So, you’ve taken out a second mortgage. Maybe you needed the second mortgage for extra funds for home improvement to increase your home’s value and your equity in the property, or maybe you had unforeseen medical or education expenses. Now you’ve hit a financial rough patch and your first mortgage is being foreclosed upon. Are you still liable for your second mortgage?
In most cases, unfortunately, the answer is yes. A second mortgage is subordinate to the first. In the event that you default on your first mortgage loan, the proceeds from the bank selling your home will first be used to pay off your first mortgage, and any remainder of the selling price will then go to your second mortgage holder. If the amount you owe for your second mortgage exceeds what the sale is able to produce, your second mortgage is in deficiency. At that point, your second mortgage lender will take steps to reclaim their loss.
They might take you to court, obtaining an injunction to garnish your wages, or bid for the property themselves in public auction. A relatively good outcome for you at this point is that your second mortgage lender considers the debt a “charge-off,” meaning that they have given up trying to collect it. This will show up on your credit score, negatively impacting it until you are able to settle the debt. It will also be considered income for tax purposes, so that you will be taxed on income you don’t actually have.
There may be a small silver lining, in the form of mortgage debt forgiveness. The Mortgage Debt Forgiveness Relief Act of 2007 allows qualifying taxpayers to avoid taxes when a lender agrees to write off debt. If you lose your home through foreclosure, you are eligible, as long as it was your main home and you used the mortgage to buy, build or improve it. However, home equity loans where the money was not used to buy, build or improve a residence do not count, so keep this in mind if you used your second mortgage to meet a separate financial need.
If you don’t end up qualifying, you could always file for bankruptcy. Debts forgiven in a bankruptcy case are not taxable. An even more common, nontaxable situation is insolvency, in which your debts outweigh your assets. In this era of large, easy-to-obtain home loans, more and more homeowners are finding themselves in this category.