Module 1 · Note Basics

Should You Invest in First- or Second-Lien Mortgage Notes?

The benefits and risks of first-lien and second-lien notes, with a real second-lien deal, so you can pick a lien position that fits.

6 min read · Lesson 1.13

Mortgage notes come in lien positions. A first-lien note is paid first and is the most secure; a second-lien note stands behind it. Each position has its own benefits and risks, and the right choice depends on your goals and how much risk you can live with.

Why first-lien notes are safer

The greatest benefit of a first-lien mortgage note is security. In first position you usually have less to worry about, and you are more likely to collect on the loan, even if the holder of the second mortgage forecloses.

Because of that added security, first-lien notes sell for top dollar, especially when they are performing. You can negotiate discounts on nonperforming first-lien notes, but you will always pay more for a first than for a second.

Liens that can still hurt a first-lien holder

A first-lien note is more secure than a second, but it still carries risk. Keep an eye on taxes and insurance, and make sure the collateral is protected so it doesn’t pick up a code violation or a municipal lien.

Municipal liens and code violations survive a foreclosure. They can leave the lender owing hundreds or thousands of dollars in fees after the foreclosure is done.

If the property is in a homeowners association (HOA), find out whether the HOA fees are being paid. Left unpaid long enough, the HOA can file a lien on the property and, if the lien isn’t satisfied, eventually foreclose. That foreclosure puts the HOA or the winning bidder on title, but it doesn’t wipe out the first-lien note. The HOA or new owner has to keep making the monthly payments on the first mortgage to keep the lender from foreclosing.

Property taxes always rank ahead of a first-lien note. If taxes go unpaid, the county can place a lien on the property, sometimes called a tax deed. Depending on the state, the property can then be sold at a public tax auction, which wipes out any mortgages on it. The first mortgage may be able to collect any overage from the tax sale, but a tax sale is normally bad news for a note investor.

Why second-lien notes cost less

The biggest benefit of second-lien notes is the price. You can buy them for pennies on the dollar, at big discounts from the balance owed. Seconds are often priced on the equity in the property and on whether the first is paying.

A second with equity behind a current first mortgage costs more than a second with negative equity behind a delinquent first. Ideally you buy seconds with equity where the first is paying, though that isn’t a requirement.

Depending on the balance, a second-lien note can cost just a few thousand dollars. A first-lien note can cost tens or hundreds of thousands, depending on where the property is and what it is worth.

The low cost can be a way to buy property cheaply or earn strong returns; the author puts the range for second-lien notes at 10% to 50% or more. A second-lien holder can foreclose even if the first mortgage is current. Sometimes the homeowner sees the foreclosure coming and sells the home to pay off the second in full. If not, the noteholder takes title and can hold the property or sell it and pay off the first mortgage.

Worked example: one second-lien note, start to finish

Here is a real deal a friend of the author closed. He bought a nonperforming second-lien note secured by a single-family home in California for $15,000. The borrower ignored his attempts to make contact, so he foreclosed. Nobody bid at the trustee’s sale, so the property reverted to him. He fixed it up and turned it into a rental that brings in $2,750 a month.

ItemAmount
Price of the second-lien note$15,000
His own funds for foreclosure costs and repairs$45,000
Current first mortgage he took over$180,000
Total cost of the home$240,000
Approximate value of the home$450,000
Monthly rent$2,750

He keeps making the monthly principal and interest payments on the first mortgage, and now owns a home worth about $450,000 for a total cost of $240,000.

A $15,000 note led to a $450,000 home for $240,000 all in.

How a second-lien note gets wiped out

A second-lien investor has to watch every risk a first-lien investor does, and also keep a close eye on the status of the first mortgage.

If the first mortgage is delinquent and its lender forecloses, your second can be wiped out in that foreclosure. You need to know whether the property is in foreclosure and how much is owed on the first.

If the borrower files bankruptcy and there is no equity in the property, meaning the first and second balances together are more than the property is worth, the second mortgage can be “stripped,” or wiped away, in the bankruptcy.

In short, there are more ways for a second-lien note to be wiped out, which makes it a riskier investment. Many second-lien investors buy them in large quantities so the good deals can offset the bad.

Choosing between firsts and seconds

There is no definitive answer to which is better. Both have benefits and risks. You can invest in firsts, seconds or both. The author invests in first-lien mortgages for the security they offer, but knows plenty of investors who have done extremely well with seconds alone or with a mix of the two.

Assess your own risk tolerance and decide which kind of note investing suits you.

Key takeaways

  • Firsts cost more but are more secure
  • Taxes, code liens and HOAs still threaten firsts
  • Seconds are cheap, priced on equity
  • A first’s foreclosure can wipe out a second
  • Match lien position to your risk tolerance

Try it yourself

In the worked example, which three amounts add up to the investor’s $240,000 total cost?

Show answer

The $15,000 he paid for the second-lien note, the $45,000 of his own funds for foreclosure and repairs, and the $180,000 first mortgage he took over.

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