April 16, 2007, Revised May 23, 2007
The term “silent second” is used most frequently to describe
self-serving or perhaps fraudulent schemes where house sellers accept
second mortgages as part of a sale transaction, without the full
knowledge of the first mortgage lender. The “silence” refers to the
absence of full disclosure to the first mortgage lender.
Silent Second Instead of Down Payment
The smaller of the frauds arises when the second mortgage replaces part
or all of a down payment. For example, the buyer and seller agree on a
price of $200,000, the buyer has a commitment for a first mortgage loan
of $180,000, but doesn’t have the $20,000 required for the down payment.
To make the deal work, the seller agrees to accept a silent second
mortgage for $15,000. As far as the first mortgage lender knows, the
down payment is $20,000, but in fact, it is only $5,000.
The silent second increases risk to the first mortgage lender because it
takes only a 2.5% decline in home value to eliminate the borrower’s
equity – rather than the 10% decline that the lender counted on. When
equity is depleted, some borrowers stop paying on their mortgages.
This silent second is also risky to the seller, because it can’t be
recorded at the time of the sale – that would give the game away. This
means that the seller has an unsecured loan until the transaction is
completed and the lien can be recorded. How long the seller must wait
before recording the lien is negotiated between the parties. The longer
the seller waits, the greater the risk that other liens will be placed
on the property, which will endanger the silent second.
A silent second that replaces the down payment should not be confused
with a "piggyback", which is also a second mortgage that replaces a down
payment. The difference is that the piggyback is usually offered by the
lender making the first mortgage, so no deception is involved.
Silent Second Inflating the Sale Price
An even more serious deception of the first mortgage lender arises when
the silent second is used to inflate the sale price beyond the true
value of the house in order to increase the size of the first mortgage.
Assume the same house as before with buyer and seller agreeing on a true
price of $200,000, but in this case the buyer has no down payment. They
collude to set a fictitious price of $222,200, on the basis of which the
first mortgage lender agrees to lend $200,000. This is 90% of $222,200
but 100% of the true value of $200,000. The seller agrees to a second
mortgage for $22,200.
In this case, the first mortgage lender knows about the second mortgage.
What the lender doesn’t know – where the silence comes in -- is that
after the transaction is completed, the seller will forgive the second
mortgage. In this way, the lender is deceived into making a 100% loan,
believing that it is a 90% loan.
This scheme won’t work unless the higher price is ratified by an
appraisal. Lenders base loan amounts on the lower of price and appraised
value, so if the appraisal comes in at $200,000, which is the true
price, the deal can’t be done. Unfortunately, many appraisers have great
difficulty in setting a value below the price agreed to by a buyer and a
seller.
Silent Seconds as a Form of Subsidy
The term “silent second” is also used to describe a benign type of
transaction in which a government or non-profit agency assists
low-income home buyers purchase more costly houses than they could
otherwise afford. The “silence” in this case refers to the absence of a
payment burden imposed by the second mortgage. Some municipalities in
California have such programs.
These second mortgages may carry a zero or low interest rate, or
interest may be deferred for some years. Usually, the principal is not
repayable until the house is sold. In some cases, the lender may recover
part or all of the subsidy on the second mortgage by receiving a share
in the house appreciation at sale. See
Is This Shared Appreciation Mortgage a Good Deal?
It is a bit incongruous that the term “silent second” is used both to
describe deceptions perpetrated on lenders by home buyers and sellers,
and subsidy programs to assist lower-income buyers. But English is a
very flexible language.