the seller stands to lose up to $10,000 (the $20,000 loss less the $10,000 increase in price). Sellers have to consider how much risk is involved, and whether they can manage it.

The Risk on a Single Deal by an Unsophisticated Seller

I don’t view a second mortgage as an appropriate investment for a seller who is doing it strictly to get a better price, and is not qualified to assess and manage the risk.

Second mortgages must be serviced, which few sellers are equipped to do effectively. Keeping records on the back of an envelope is a recipe for trouble. A moderately intelligent seller can learn to keep track of payments and balances using a spreadsheet because this only requires following 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, the one-shot investor is not diversified. Even if he does a great job of risk assessment, reducing the probability of default to one in a hundred, he might be unlucky enough that the one borrower who defaults turns out to be his.

Selling the Second Mortgage to an Investor

A way out for the unsophisticated and undiversified home seller is to sell the second mortgage to an investor who is in the business. The investor has a servicing system in place, and because he buys from many different home sellers, his risk is diversified. Furthermore, he knows how to manage the risk when a borrower gets into trouble.

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. If the second mortgage lender is a novice at the game, the gamble will probably pay off.

The professional, on the other hand, if in a state with non-judicial foreclosure rules such as California, will foreclose as quickly as the law allows. When the house is auctioned, the second mortgage lender places a bid equal to the loan balance, which will usually be successful. He now owns the house, subject to the first mortgage, and has a number of options for getting his money back. I am indebted to Steven Schwaber, a specialist in bankruptcy law in California, for educating me about this process.

Preparing to Sell the Second Mortgage

The seller who needs to offer a second mortgage to get the price he wants, but is not not equipped to be an investor in second mortgages, should prepare to sell the mortgage before writing it. The way to do that is to find the investor beforehand, obtain a contract form that the investor finds acceptable, and negotiate the terms of the deal, including the rate and the price.

For example, the investor might offer to purchase the $20,000 second mortgage referred to earlier at a discount of 10%, provided the seller uses the investor's contract, the mortgage has an interest rate of 12%, and the buyer retains 5% equity. This means that if the buyer can be induced to pay 12% rather than 10%, the cost of the second to the seller is only $2,000 as against the estimated $10,000 increment to the price.

Where do home sellers go to get reliable information about investors in second mortgages? I will add such information to this page as soon as I can get it.