Assuming risk when foreclosing on a note

[Ann Howell]

Hi all - I am new to Bigger Pockets, and I am exploring several investment options.  One option is to buy first position, performing notes.  I want the monthly cash flow more than I want to get the property.

However, I am unclear on what happens if I have to foreclose.  I understand that it would involve a legal foreclosure, and I would end up with the property.  But would I also inherit other liens against the property?  If the owner took out a second position note, would I be responsible to pay for that? Would I be responsible for unpaid taxes and/ or tax liens that came after I got the original note?  

[Dion DePaoli]

A performing loan always carry a risk of default.  An investor can offset that default risk with equity. Either through the loan it self, like limiting the loan to value to a level which will accommodate recovery of the advances required to enforce the security instrument, or through limiting the capital invested in the loan through discounting.  Fundamentally they are the same but have different mechanics.  

Borrower gives an interest in the property as collateral.  The interest given is limited and defined through the security instrument.  That interest does not include possession.  As Bob mentioned you are not entitled to own the property.  You are entitled to use the property to recover what is owed under the note.  As such, a Mortgagee does not "inherit" anything.  A Mortgagee defends their interest in the property from liens which 'may' have priority.  An example would be property taxes.  A property tax lien has super status meaning it always has the highest priority regardless of time of recording.  The security instrument will define what types of defenses a Mortgagee can take and to what extent the Borrower will owe or Mortgagee be entitle to recover.  Preserving the property condition (with restrictions/limitations) is another example of that idea.  

The key to those ideas is they are not necessarily things that require immediate and direct action.  For instance, property taxes may go delinquent in a default event.  That does not mean that the Mortgagee must advance payment for those taxes immediately.   A Mortgagee would advance that tax payment 'IF' the tax lien stands to encumber their lien priority.  If taxes are simply delinquent the property can still be foreclosed and provided the delinquent taxes do not give way to a tax lien foreclosure then the taxes will be recovered through any foreclosure auction sale.  If the property reverts back to the Mortgage due to a lack of a proper buyer at auction then the taxes may need to be paid post [failed] sale.  In other words the tax payment can be advanced, especially when it stands to jeopardize the priority of the Mortgagee.  It does not always have to be advanced because the taxes due are not an immediate danger to lien priority in every instance.  Rest assured, property taxes always get paid somehow or the other.

Similar ideas go with almost all the other allowable (customary) advances under the security instrument.  For instance, property insurance may elapse due to Borrower lack of payment.  As a Mortgagee you have a right to insure the property if the Borrower fails to do so.  That does not mean you are mandated to make an advance for property insurance.  Obviously if some damage happens to the property while it is not insured then there would be no insurance money to file a claim to repair the property.  So if it burns down it will likely be pretty tough to recover the amounts due under the note since the property value will have diminished due to the fire.  

It is probably worth a mention that a performing loan will go through a delinquent stage before being in default.  Delinquent loans along with defaulted loans do have some mandated actions as a foreclosure alternative.  State requirements vary a bit.  Mixed in there are ideas such as Deed in Lieu or Short Sale/Short Pay as methods to resolve the default or delinquency and avoid foreclosure.  The point is to make sure we understand that a missed payment does not immediately mean foreclosure and the path to foreclosure may involve additional steps to see if it can be avoided.

Understand that foreclosure is actually the termination of junior interest's (to those of the Mortgagee foreclosing) right or equity of redemption.  So through the process a junior interest can redeem a senior interest, by paying the total due or they forfeit their right and their interest is removed from the Subject Property.  Those interests can be lien holders or title holders.  A lien can not foreclose interests senior in priority.  A foreclosure extinguishes 'all' junior priority interests regardless of payment distribution from an auction sale. Proceeds distributed to lien holders also means collect-ability of that debt can no longer take place and the lien is extinguished and the debt owed is satisfied.  So "Yes" Arthur, the second's lien is extinguished and the debt (since they received proceeds) is satisfied.  Two different ideas there.  Sometimes a lien can be extinguished but the debt can survive.  In that event the property can no longer be used to recover what is owed.  (Lien extinguished & Debt 'not' satisfied)   Other collections methods would have to be deployed to collect then.  A tale for a different thread.