June 13, 2013 by Dymphna

How to REALLY Use a Second Mortgage

Last time I talked about caveats and their uses, but today, I want to shift our focus just a bit and look at some of the details and uses of second mortgages. The reason is, in some cases, a second mortgage can be more useful than you might realize. So let’s get to it!

Second mortgages are actually similar to caveats in that they are both registered on the title of the property. Under our Torrens title system that we have here in Australia, property titles list owners of a property as well as debts against that property, such as mortgages and caveats. Now, as students of iLoveRealEstate.com, you know that a mortgage is a form of security, usually against a loan, right? Right!

How second mortgages work

A key point here is to understand how mortgages work. They rank in priority in order of their registration. This means that whoever holds the earliest registered mortgage has first priority against the property to get the money they loaned against the property, repaid to them. Banks will usually issue first mortgages, which gives them the right to sell the property to recoup the money they loaned against it.

Second mortgages are common enough and can be quite practical or necessary in several different circumstances. For instance, when you as a property owner have a financial need that must be met, you may often need to access equity in a property that already has a first mortgage against it. Second mortgages are often issued by lenders of last resort or other higher-risk tolerance lenders like private investors, trusts and the like. They are protected to some degree, but that protection is limited to whatever value is left in the property—if any–after the holder of the first mortgage is paid from the sale of the property.

Second mortgages as asset protection

Second mortgages aren’t just useful if you may be going through financial difficulties. You can also use them as a form of asset protection. In some cases, a second mortgage can be used to “absorb” equity in your property to protect it from third party creditors or legal claims against you.

Say, for instance, you’ve got a block of apartments that you’ve owned for a while and they have greatly increased in value. The first mortgage may be quite small compared to the total value. Taking out a larger, second mortgage that removes your equity from the property protects the property and you because it leaves little left for legal claims or creditors.

There are, of course, steps you need to take to make this strategy as strong as possible. One of them is to use a “friendly” second mortgage. This is where you make sure the lender of your second mortgage is a trusted ally or family member. It is usually a family or business trust, a corporation, or some such other legal entity that you control or can trust to act in your interest.

Other factors to consider

But there are other factors involved in second mortgages as well. Some banks, i.e. first mortgage holders, will not allow you to take out a second mortgage. It depends upon the bank, your relationship with the bank, and the circumstances for the second mortgage. There are some good reasons for this.

They may view it as a risk, as a mark against your financial stability, or simply as an unwelcome risk that might “contaminate the tile”. This is may come into play if the second mortgage is to be held by a less-than financially secure or established lender or if the value of the property is in question.

And of course, there are also the costs to consider. The costs of obtaining a second mortgage can be rather expensive. It may depend on complexity of the mortgage itself. Preparation costs can vary, but figure around $500. Registration costs will be a few hundred dollars, as well.

There can also be other costs, too; especially when you’re asking your bank to approve the second mortgage. For example, they may require you to register a deed of priority, which banks can require you to do just to further protect their first position. You may even need to have it just to apply for their approval to get a second mortgage.

The bigger banks will also often require you to use their lawyers for the deed of priority, which can cost additional thousands of dollars—and they may even turn down your request after paying for the deed of priority! Talk about always having a hand out… In most cases, though, if you’re taking a second mortgage out for asset protection and it’s friendly debt to a family trust, the bank should not have a problem with it.

Irrevocable mortgages

An irrevocable mortgage doesn’t really have a specific legal meaning. However, the “irrevocable” part of the mortgage means that it can’t be revoked or ended.  The mortgage part of it protects the interests of the lender. An irrevocable mortgage isn’t necessarily registered on title, but in this context, it is signed but does not have to be registered on title. But it is an enforceable mortgage to collect on a debt that the borrower cannot get out of paying.

Like a registerable caveat, an irrevocable mortgage is contractually binding, but takes priority over other claims or mortgages only if it has been registered. You would usually use this kind of mortgage on a friendly deal. You would not like to miss the boat on a deal gone south by not registering the irrevocable mortgage until after the borrower has already borrowed additional money from somebody else that has registered their mortgage. It’s most convenient to use it in friendly deals without a first mortgage in place.

Is an irrevocable mortgage worth its salt?

An irrevocable mortgage can be helpful for asset protection purposes, particularly where you want to transfer money around to secure a debt or gift equity to a family member and secure it with the mortgage. But you have to be careful here as well. If you’re using an irrevocable mortgage for the sole purpose of avoiding creditors or claims against you, without a legitimate debt in lace, then there may well be a “claw-back period” enforced by the court. This could nullify the effect and protection of the mortgage.

Like many legal structures, there are very legitimate and powerful uses for second mortgages. There are also times not to use them. The absolute best way to go about it is to take a look down the track, get professional advice and have the right pieces in place so they’re there when you need them.