Second trusts can be regarded as a kind of financial ball of putty, loans that can bestretched, compressed, pulled and flattened into any shape acceptable to both buyer and lender. The ability to individually tailor second trusts is an important component in the formation of many deals, sale which otherwise might be impossible to complete.
Because they entail more risk, it follows that second-trust interest rates should be higher than those for primary financing. However, this is not always true. Rates often so manipulated to favor either the buyer or seller.
Imagine a situation where the prevailing rate of interest for a conventional loan is 14 percent while second trusts are available for, say 18 percent interest. In a particular sale, a property is sold for $120,000. By adjusting the cost, size and terms of a second trust, different results can be produced from a single core transaction.
* Case No. 1. The property is sold for $120,000, a lender put up $80,000 for a first trust, the seller takes back a $16,000 second trust at 18 percent interest and the buyer puts up the balance of $24,000 in cash.
In this illustration, there is market financing for both the first and second trusts, 80 percent of the deal is financed and 20 percent of the sale will be paid in cash by the purchaser. This is an essentially neutral deal, with no advantage to either buyer or seller, assuming the property has a market value of $120,000.
* Case No. 2. The property is sold for $120,000, and a lender puts up $80,000 at 14 percent interest for a first trust. The seller takes back $16,000 second trust at 14 percent, and the buyer pays the $10,000 balance in cash.
Here the buyer has an advantage because the interest charge on the second trust is less than the prevailing market rate for such financing. Alternatively, a deal with the same financial result could be arranged by lowering the sale price.
* Case No. 3. The property is sold for $120,000, and a lender puts up $80,000 at 14 percent in the form of a first trust. The seller takes back a $40,000 second trust at 21 percent.
In this example, the buyer is trading costlier financing for the opportunity to purchase property with no money down. This scenario works for buyers who have enough income to support enlarged monthly mortgage payments and who are in the upper tax brackets, a factor that partially offsets high mortgage costs. The seller here is getting $80,000 in cash (the proceeds of the first mortgage) plus a note with an above-market interest rate, a good deal for owners who do not need the cash represented by the second trust, $40,000 in this illustration.
Second trust can be manipulated in terms of size as well as interest. It often happens that a buyer or seller has an intense ego commitment to a particular dollar figure. For example, a seller may want $200,000 for a given property, not because the home is worth that much but because the owner feels the $200,000 figure conveys a certain social status. Similarly, a buyer may not want to purchase real estate for more than a particular dollar value, say $150,000.
* Case No. 4. A property is sold for $120,000, and a lender puts up $80,000 in cash. The buyer is willing to pay the $120,000 price, which he feels is excessive, only if the terms of the deal can be negotiated: In this instance, the buyer asks for, and gets a $30,000 second trust from the seller at 10 percent interest and pays $10,000 in cash at settlement. The true economic value of this transaction is far less than $120,000 may indicate.
* Case No. 5. A home is marketed for $120,000, but a buyer will offer only $115,000 his "limit." The seller agrees to a deal with an $80,000 first trust from a local lender, $10,000 in cash from the buyer and hold a $25,000 second trust at 22 percent interest. The buyer has not exceeded his paper limit, but the value of this package is worth more than a cash deal for $115,000.
One way to regulate terms is to vary the length of the second trust. A loan with a two-year term will require a different financial strategy than a second trust of equal size but with a 10-year life. A longer loan will give a borrower more time to refinance a property at an attractive rate before the end of the loan term. A long loan term also means the potential of more interest to pay out.
Another approach to adjusting loan terms is to vary the size of the monthly payment. Compared to monthly payments needed for a self-amortizing loan, lower payments may allow a buyer to purchase a bigger or better home or at least one which is more expensive. Small monthly payments, however, often translate into large balloon payments at the end of the loan term, a major problem for unwary borrowers.
* Case No. 6. A home is marketed for $120,000 with $20,000 in cash from the purchase, $80,000 from a local lender and a$20,000 second trust from the seller at 18 percent interest. If the second trust is self-amortized over three years, the payments would be $723.05 a month. If the payments were set at $200 -- a far more affordable figure for most purchasers -- there will be a large balloon payment of $22,863.35 due in three years at the end of the loan.
* Case No. 7. A home is marketed for $120,000 with $20,000 in cash from the purchaser, $80,000 from a local lender and a $20,000 second trust held by the seller at 18 percent interest. The term of the loan is set for 15 years, and the monthly payments are $322.08, a figure which produces a self-amortizing loan. This arrangement may be attractive to buyers because it eliminates the future burden of a balloon note.
NEXT WEEK: Second Trusts, continued.