By Hard Money Russ
When making a hard money loan, most lenders prefer to be in 1st lien position.
However some lenders with a higher risk tolerance, are willing to take on a 2nd lien position.
These loans garner more interest, usually at least 3 or 4 percent higher than 1st position loans.
In the event of a foreclosure, lenders in 1st position will be paid in full before a lender in 2nd position receives a penny.
If the sale of the property was less than the amount of the loan, the 2nd lien position will be out of luck.
Let's explore a hypothetical, but common example.
Jack owns a rental property outright in California that has been appraised for $1.5 million dollars.
He decides he wants to expand his business and purchase an additional fix and flip investment property.
He contacts ABC Lenders and is able to secure a $1 million dollar hard money interest only loan at a 9% rate, against his rental property for a term of 24 months.
ABC Lenders now has the 1st trust deed position on the rental property with a 66% loan to value ratio (a $1 million dollar loan divided by the $1.5 million dollar property used as collateral).
Six months go by and Jack realizes he has underestimated his construction costs on his new investment property and will need to secure more capital to complete the rehab project.
Jack contacts XYZ Lenders who are willing to assume a 2nd position hard money loan on the rental property for $300,000 dollars, at an interest only rate of 13% for a term of 18 months.
Jacks current loan to value ratio on the property is now 86% (66% from ABC Lenders plus 20% from XYZ Lenders).
Unfortunately for Jack, 6 months later the real estate market collapses and Jack loses his tenants from his income producing rental property.
Unable to service his hard money loan interest payments, ABC Lenders decide to foreclose on Jack's rental property due to non payments on his debt obligations.
For this example, let's assume the process of foreclosing and auctioning off the property took exactly 200 days and the property was sold at auction for $1.2 million dollars.
In those 200 days, interest payments were missed. This is called accrued interest and equates to roughly $54,000 dollars (with compounding).
Under these circumstances, ABC Lenders will recover it's initial $1 million dollar investment as well as the $54,000 dollars in accrued interest before XYZ Lenders in 2nd position receives a penny.
Since the property was auctioned off for $1.2 million dollars and ABC Lenders recovers $1,054,000 dollars there is $146,000 dollars remaining for the 2nd lien position holder, XYZ Lenders.
While XYZ Lenders was able to collect interest payments for the first 6 months equating to $19,500 dollars, they end up taking a loss of $154,000 dollars on their investment principal of $300,000 dollars.
Foreclosure in California
Foreclosure in California takes approximately 200 days, from the date of the first payment missed (most foreclosures usually take longer than this).
Clearly from this example the 2nd trust deed position is riskier than the 1st trust deed position, hence the higher interest rate XYZ Lenders were able to command.
There is a correlation between higher risk and higher interest rates.
For this reason, not all lenders are willing to assume a 2nd trust deed position.
Therefore, it is generally more challenging for borrowers to find a lender comfortable with 2nd trust deed positions. But these types of lenders do exist.
Some in the hard money lending industry will say "2nd position is always the 1st loser."
An Interesting Caveat
Generally the borrower can acquire a 2nd loan without permission from the 1st position lender.
However, in some cases there are contractual clauses that disallow a 2nd position or require permission from the 1st position lender.
There are instances where borrowers don't tell the 1st position lender and acquire a 2nd loan without their knowledge.
In this case, if the 1st position lender finds out they could potentially call the loan in 1st position due.
If this were to occur the borrower would need to have the complete funds to pay off the 1st position loan or risk losing the property.
While taking on a second position loan can free up more cash, it also comes with more risk and a higher interest rate.
It's important to understand those risks, which is why this strategy is only advisable to seasoned investors.