Many of us have borrowed money and used real estate as “collateral” for that loan of money. These arrangements essentially provide that if the borrower does not pay back the money owed to the lender, the lender can sue the borrower and eventually force a sale of the real estate that would provide money to pay off the lender. In these situations, the “collateral” is the real estate promised by the borrower to be sold if the borrower does not repay the loan completely and on time.
This process of having a loan in default that will be paid by sold collateral (property promised to be sold if there is a loan default) is pretty commonplace in our economy. And the loan with collateral process is not particularly complex as long as a borrower only uses certain collateral for one loan.
The law on payment of multiple loans secured by the same collateral is not instinctual. One lender may loan $25 to a borrower and be “secured” by a mortgage/lien against the borrower’s real estate. A second lender may come along, thinking that the real estate is worth $37, and loan an additional $12 to the borrower, with that $12 loan being secured by a “second mortgage/lien” against the borrower’s real estate. The total indebtedness of the two loans secured by the real estate then totals $37.
The borrower may default on one or both of the loans causing the real estate to be sold to pay the loans. At the time of the sale, let’s presume that the total amount owed to the two lenders together remains $37.
However, the value of the real estate may have decreased since when the second lender loaned the $12. Thus, if the sale of the real estate only nets $30 of proceeds, the law is specific on who gets paid first. In such a circumstance, the first lender would be paid the full $25 owed to that lender. The second lender would receive the balance of the proceeds, $5, and be forced to take a loss of $7.
Many people presume that the insufficient sale proceeds in the context of multiple lenders would somehow be distributed pro-ratably with each lender taking a proportional, financial hit. However, the law applies a strict “first in time, first in right” principle when it comes to multiple mortgages/liens against property. This principle allows lenders who are “first in priority” to be confident in their repayment resources regardless of whether the borrower uses the same real estate as collateral for another loan.
Nevertheless, many lenders prohibit “second” or “junior” mortgages to be given to other lenders. This is because the more loans that are tied to a property, the more likely that the borrower will default, which would cause the first lender to receive proceeds (even if the first lender is being paid in full) and not get the interest earnings (benefits) that the first loan was designed to originally provide to the first lender.
Lee R. Schroeder is an Ohio licensed attorney at Schroeder Law LLC in Putnam County. He limits his practice to business, real estate, estate planning and agriculture issues in northwest Ohio. He can be reached at [email protected] or at 419-659-2058. This article is not intended to serve as legal advice, and specific advice should be sought from the licensed attorney of your choice based upon the specific facts and circumstances that you face.
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