Why do some 1st mortgages prohibit a 2nd mortgage?

5 Replies

I've noticed this in several 1st position notes but never fully understood why.  I have some ideas but am curious what others think.

Because having a second in place makes it more difficult for the first lienholder if the borrower defaults. If a borrower takes out a hard money loan and defaults the usual process would be for the borrower to do a deed in lieu and hand the property to the lender. If there's a second in place, though, the second would still be in place after the deed in lieu. So the second becomes the HML's problem. In order to wipe that out the HML would need to foreclose rather than the simple deed in lieu.

I did have a discussion with @Bill Gulley a while back and he was skeptical about the enforceability of such clauses.

Jon Holdman, Flying Phoenix LLC

I'm not sure I agree that a 1st lien holder would "usually" want a DIL. Personally, in a million years, I couldn't imagine a situation where we would want the property. To be only a bit more facetious, we encourage our borrowers to obtain 2nd's, 3rd's, 4th's, 5th's, and 6th's.

Every lender who is subordinate to our lien will be supremely motivated to encourage our borrower to pay his bills. If he or she doesn't pay us, we then have several others in line who might want to pay, or risk getting wiped out in foreclosure.

I had a conversation with my lawyer about this and he said that we really couldn't explicitly prevent a borrower from obtaining additional loans. He said that what we could do is add a clause that calls the note in the event the borrower obtains a second. Sort of like a "Due On Additional Loan" clause.

Realistically, many/most of our borrowers obtain their rehab money using a 2nd and we have no problem with that. To prevent it would severely limit any reason they would want to borrow from us.

Good input Jeff S Na 

My thoughts were:

1) Borrower has less skin in the game to the extent of the junior liens, thus less motivated to solve problems and get things done, (s)he may actually have all his/her cash back.  Junior lien holders are usually less sophisticated (friends and family) so it's tough for them to keep borrower on the straight and narrow.

2) In a short sale situation the junior lien may pressure senior lien to discount, not that the senior has to but this could be an unpleasant situation.

3) Junior liens do prevent a DIL, but I'm not sure as a lender I would accept a DIL under any circumstances, since things like a mechanic's lien can sneak in there.

I'm starting to thing there is not a clear cut argument either way.

I have taken a property back deed in lieu from a defaulted borrower.  Not a great situation, but better than spending time and consuming money foreclosing.

This is covered in the promissory note now by prohibiting placing any encumbrances on the property.  Doing so causes the loan to be in default.

Also when I did the deed in lieu we did buy title insurance on the transfer and included an additional provision at extra cost to cover any unrecorded liens.  We were specifically concerned about unpaid contractors.  We did a hold open on that policy and updated it when we eventually sold this property to a retail buyer.

Jon Holdman, Flying Phoenix LLC

Thanks for your response guys.