Now, let’s look ahead to mid-2020. Suppose you fell into some rough times and you were three months behind on payments for both loans. The first mortgage lender started the foreclosure process and after a few months was able to sell the property for $150,000. The first mortgage lender uses that $150,000 to pay off your original loan. You’ll recall it was for $200,000, but over the years you’ve made steady payments and now it has a balance of only $130,000. The proceeds that are left after the first mortgage is paid off amount to $20,000. So your first lender is happy, but your second loan is still unpaid. The $20,000 that remains from the sale goes to the second loan. It might or might not cover the full balance on the second lien, but the home equity lender would have little in the way of recourse because it held the second mortgage and was in line behind the first mortgage for payment.
Alternate name: First lien
How Does a First Mortgage Work?
There are two common reasons you might have a first mortgage and a second mortgage loan on a single property. Multiple mortgages can occur either upfront, when you first purchase the home, or down the line after you’ve been living there for some time, as in the example of the home equity loan. Some buyers use two mortgage loans to purchase their property. The first mortgage is used to cover the bulk of the purchase price of the home, minus a down payment. The second loan helps to cover the down payment and the closing costs that come with the transaction. This strategy is often called “piggybacking.” The second mortgage would be the piggyback loan, also referred to as a combo loan. Home equity second mortgages allow you to tap into the equity in your home to pay for renovations, medical bills, debts, or any other expenses you might have.
First Mortgages vs. Second Mortgages
The biggest difference between a first and second mortgage is first claim to the property in the event of default. The first lender can foreclose on the property and use the returns to pay off your loan if you don’t make your payments. The second lender can only claim any portion of the returns after the first loan is paid off. Second mortgages often have higher interest rates than first liens for this reason. They present more of a risk to the lender because the first lender has the right to claim the property if you don’t make your payments. It’s possible the second lender won’t receive anything from the sale at all. The second lender has to protect itself, and the higher interest rate is part of that. Another big difference between first and second mortgages is how each is treated in the tax code, in particular the federal mortgage-interest tax deduction. You can deduct the interest you pay on your first loan up to certain limits, but the IRS does not allow you to deduct interest on home equity and second mortgages unless you use the money to “buy, build, or substantially improve” the home.
