First Liens vs Second Liens: Why it Matters for Investors
Lien position determines how lenders and others get paid if a borrower defaults on a loan. Learn how this affects private real estate debt investors.
When lenders make loans to purchase or renovate real estate, they need something to assure them that they can recoup their losses if the borrower defaults. The property typically serves as security or collateral for the loan. Hard money loans, for example, use the property as a hard asset that secures repayment. The borrower signs a contract giving the lender the right to foreclose on the property if they stop making payments. The lender’s legal interest in the property is known as a “lien.” Real property can have multiple liens simultaneously, which raises the question of what happens if a lienholder wants to foreclose, or the property owner files for bankruptcy. Texas law establishes a priority for liens, stating that some liens must be paid before others. This article describes how lien priority works in Texas and how it affects private real estate debt investors.
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What are first and second liens?
The terms “first lien” and “second lien” refer to the priority in which liens may get paid in the event of foreclosure or bankruptcy. A loan secured by a first lien has a higher priority than a loan with a second lien.
Debts that may lead to liens on real property may include the following:
Purchase money loans, such as home mortgages
Refinance loans
Home equity loans and home equity lines of credit (HELOCs)
Unpaid property taxes
Other unpaid taxes
Assessments and penalties owed to home owners’ associations (HOAs)
Fees owed to contractors for work performed on real property, known as a “mechanic’s lien”
Court judgments
Texas law exempts residential homestead property from seizure for some kinds of liens, such as judgment liens. Homestead property is also protected in many bankruptcy proceedings. Commercial and non-homestead residential property does not have these protections.
First and second liens have equal standing when it comes to principal and interest payments. For example, suppose a homeowner has a mortgage and a home equity loan. They must make monthly payments to both lenders. Lien position only becomes an issue if the homeowner defaults or declares bankruptcy.
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What does it mean to be a first or second lien holder?
Senior lienholders get paid before junior lienholders in foreclosure or bankruptcy. Using the above example of the homeowner with a mortgage and a home equity loan, let’s assume the following:
The mortgage has an outstanding balance of $200,000.
The home equity loan has a balance of $50,000.
The home is valued at $500,000.
Either lender can foreclose if the homeowner defaults, but the distribution of proceeds after foreclosure must follow the lien priority. The mortgage lien has higher priority for two reasons:
It is a purchase money lien.
It is older than the home equity lien.
Now, suppose the home is sold at a foreclosure auction for $500,000, its full market value. Ignoring fees associated with the foreclosure sale, the proceeds would be distributed as follows:
The mortgage lender would receive $200,000.
The home equity lender would receive $50,000.
The borrower would receive the remaining $250,000.
Foreclosure sales aren’t always so lucrative, unfortunately. If the home sold for half its market value, the distribution would look like this:
$200,000 to the mortgage lender
$50,000 to the home equity lender
Nothing to the borrower
Divide the auction sales price by half again, and the payout looks like this:
$125,000 to the mortgage lender
Nothing to the home equity lender
The borrower has unsecured debts to the mortgage lender and the home equity lender of $125,000 and $50,000, respectively.
Lenders perform a great deal of due diligence to ensure that this last scenario rarely occurs.
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What determines which lien gets first position and which gets second?
The general rule in Texas is “first in time, first in right.” This means that the first lien to be recorded on a property has the highest priority. Any lien filed after that is a second lien. As always, though, some exceptions apply.
Certain liens have first lien priority even if they are not the first ones to be recorded:
Tax liens, including property tax liens filed by local appraisal districts and liens filed by the IRS, always have the highest priority.
Liens for HOA assessments have priority over everything except tax liens and purchase money mortgages, provided that the mortgage lien was recorded before the date the assessment was due.
A mechanic’s lien could have priority over a mortgage or other purchase money lien if the work began before the purchase money lien was filed with the county clerk. This applies even though the mechanic’s lien will not be filed until later.
Why do some people choose to invest as second lien holders?
First liens present less risk for private real estate loan investors. If the borrower defaults, they have the superior right to recover their investment. This translates into lower returns from interest payments.
Investing in a second lien offers some potential benefits for investors who are willing to tolerate greater risk:
Higher returns: Because of the greater risk, interest rates are typically higher for second lien loans.
Lower investment amounts: Second liens attach to properties that already have one or more liens, such as home equity loans on homes with outstanding mortgages. The amount of a second lien loan is often based on the owner’s equity, resulting in a lower minimum investment.
What is a lien position in a fractional loan program?
Hard money lenders prefer to lend money in the first lien position. Capstone's fractional loan program allows multiple participants to contribute to a first-position loan. As a result, every participant is a first lien holder. The fractional loan program allows you to “be the lender” without the hassle of running a lending business. We’ll handle the day-to-day administrative tasks. You can sit back and receive interest payments.
While fractional real estate debt ownership is not technically an “investment” (because it doesn’t produce returns in the same way as a fund or stock), it is a reliable, hard asset-based vehicle to steady income through real estate.
Learn more about investing as a first lien holder
Real estate debt investments offer excellent passive returns with little risk. Capstone Capital Partners’ trust deed and first lien investments target returns of 8% to 9% net annual yields. To learn more about our investment opportunities, please contact the Capstone team today through the online contact form.
