Silent Second Mortgages – Are They Legal

Borrowers take out second mortgages against their homes to fund large expenses. Medical bills, college fees, and home improvement/remodeling are some of the common expenses that borrowers pay off by taking such mortgages. There are some borrowers and sellers who also enter into a ‘silent second mortgage’ agreement. This is most often unethical and in many cases outright illegal.

What are silent mortgages?

Second mortgages in Toronto that are created without the knowledge of the first mortgage lender are called ‘silent second mortgage’. They are mostly taken because the borrower cannot afford the down payment of the first mortgage.

For example, Borrower Bill takes a first mortgage from Lender L to finance a house worth $200,000. The down payment he needs to make is $20,000. Now, Bill can afford only $5000 and the seller of the house agrees to loan him the rest of his down payment (i.e., $15,000). This seller-buyer loan is a mortgage on the house property that is concealed from the first mortgage lender in Toronto. This is the silent second mortgage.

Why are such mortgages concealed?

· The capacity of the borrower to make the down payment often plays an important part in determining the total loan amount. The first mortgage lender’s calculation of the borrower’s repayment capacity also takes into account the amount of cash he can offer up upfront.

· When the borrower pays only a fraction of the actual down payment, his exposure in the home is dramatically reduced. For example, Bill has a total exposure of 2.5% in the home with his $5000 down payment. The first mortgage lender believes that he has a 10% exposure with a $20,000 down payment. The risk of default faced by the first mortgage holder is immensely higher with Bill’s lower down payment. This is especially dangerous in scenarios such as the housing crash crisis when home values hit rock bottom. Homebuyers with low exposure are likely to simply walk away from their loan leaving the home ‘underwater’.

Risks for the seller

The lender also faces a higher risk of default by the borrower. In addition, as this mortgage cannot be documented until the first is finalized, a silent mortgage is often an ‘informal’ agreement. In other words, there is no written legal agreement, meaning that this is an unsecured loan with no recourse in the case of a default.

The question of legality

Silent second mortgages in Toronto are most often illegal for the above reasons. The borrower deliberately misleads the first lender about his financial circumstances by hiding the loan. But there are some situations where these mortgages can be taken legally.

It may be taken in the form of a subsidized mortgage that is waived once certain conditions are fulfilled. One example is the Good Neighbor Next Door program sponsored by the HUD. There are also other circumstances where such a mortgage can be taken in line with the law.

A silent second mortgage may seem to be a wonderful lifeline to a home buyer who cannot afford a down payment. Both seller and buyer need to understand the legalities of such an agreement before entering into a deal.

You should avoid using silent second mortgages.

A quiet second mortgage occurs when a property buyer discreetly obtains a second loan from another lender or a private investor to fund their down payment. This is because the existence of this loan is concealed from the initial lender, which is against the law. For the primary lender, it will appear as though the borrower invested his own money while the funds are actually borrowed.

Another possibility is that the seller gives the buyer some or all of the money required for the down payment, with the understanding that it would be repaid over time. While this may appear to be an innocent transaction, it is nevertheless deemed fraud because the lender is ignorant that the purchaser is putting down virtually nothing.

A more egregious fraud occurs when the silent second mortgage is utilized to inflate the sale price over the actual home value in order to increase the first mortgage’s size. Assume the buyer and seller agree on a price of $400,000, but the buyer does not have any funds available for a down payment. The buyer and seller conspire to fix a fictitious price of $444,400 on the assumption that the first mortgage lender will lend $400,000 on the grounds that the first mortgage lender agrees to lend $400,000. This is 90% of $444,400, but 100% of the actual worth of $400,000. The seller agrees to a second mortgage in the amount of $44,400 but will forgive it after the deal is finalized. This is dishonest because the lender writes a 100% loan under the mistaken belief that it is a 90% loan. (This is an excerpt from The Mortgage Professor.)