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Be Careful When Giving Your Debtor a Break

Suppose you own a note secured by a mortgage or deed of trust (for convenience, I will refer to both as a "mortgage"). It would not be terribly unusual for the debtor to come to you for some relief if he is having trouble making the payments. He might want the interest rate lowered, the payments amortized over a longer period, or a balloon payment postponed. Being a reasonable person, you might be inclined to work out a deal--after all, it's better than foreclosing--but you would probably ask for something in return. For example, you might agree to stretch out the payments, but in return you might want to kick the interest rate a point or two.

Although this seems perfectly straightforward and reasonable, it can also result in the application of the rule that “no good deed goes unpunished.”

The Problem
The problem arises when the debtor has placed a junior lien on the property, because the modification of your note may cause your mortgage to lose priority--that is, to become junior to the junior mortgage. If this happens, your mortgage is still enforceable--it just becomes a second mortgage instead of a first mortgage.

Three rules govern this situation:

Rule No. 1 is that if the modification does not make the loan more onerous to the borrower in any way, your mortgage retains its priority. Thus, if you grant concessions but take nothing in return, your priority remains intact. An example might be stretching out the payment schedule but leaving all the other terms the same. However, if you trade a concession for a benefit--for example, if you lower the monthly payments in return for an increase in the interest rate--you may lose priority, in whole or in part, even if the restructured loan, taken as a whole, is more favorable to the borrower. In most cases, priority is lost only to the extent the loan becomes more onerous, such as the amount of additional interest that becomes payable. However, in some cases, where the overall change endangers the junior lender's security, the priority of the entire mortgage may be affected.

Rule No. 2 is really an exception to Rule No. 1. If the mortgage specifically allows modifications to the note, priority is not lost, even if the restructured note is more onerous (see the sample language below). This exception is not available in every state; therefore, legal counsel should be consulted before relying on this exception.

Warning to Junior Lienholders: If you are about to accept a junior mortgage, review the first mortgage carefully. If it contains a provision allowing the note to be modified, you are on notice that the senior obligation may be increased or made more onerous in some manner, which could endanger your security.

Rule No. 3 is simply that if the junior lienholder consents to the modification and agrees that it will not affect his priority, then it will not.

It will not hurt your legal position to give your debtor a break as long as you receive nothing in return. If you do desire to receive something in return, it is best to order a title report to see if a junior encumbrance has been placed on the property. If so, the best advice is to seek legal counsel to make sure the transaction is handled in a way that will not adversely affect the priority of your mortgage.

If you are accepting a junior mortgage, read the senior mortgage carefully to determine whether there is any provision that could allow the obligations secured by the senior mortgage to be enlarged. If so, you will need to take steps to eliminate the possibility that your security could be denigrated by a modification to the senior mortgage.

A good state-by-state review of this topic is contained in Restatement of Property Third, Mortgages, Section 7.1 et seq.

Sample language
Here is the wording for a provision allowing modification to a mortgage without losing priority: "This mortgage shall also secure all extensions, amendments, modifications, or alterations of the secured obligation including amendments, modifications or alterations that increase the amount of the secured obligation or the interest rate on the secured obligation." If you are accepting a first mortgage, try to include this language in your mortgage so that you will have the flexibility to restructure the debt if necessary without losing priority.

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