A first mortgage is a first lien on the property. If the owner cannot pay, the investor can cause foreclosure proceedings, which will result in the sale of the property, which sale would pay him off.
In order for the investor to be paid off, the property must bring enough to pay him off. If, for example, a home that sold for $20,000 has on it an $18,000 first mortgage in which you have invested, it is entirely possible that in a foreclosure sale it would bring less than $18,000. A foreclosure sale is entirely unlike the real estate agent's normal sale, which is often attended by glowing advertising and excellent salesmanship. A forced sale of property is to a real estate agent's normal sale what a Police Department sale of confiscated cars is to a used car dealer's operation. Little elaboration on this point is required.
If the property brings only $17,000 after foreclosure expenses, which are deducted before the mortgage holder is paid off, he has obviously lost $1,000 since his mortgage is for $18,000 in the case we have hypothetically set up.
Now if the first mortgage is for $18,000 and there should be a second mortgage for $2,000 on the house that sold for $20,000 and the results of the foreclosure sale were as set forth above, the first mortgage holder would lose $1,000, but the second mortgage holder would be entirely wiped out.
This is the exact safety factor of many second mortgages being sold today. A real estate firm prices a house over the market and effects a sale by pointing out to the purchaser that he can buy this $20,000 house for only $1,000 down. The real estate firm explains that it will take the second mortgage for $2,000 at only 6 percent interest and the bank or building and loan association will take the first mortgage for $17,000.
The real estate firm in this hypothetical case would have realized its usual profit on the house if it had sold it for only $19,000 instead of $20,000, but the purchaser has been induced to pay $20,000 since if he pays $1,000 more the real estate firm tells him all he needs to pay down is $1,000.
The deal goes through. The real estate firm receives the $17,000 first mortgage money plus the down payment of $1,000 plus the second mortgage for $2,000 $20,000.
If the real estate firm had received $19,000 it would have realized the normal profit, and since it wants to buy up more houses for resale, as purchase and sale is its business, it wants to get its cash out of the second mortgage. It consequently sells the $2,000 second mortgage for $1,000 cash to the investorat a 50 percent discountand goes on to something else.
If the property purchaser continues to pay, all is well. But if he should lose his job or have unusual financial strains placed on him or if he should be offered a comparable home at $19,000, the real value, particularly in time of national business recession, he may very well default with the result that the second mortgage is impaired and possibly wiped out.
This hypothetical example of a second mortgage leads us to one of the major criteria for judging the soundness of a second mortgageequityand equity is what the buyer has in the house. To look at equity in another way, it is the excess of what the house is worth above any and all mortgagesfirst and second.