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

Nov 18, 2019 by Liz Brumer
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Mortgage note investing isn't a well-known avenue of real estate investing, but it can be very profitable. There are several ways to invest in mortgage notes, such as wholesaling, buying directly from a bank, or purchasing from a note holder. 

You can buy nonperforming or performing notes and can even buy notes based on their lien position. Lien position is one of the most important variables that differentiate the types of mortgage notes. 

Let's compare the differences between first- and second-lien mortgage notes. We'll look at the benefits and risks to help you determine which is a better investment option for you.

What is a mortgage note?

A mortgage and a note are two separate documents that are executed when money is lent for the purchase of a property. 

A promissory note is a document that outlines how much is being borrowed and the terms under which that money is lent. This includes things such as the interest rate, length of the loan, and payment amount. The borrower signs the note, promising to repay the lender according to the outlined terms.

The mortgage is a separate document that's used as a security instrument. In real estate, the mortgage outlines the roles and responsibilities of the lender and buyer and defines the property or asset being used as collateral. In most cases, the property being purchased is used as collateral. If the borrower fails to repay the loan, the lender can foreclose on it.

How can you invest in notes?

There are a number of ways to invest in mortgage notes, but the easiest way is to find a seller who owns a note and has an immediate need for cash. A seller could be an individual who created an owner-financed mortgage note or a bank that has thousands of notes to sell. While some notes are sold at face value, they're often purchased at a discount. 

The sale of the note transfers all rights to collect the debt to the buyer, putting you in the shoes of the bank. If the loan is performing, or paying on time, you now collect the monthly principal-and-interest payment and enjoy your new cash flow -- just like a bank would. If the borrower isn't paying, there are ways to regain your security or interest in the investment, like a deed in lieu of foreclosure, foreclosure, or loss mitigation.

You can create your own note and mortgage or buy an existing one, but they're always bought and sold together.

What is a first-lien or second-lien mortgage note?

First-lien notes and second-lien notes are both mortgage notes, meaning they use the same documents and bestow the same legal rights to collect on the debt. They simply have different lien positions. The lien position is the priority the note is paid off, especially in the event of default. 

A first-position mortgage note is the most secure because it'll be paid first. If a note is in the second position, it's inferior to the first. A second-position note will only get paid once the first position is satisfied.

Here's an example. A couple purchases a home for $300,000, getting a mortgage from Bank A for $250,000. Bank A is in first position because there are no other liens on the home. 

Ten years later, the homeowners decide to update the home. They get a second mortgage from Bank B for $50,000 to help with the renovations. Bank A's mortgage still exists, but now the homeowners have two separate mortgages they pay each month to two separate banks.

If the homeowners stop paying, either bank can foreclose, but Bank A will always be paid first from any debts collected before Bank B is able to recoup their debt.

A first mortgage is the most common form and is likely what you think of when you think of getting a mortgage from a bank. Second mortgages are less common than first-lien mortgage notes and can come in many forms, such as:

What are the differences between first- and second-lien notes?

The biggest difference between first- and second-lien mortgage notes is risk. This is because of the position of the loan. When you buy second-lien mortgage notes, you're in a riskier position than if you’d bought a first-lien mortgage note because you're always in a subordinate position. If a borrower stops paying on both mortgages and the first one forecloses, your debt could be wiped away through foreclosure action or bankruptcy.

Because the risk is higher, second-lien mortgage notes are often sold at a significant discount, especially if they're nonperforming.
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What are the benefits of investing in first-lien notes?

The greatest benefit of investing in a first-lien mortgage note is security. Since you're in first-lien position, you typically have less to worry about and the likelihood to collect on the loan is higher, even if the provider of the second mortgage forecloses.

Because of the added security, first-lien mortgage notes are sold for top dollar, especially if they're performing. Discounts can be negotiated for nonperforming first-lien mortgage notes, but you'll always pay more for a first-lien note than you would for a second-lien note.

