Foreclosing Second Mortgages: Important Considerations in Exercising Cure and Redemption Rights

Holders of second mortgages face challenges that first mortgage holders do not, particularly because they must often exercise statutory cure or redemption rights to preserve their interest in the real property collateral. A second mortgage in Colorado is typically created when a deed of trust is granted on the property subsequent to an existing deed of trust or when an existing deed of trust is consensually subordinated to a new deed of trust. As the holder of a lien that is junior in priority to other interests, a second mortgage holder may be required to take steps to protect its collateral, particularly when senior debt is also in default.

When a second mortgage holder begins foreclosure proceedings, the first mortgage will almost always be in default. Even if the loan secured by the first mortgage has been kept current and there is no payment default, the borrower's default under the loan secured by the second mortgage and/or the commencement of foreclosure against the subject property will likely constitute a default under the first mortgage. The question is whether the first mortgage holder will commence foreclosure.

What happens if the first mortgage holder does start foreclosure proceedings prior to the foreclosure sale for the second mortgage? In that case, the second mortgage holder has three fundamental options for protecting its interest in the collateral: pay off the first loan and foreclose on the property free and clear of the first deed of trust; exercise its cure rights and foreclose on the property subject to the first deed of trust; or let the first mortgage holder foreclose on the property and exercise redemption rights after the sale.

If the second mortgage holder has sufficient funds available, it may choose to pay off the first deed of trust. If there are not sufficient funds available, or if the second mortgage holder prefers not to pay off the first mortgage, it will need to cure the default under the first mortgage to preserve its rights in the property.

Although the second mortgage holder might prefer to acquire title through foreclosure and then cure the default under the first deed of trust, it is not clear whether statutory cure rights will still be available. The statute provides cure rights for junior lienors and the owner of the property, but only if the owner acquired title prior to the recording of the Notice of Election and Demand or lis pendens by the first mortgage holder. See CRS §38-38-104(1). Accordingly, second mortgage holders are often in the unenviable position of curing a loan default secured by property they do not yet own, with the risk that the amounts paid to cure will be tied up in a subsequent borrower bankruptcy. However, the amounts involved should be lower than a full pay-off because the cure amount provided by the first mortgage holder cannot include accelerated loan principal but only sums otherwise due and owing.

Alternatively, the second mortgage holder may protect its interest in the property by exercising its statutory right of redemption as a junior lienholder following the foreclosure sale for the first mortgage. See CRS §38-38-302. To do so, the second mortgage holder must pay the statutory redemption amount, which consists of the foreclosure sale price of at least the entire principal balance of the first loan plus allowed interest and costs. The redemption amount could be even higher if the first mortgage holder is outbid at the foreclosure sale.

Besides being prepared to pay the full redemption amount, the redeeming second mortgage holder must make sure that it timely files the required Notice of Intent to Redeem and otherwise complies with the requirements of the redemption statute. The redeeming second mortgage holder must also be prepared to deal with other redeeming lienholders, including holders of mechanics' liens, judgment liens and liens arising under federal law, the relative priority of which may not always be clear.
Given the potential complexity and cost involved in redeeming as a junior lienor, it is no surprise that second mortgage holders often negotiate a pay-off of the first mortgage holder or protect their rights in the real property collateral by exercising their statutory cure rights whenever they are available.