In communities having no building and loan associations and in those where the associations and other agencies are unwilling to supply on first mortgage from 60 to 75 per cent of the amount needed to acquire the home, borrowers in the second group generally find it necessary to use two loans, the first obtained from any one of the agencies previously mentioned and the second from an individual or organization advancing funds on second-mortgage security.
There are numerous private investors engaged in this kind of lending, and a large part of the business is handled by organizations called "second," or "junior," mortgage companies. In Maryland and Pennsylvania many of the building and loan associations make second-mortgage loans.
As the legal rights of the second-mortgage lender are subordinate to those of the lender on first-mortgage security, and as his risks are usually greater, he charges more than the first-mortgage rate. The whole charge is rarely made directly, however, for the reason that the maximum rates permitted by the usury laws of most of the states are not high enough to yield a return satisfactory to the second-mortgage agency. In order to avoid violating the usury laws and yet obtain a rate which they consider adequate to compensate them for the risk they assume, second-mortgage lenders conduct a discount business, purchasing second-mortgage notes at less than their face value. As an example of the operation of this method of advancing funds, we may take the case where a note is purchased from an operative or speculative builder who has accepted it from a home buyer as part of the selling price of a property. Though the builder usually adds to his price the amount of the anticipated discount and the buyer, in effect, pays a usurious rate on the obligation transferred, the second-mortgage agency does not violate the usury law.
However, much of the demand for second-mortgage funds comes from operative builders who need the money for construction purposes and from persons building their own homes. In order to obtain the business of these two types of borrowers and yet make the transactions appear to be note purchases, a considerable number "of second-mortgage lenders grant loans through a third party whom they procure to act as the lender. The borrower's note is executed in favor of this party, who indorses it to the second-mortgage agency. The latter "discounts" the note, to obtain an interest rate greater than the legal maximum, and turns the proceeds over to the borrower. This is a mere subterfuge and the transaction is tainted with usury. In those states which impose a light penalty on the usurious lender, such as the loss of interest or part of it, this practice is freely indulged in, however, and borrowers seldom attempt to take advantage of its illegal feature.
As a rule, second-mortgage loans are made on the amortization basis. Charges vary according to the locality, the demand for funds, the risk, and the length of the loan period. Interest rates are usually 1 or 2 per cent above the prevailing first-mortgage rates, where the state law permits, and discounts are quoted at from 4 to 10 per cent a year. Since the borrower is usually required to curtail the loan periodically, and therefore does not have the use of the whole amount for the entire loan period, these discount rates are actually considerably higher. In fact, under the usual regularly amortized loan the real discount rate is approximately double the advertised rate. But, expressed entirely as an interest charge, the rate paid by the borrower is even higher than the total of the combined nominal interest rate and the actual discount rate, because "discount" differs from "interest" in that it is paid at the beginning of the loan term and not during the term or at the end of it. Thus, on a typical monthly payment three-year second-mortgage loan bearing 7 per cent nominal interest and a 15 per cent discount (5 per cent annually, so called) the rate paid by the borrower is approximately 18 per cent a year.
In many communities the high rates charged for second-mortgage funds have had a tendency to discourage home building. In some of these communities this situation has been partly overcome by chambers of commerce and other local groups.
In Gardner, Mass., a group of about 100 business men, cooperating with the local chamber of commerce, agreed to become liable to the extent of $1,000 each on second-mortgage-note indorsements of a committee which they formed. No actual cash was required of the members of this group, but by thus lending their credit they were able to obtain second-mortgage funds for home-owners from a local bank at a low rate of interest and without a discount charge. Similar plans were used in several other cities.
A second-mortgage company was formed in Providence, R. I., to provide funds for periods of 50 months at a total discount of 5 per cent, covering the whole term. This company helped to relieve the second-mortgage situation in two ways. It loaned several hundred thousand dollars at relatively low rates, and through its operations caused other local second-mortgage agencies to reduce their charges.
In some sections lumber dealers assist in solving the problem, and at the same time increase their sales, by indorsing the second-mortgage notes of home builders who purchase material from them.
The home buyer able to make but a 10 or 15 per cent cash payment can sometimes obtain a second-mortgage loan large enough to bridge the gap between his initial payment and first-mortgage loan and the selling price. Where the transaction is handled by means of mortgages, however, the buyer is frequently compelled to use three loans. The seller of the property as a rule holds the third mortgage and receives no principal payments on it until the buyer has paid off the second. In order to facilitate sales, many builders accept third-mortgage notes as a part of the purchase price, but where they sell these notes they usually add an allowance for the discount to the price of the property. In these instances the financing charges borne by the home-owner are extremely heavy, as discounts on third-mortgage notes are considerably larger than those on second-mortgage paper. Buying a home from an individual or organization unwilling or unable to hold the note and to allow the purchaser the full face value thereof is therefore not to be recommended.