Updated: Nov 6, 2020
Both are great investments, for different reasons.
When buying a loan, investors can choose whether to buy a lien in the first or second position. Title companies use the old title expression, first in time, first in right, to decide which lien gets paid off first when a property is sold or liquidated. This means that, with some exceptions, liens recorded first are paid off first, while second and third liens are paid off with any remaining funds.
There are two reasons investors traditionally believe that second liens are riskier:
● If the borrower defaults, either lender can foreclose, but the lender in first-position lien will be paid first. If the first lien forecloses, it can unsecure the second-position lien at foreclosure sale.
● Owning second liens can pose a risk when markets fall and home values drop, potentially unsecuring the second lien due to loss of equity.
In theory, both of these concerns are valid, but in my experience, due to the power of emotional equity, they have proven to be unfounded. Let’s explore why.
Busting the Second Lien Danger Myth
The most common type of second lien loan today is a home equity line of credit, or HELOC, which allow borrowers who have equity in their homes to go to a financial institution and take out a second mortgage on their home.
For example, let’s say a borrower has a $150,000 first mortgage balance on their home worth $250,000. In order to add on an extra bedroom to their home, they take out a $40,000 HELOC. The borrowers will now have two mortgage payments each month, usually to two different lenders.
HELOCs tend to be structured differently, with an initial draw period, during which the borrower can use the credit line like a checkbook and only pay interest on the amount of money they use. At the end of the prescribed draw period, the loan converts to a repayment period, during which borrowers usually make regular monthly payments to repay the balance with interest.
HELOCs are primarily used for home improvements. This is not generally a move made by someone who is ready to lose their home. In fact, second liens can be preferable to buying a first lien. Why? Because second liens usually are characterized by:
● higher property values
● more financially sophisticated, higher-income borrowers able to withstand recessions
● lower loan purchase prices
● more frequent refinancing
● less competition from other buyers/investors
Other benefits of second lien purchases include:
● taxes and insurance escrowed/monitored by the first lien servicer
● the ability to monitor the status of the first lien
● risk can be spread amongst many more loans
● higher yields and greater discounts
Because of my experiences in real estate investing during the 2008 recession, I expected my inventory of second liens to have a higher default rate during the COVID-19 recession of 2020. I was shocked when that didn’t happen. Not only did it not happen, I found that the few defaults I had were on first liens! I suspect this is because the borrower’s income is usually tied to the value of the home, and most first liens are on properties with values under $150,000.
So while most people think that second liens are riskier, lower-income borrowers are more often living paycheck to paycheck and are more likely to run into financial trouble during economic downturns.
Another benefit I have found to investing in second liens is that first lien servicers are usually handling tens of thousands of loans, and they are usually understaffed and slower to react to borrower default. If I keep an eye on the first lien status, it allows me to act first to best control the outcome if there is a first lien default. Better yet, there are many ways an investor can protect a second-position lien, and to date, I have never lost a second lien to foreclosure.
Even if you don’t want to monitor the performance of the first lien, you will be notified of any adverse actions because in most states, first lienholders are required to notify second lienholders in the event of foreclosure action.
With second liens, time is on the investor’s side. Following every scheduled payment, the first lien balance is reduced as principal is paid back; at the same time, the value of the property is increasing. This creates a constantly increasing equity position that benefits the borrower and protects the second lien lender.
Due Diligence on Second Liens
When underwriting junior liens and deciding whether to buy them, investors should ask the seller for proof of the status of the first lien to ensure it is current and in good standing.
They should also consider the combined loan to value (CLTV), which is the amount of equity above both the first and second liens. This is found by dividing the total UPB of the loans by the value of the property. Here’s an example of a low CLTV scenario I’d be very comfortable with:
1 Full Equity Street, Anytown, USA
Estimated value: $400,000
First lien UPB: $225,000
Second lien UPB: $57,000
Combined mortgage loan debt: $282,000
CLTV: $282,000/$400,000 = 70%
Here is a loan scenario that is less desirable due to a CLTV of more than 100 percent:
2 Riskier Street, Anytown, USA
Estimated value: $400,000
First lien UPB: $385,000
Second lien UPB: $57,000
Combined mortgage loan debt: $442,000
CLTV: $442,000/$400,000 = 110%
In the last example, there is only $15,000 of equity coverage for the loan of $57,000. Simply as a conservative measure, I generally look for loans that have a CLTV under 80 percent. More equity means more security for both the borrower and the junior lien lender.
Some investors use investment to value (ITV) in place of CLTV. ITV represents what the investor paid for the loan instead of the UPB of the loan. It’s calculated by dividing the purchase price of the loan by the value of the property.
The goal of any investor is to build as diversified and balanced a portfolio as possible. For mortgage loan investors, that means buying loans in markets across the country, in both first and second lien positions. Diversification lowers risk and second liens allow investors to spread their risk so much more.
When I was getting started in note investing, I spent a great amount of time researching the pros and cons between first and second liens. Ultimately, the choice became very clear-2nd liens can be superior to firsts despite some widely held fears, namely, that a second lien can be unsecured by a first lien foreclosure. While that CAN happen, I am happy to say that to date it has never happened, even through the COVID recession.
Pricing: Personally, spending $50,000 for a note on a low-value property in a rough area makes me queasy. Many 2nd liens I purchase are under $35,000 each.
Yield: The yields on second liens are higher. This means that an investor's risk can be spread over many more assets.
Collateral Properties: To me, it seemed like first lien investing was too much like landlording. Run down, low value properties in areas where break-ins would be common. In 2nds, most of the collateral properties I see are between 250-500k. These borrowers have better jobs, stronger connections to their homes, and are less likely to just leave and rent because there aren't many rentals that will be as nice as their current home.
Borrower Income: Higher incomes give so many more opportunities during economic downturns. More sophisticated borrowers are more likely to be able to survive economic downturns.
1st lien responsibilities: The first lien collects the insurance information and monitors and/or escrows for taxes, but is typically much slower to file foreclosure after a default. I can use this to my advantage to create huge winning outcomes for myself. More on this in future emails.