Real estate sales that are not made entirely for cash involve the use of at least one mortgage or deed of trust. However, a large number of transactions involve more than one loan, and in those cases where a single property is used to secure multiple loans, an important question arises: Who gets paid first? An order of repayment among private lenders is established in the loan papers created between property owners and lenders. Claims will be settled fully in order; that is, the claims of the first mortgage or trust holder will be repaid completely before any claims by a second loan holder. In turn, the claims of the second mortgage or trust holder must be fully satisfied before the debt of a third lender can be addressed, and so on.
The catch for junior trust holders is that there may not be any cash remaining once prior claims have been satisfied. Second trusts and mortgages represent more risk than first loans and therefore command higher interest rates. The following example illustrates why secondary financing has inherently more risk than primary loans.
A home is bought for $100,000 and Smith, the buyer, knows that he can get an $80,000 loan by putting down $20,000 in cash. Smith has $8,000 and borrows $12,000 from Uncle Bob. It is agreed that the $12,000 will be in the form of a second trust secured by the property. Smith, with Uncle Bob's money in hand, approaches a regulated lender and receives an $80,000 first mortgage. After two years, Smith defaults, and the property is auctioned at foreclosure for $80,000. The first mortgage holder takes the $80,000, leaving nothing for Uncle Bob or Smith, the buyer.
Note that the first trust holder has no economic incentive to sell the property for more than $80,000 plus foreclosure costs. Thus, while a lender with a second trust can seek to foreclose on a property if his loan is in default, consideration must be given to the idea that a second mortgage holder may do little more than satisfy the claims of a prior lender by triggering a foreclosure. In effect, the threat of foreclosure by a second trust holder and the protection offered by foreclosure, is greatly reduced by the prior claim of another lender.
If second trusts represent enhanced risk, why are so many sellers, lenders and investors willing to hold such paper? One answer might be that the element of risk is offset by the higher rate of return. Another response is that some transactions are not feasible without the use of junior financing. A third idea is that junior mortgages are often excellent investment vehicles.
It is possible that a junior loan can resemble a first trust in all particulars but this is not likely. In a typical situation, several distinctions are common.
* Loan Term. While a conventional loan may have a term of 30 years, second trusts are generally for a shorter term, say 2 to 10 years, with most loans being for fewer than 5 years.
* Amortization and Monthly Payments. Because secondary loans have a short term, they can be self-amortizing only if they have large payments. For example, a 30-year, $75,000 loan at 12 percent interest requires monthly payments of principal and interest of $771.46. A 10-year self-amortizing loan for this amount would require monthly payments of $1,076.32, and a five-year note would call for payments of $1,668.33 per month.
Instead of a self-amortizing loan, secondary financing is likely to feature relatively small monthly payments. Such payments have two effects: They make the laon affordable to a borrower, and they create a balloon note, a huge final payment at the end of the loan term. Indeed, if the interest rate is sufficiently high and the monthly payments are sufficiently low, "negative amortization" may occur, that is, the balloon payment will be larger than the original debt.
* Coverage. With a conventional loan, the purchaser typically makes a 20 percent down payment in cash, while a lender puts up the rest of the sales value in the form of a mortgage. With a second trust, coverage may vary. Two examples follow.
In the first example, a buyer puts down 20 percent of the purchase price in cash. The value of the first and second trusts together equals 80 percent of the purchase value of the property. A conventional lender is likely to be satisfied with this arrangement so long as the buyer is financially qualified, particularly because the lender's exposure in this situation is less than the 80 percent level that would occur with a conventional loan.
In the second example, a buyer wants to put down 5 percent of the purchase price in cash. The remainder of the price would be represented by an 80 percent loan from one lender and a 15 percent second trust from another lender. Both lenders will want to check the finances of the buyer with care, but such deals are possible for qualified buyers.
NEXT WEEK: More about second trusts.