What are the risks of investing in first-lien notes?

While a first-lien note is more secure than a second-lien note, there are still risks associated with investing in firsts. It's important to monitor taxes and insurance and make sure the collateral is protected to avoid a code violation or municipal lien.

Liens such as municipality liens or code violations will survive a foreclosure, potentially leaving the lender with hundreds or thousands of dollars in fees after a foreclosure.

If the property has a homeowners association (HOA), it's important to know whether the HOA fees are being paid. If they go unpaid for long enough, the HOA can file a lien that attaches to the property. Eventually, if the lien isn't satisfied, the HOA can foreclose on the property. The foreclosure process places the HOA or the winning bidder from the foreclosure sale on title but doesn't wipe away the first-lien note. The HOA or new owner will need to maintain the first mortgage by making monthly payments to keep the lender from foreclosing.

Taxes are always in a higher security position than a first-lien note. If property taxes aren't paid, the county can place a lien on the property, sometimes called a tax deed. Depending on the state the property is in, it can be sold at a public tax auction, wiping away any mortgages on the property. The first mortgage may be able to collect any overages from the tax sale, but a tax sale is normally unfavorable for a note investor.

What are the benefits of investing in second-lien notes?

The largest benefit of investing in second-lien notes is the price. You can purchase second-lien mortgage notes for pennies on the dollar and at significant discounts from the balance owed. Second-lien notes are often priced based on the equity and pay position of the first.

A second-lien note that has equity with a first-lien mortgage that's current will cost more than a second-lien note with negative equity and a first-lien mortgage note that's delinquent. It's ideal to buy second-lien notes with equity and where the first note is paying, although it's not a requirement.

You can buy second-lien notes for a few thousand dollars, depending on the balance, whereas a first-lien note will cost tens or hundreds of thousands, depending on the property location and value.

The low cost can be an excellent way for investors to purchase property cheaply or earn substantial returns. Second-lien notes can earn 10% to 50% or more. Second-lien noteholders can still foreclose even if the first mortgage is current. Sometimes the homeowner realizes the second is foreclosing and sells the home to pay off the balance in full. If this doesn't happen, the noteholder gains title to the property and can hold it or sell it to pay off the first mortgage.

Let’s look at an example of a real note deal my friend recently closed. He purchased a nonperforming second-lien note secured by a single-family home in California for $15,000. The borrower ignored his communications, so he foreclosed. No one bid on the lien at the trustee foreclosure sale, so the property reverted back to him. He updated the property and turned it into a rental that brings in $2,750 a month. After foreclosure costs and repairing the property, he spent a total of $45,000 of his own funds and inherited a $180,000 first mortgage that was current. He continues to pay the monthly principal and interest payment to the first mortgage and now owns a home valued at around $450,000 after paying just $240,000.

What are the risks of investing in second-lien notes?

While a second-note investor needs to monitor all of the risk variables a first investor would, he or she also needs to carefully review the status of the first mortgage.

If the first mortgage is delinquent and the lender forecloses, your second-lien position can be wiped out in the foreclosure. It's extremely important to know if the property is in foreclosure and how much is owed on the first mortgage.

Additionally, if the borrower files bankruptcy and there's no equity in the property, meaning the first and the second mortgage balances are greater than the value of the property, the second mortgage can be "stripped," or wiped away by the bankruptcy.

All in all, there are more opportunities for a second-lien note to be wiped away. For this reason, it's a riskier investment. Many second-lien note investors buy them in large quantities so the good deals can offset the bad.

So what's better to invest in -- first- or second-lien notes?

There's no definitive answer as to which is better to invest in. Both have benefits and risks. You can invest in both first- and second-lien mortgages or in just one lien position. I invest in first-lien mortgages because of the security they offer, but I know plenty of investors that have done extremely well investing solely in second-lien mortgages or a combination of the two.

Assess your risk tolerance and determine which avenue of investing in mortgage notes is better for you.

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