Real Estate Finance: Chapter 7 Junior Loans in Real Estate Finance

Piggy-Back Loans

A second mortgage created simultaneously with a first mortgage.

*Anatomy of a Second Mortgage/Deed of Trust

A second mortgage or deed of trust is a lien on real property that is second or junior in position behind an existing first lien. Just as a senior loan requires the execution of a note specifying the terms and conditions of the promise to pay, so also does the junior loan form call for such a promissory note. The property that is described as collateral for the junior loan will be the same property that is pledged as collateral for the existing senior loan. Because the second mortgage is in a subordinate position, the junior lien-holder is in a relatively high-risk position. If the senior encumbrance is not paid according to its terms and conditions, the senior lienholder may foreclose on the collateral property and sell it in order to recover as much of the outstanding senior debt as possible. This foreclosure process could effectively eliminate the junior lienholder's position in the subject property without commensurate compensation. After costs, the proceeds from the sale would be allocated to the senior lienholder first, and then to the junior lienholders, according to their priority positions. If the property didn't sell for a price sufficient to satisfy the senior lender, there would be no funds left to distribute to the junior lienholder(s). In the event of a default, a senior lender, knowing of the existence of a junior lien, will usually give the junior lender a chance to step in and make the delinquent payments. Then the junior lender will foreclose against the collateral property. But the primary lender must be protected and will pursue any legal means available to maintain the value of the investment.

-Clauses

Certain provisions can be incorporated into a junior lending instrument to protect the junior lienholder's position against that of the senior lender. A clause can be included that grants the junior lender the right to pay property taxes, insurance premiums, and similar charges for a borrower who is not making these payments. These charges can then be added to the total debt in anticipation of foreclosure. Another clause can allow the junior lender to pay into escrow the funds for taxes and insurance and make any delinquent senior loan payments to offset any possible default. The junior lender can also reserve the right to cure any default on the senior loan. Another junior loan provision includes the requirement of a borrower's personal guarantee to be liable for any possible deficiencies in case of a default and subsequent foreclosure. Still another prohibits the junior borrower from amending the terms of the existing first loan without the written permission of the junior lender. Some junior loans include a lifting clause that allows a borrower to replace a senior loan without disturbing the status of the junior loan, but the amount of the new senior loan can't exceed the specific amount of the original senior loan outstanding at the time the second loan was established. Finally, if a cross-defaulting clause is included in the junior loan provisions, a default on the senior loan will automatically trigger a default on the junior loan.

-Junior Loan Risks

Higher risks are involved in the use of junior financing than with senior financing. The greater the risk, the greater the possibility of being unable to secure the full balance of both the first and second loans at a public sale in the event of a foreclosure. Although the senior lender is generally protected by a reasonable cash down payment, or by some insurance or guarantee, the junior lender is usually self-insured. The second lender is generally financing the difference between the amount of the first loan, the borrower's down payment, and the property's sale price. A junior loan helps to fulfill the down payment requirement to a first loan, and the second lender assumes the full risk for the top portion of a collateral property's value. Although junior financing is sometimes employed after high down payments, it's most often utilized in low down payment transactions. Occasionally, after the expiration of some agreed-upon time period, usually 5-years, a borrower will merge a junior loan with an existing senior loan by increasing the senior loan by an amount sufficient to satisfy the balance of the junior loan.

-Junior Loan Interest Rates and Usury

It would appear that interest rates would be high on loans that are in a high risk position, such as second and third. In many instances this is correct. The high interest rates offset, to some degree, the possibility of losses due to defaults. Although junior loans secured from mortgage brokers and bankers, institutional lenders and small loan companies usually do carry relatively high interest rates, it is interesting to observe that junior carryback loans issued by sellers intent on completing the sales of their properties often include interest rates that are at or below market rates. The phenomenon stems from the different motivations of these various lenders. Those that are in the lending business seek to maximize their profits by charging as much interest as the law and the borrower will accept. Other persons are trying to sell their properties, especially when prices are high, and are often forced to carry back junior financing at low interest rates in order to actually complete a sale. Their goal is the sale of the property, not the yield on the loan. There can never be an effective legal limitation on the amount of interest that can be charged on a loan. If the law stipulates a specific maximum interest rate, a lender can circumvent it by charging points or by raising the principal amount to reach a desired effective yield. A charge of four points on a $100,000 loan will result in the borrower's receiving only $96,000 in actual proceeds, raising the effective yield on a 10-year loan about a 1/2%. The alternative is to add the $4,000 to the loan's balance, creating the same effect.

