Second lien loan?

Answer

When you get a loan on a property you own, you pledge the property as collateral for the loan through a document called a mortgage (or Deed of Trust in some states). The mortgage gives the lender a "lien" on the property -- that is to say a "right" to sell the property in an attempt to recover the original loan amount.

For the lien to be enforceable, it has to be recorded in the county clerk's office. This establishes the official date and time the lien was established.

If you are the first lender to loan money against the property, you will have the lien of first priority (in terms of date and time) -- or, the first lien. If you are the second lender, the mortgage document which you receive from the borrower (pledging the property as collateral) is the second lien mortgage. This means you stand second in line behind the 1st lien mortgage holder in your claim to the asset.

Usually, the interest rate charged on a 2nd mortgage loan is higher than the first because of the added risk of standing second in line.

Why is that riskier? Here is an example:

Mr. Able owns a property free and clear (no debt) which is worth $100,000. He borrows $70,000 (signs a note) from Mr. Baker who charges him 5% interest. Mr. Able also signs a mortgage (as the Grantor) and thereby pledges his interest in the property as collateral for the loan. Mr. Baker has a first lien on the property.

Mr. Able needs more money and borrows $20,000 from Mr. Chance who charges him 10% interest and requires Able to sign a second mortgage. Mr. Chance has a 2nd lien and stands behind Mr. Baker in his claim against the asset.

Mr. Able becomes disabled and no longer pays on the loans. Mr. Baker, as the 1st lienholder, forecloses and takes possession of the property. He sells the property on the open market for $87,000 and spends $2,000 in legal fees to get this done.

The court sees to it that Baker gets his $70,000 back, plus the $2,000 in legal fees. How much money is left over? 87,000 - 70,000 - 2,000 = 15,000. Baker has been made whole... so Mr. Chance now gets his chance. He originally loaned 20,000 but only gets the remaining 15,000 -- so he has lost $5,000.

Which brings me to my final point regarding 2nd liens: did Chance get enough additional interest to adequately compensate him for the additional risk of standing second in line? If he had stood 1st, he would have been repaid in full (including legal costs). But by standing 2nd, he lost $5,000.

Chance received an additional 5% per year (his loan's 10% rate less Baker's 5%). That's an extra $1,000 per year (20,000 x .05). It would take 5 years for Chance's additional interest to recapture the principal loss of $5,000.

At this point, the two lender's experiences are financially the same. For 5 years, Baker collected 5% per year and then got all of his money back. Chance collected 5% per year for 5 years too. But then he lost $5,000 at the end of the loan period. Fortunately, his "additional" interest added up to $5,000 to make him whole.

Conclusion: In this case, with this expected loss rate, the 10% interest rate on the 2nd lien loan is an adequate "risk adjusted" return ONLY if the loan performs for 5 years before going into foreclosure. Any less time and Baker gets the better return. Any longer time frame and Chance comes out ahead (again, not taking compounding into account).

If you are considering making a 2nd lien loan to someone, you need to know (1) how much money is standing in line in front of you, (2) how long you think the loan will perform before it might go bad, and (3) if that happens, how much property value might be lost. Only then can you estimate an adequate, risk-adjusted rate of return to charge for making the loan.

First answer by REIBanker. Last edit by JohnCorey. Contributor trust: 29 [recommend contributor]. Question popularity: 1 [recommend question]