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.