*Home Equity Loans

Primed by the Tax Reform Act of 1986, which eliminated interest deductions on consumer finance but allowed them on home loans, junior financing is being used with greater frequency by owners who have accumulated measurable equity in their property. This equity, acquired through a paydown of the first mortgage balance or through an inflationary rise in a property's value, or both, is being pledged as collateral to secure funds over short-term periods of up to 5-years. When these equity loans become due, the borrowers invariably refinance the entire property to secure a new first trust deed adequate to pay all liens in full. Many lenders actively solicit for home equity loans. The relatively short-term quality of these loans affords the lenders the opportunity to control the interest rates and periodically check the value of the collateral and the credit of the borrowers. The modern day equity loan is a throwback to the real estate finance of the 1930s when 5-year rollover loans were the norm. Some equity lenders offer lower-than-market interest rates. The borrowers should be aware that these lower rates may prevail for only a short period of time before the contract specifies their rise to market or even higher rates. Some lenders offer to waive the first month's interest charge while others offer different incentives to encourage borrowers to make these loans. Some of these incentives include zero placement or origination fee, or guaranteed renewals, but at adjusted interest rates and fast processing to provide instant cash. Home equity loans face significant defaults when the economy slows. Particularly at risk are the high yield loans amounting to more than 100% of the value of the collateral. Interest on these loans is well above standard rates. Because most of these loans are pooled into residential-backed mortgage securities, the risk are being spread to a wide group of investors. Owners also pledge their equity to secure funds for home improvements. Improvement loans are somewhat safer than other types of junior financing because they are secured not only by the equity pledged but also by the enhanced value of the improved property. Improvement loans may have longer terms of repayment than other forms of junior finance -- some for as long as 20-years. Responding to changing economic conditions, many homeowners improve their properties rather than re-enter the housing market. Freddie Mac has a program for the purchase of secured home improvement loans, allowing lenders to leverage into additional business.

Carryback

Seller agrees to finance buyer in order to complete a property sale.

Summary

When a perspective buyer does not have enough cash to satisfy the down payment required in a purchase of real property, a second mortgage or a second deed of trust may be carried back by the seller to finance the difference. Owners who have developed equity in their property also use junior mortgage, pledging their equity as collateral for new loans for home improvements or personal needs. A second or third mortgage or trust deed is junior in priority to an existing senior loan issued by a financial fiduciary. Being in second position, a junior financier anticipates certain risks and charges appropriate interest rates to offset these risks. Economic conditions limit the amount of interest than can be charged on loans between individuals.

Junior Loans

When special problems or needs arise in the financing of real estate, junior financial instruments are often used as part of the solution. The senior loan forms can also be used for junior loans. Generally, when a mortgage or deed of trust is used as a second encumbrance, the loan involoves a higher risk. To distinguish between senior and junior loans: first trust deeds are typically made in larger amounts than junior liens, and first trust deeds usually carry lower interest rates than subordinate financing due to lower risk in the event of a default. There are no litmus tests to determine whether or not a loan is a first or junior lien. The only thing that definitely sets the liens apart are the time and date of recording and in the event the two liens are recorded simultaneously, the document with the lowest sequential number at the county has priority. Under normal conditions, most real estate sales are finalized when a buyer secures a new first deed of trust from a financial fiduciary to cover the major portion of a property's purchase price. The balance is usually paid in cash as a down payment. However, if a buyer who has insufficient cash for the entire amount of the required down payment will make an offer to purchase a property based upon the condition that the seller carryback a portion of the sale price n the form of a junior emcumbrance. A seller might be asked to accept a purchase-money second mortgage or deed of trust (trust deed) for the amount needed to complete the transaction. Thrifts and commercial banks sometimes participate as junior financiers in an effort to enhance their earnings. The offer combinations of first and second mortgages, known as piggy-back loans, to allow the borrower to avoid paying mortgage insurance premiums. Examples of these programs are: 80/10/10; 75/15/10; and 80/20; with the first mortgage remaining at 80% or less, a second mortgage of 10% or 15% and the remainder as a down payment. Mortgage brokers, mortgage bankers, and various small loan operating on direct lines of credit from commercial banks will arrange junior loans. Some companies buy and sell these so-called second securities on a regular basis. This activity has diminished substantially in the current market. In addition to commercial and residential properties, junior financing often provides funds for land developers to pay for offsite improvements such as streets, sidewalks, sewers, and other utility installations. A lender would advance the funds necessary for these improvements and accept a lien on all of the property involved. Such a lien would usually be in second priority position behind a developer's purchase-money loan, which had been given as part of the purchase price of the land in its raw form. Once the land was subdivided, improved, built upon, and sold, the underlying first lien and the junior lien for improvements would be replaced by individual conventional or guaranteed loans executed by the buyers of the buildings constructed on the developed land. There are also third deeds of trust in California. An example of a third-position loan would be one that warps around existing first and second loans.