You may have heard of the term lien position or lienholder in a real estate or mortgage transaction. This article discusses lien positions and why attention should be given to them when considering certain seller financing agreements.
To understand what a lien position is, let’s start with a little bit of background on how a mortgage transaction works.
Most individuals buying their first home aren’t likely to have saved the large amount of money needed to pay for the property in cash. Even if they did, it wouldn’t make much financial sense to sock the entire $200,000 in cash into a home. Especially when interest rates are at 4%, and the stock market is returning 10%. They could make a much nicer return on investment by borrowing money for the house, and realizing a net 6% return on their cash.
Regardless, most first-time buyers don’t have that kind of money sitting around anyway and usually turn to institutional mortgage lenders instead.
Mortgage lenders are willing to lend large amounts of money to borrowers because they’ll receive a return on their investment from the interest rate they charge. Also, the loan is backed by collateral. If the borrower defaults on the loan, the lender can foreclose on the property and resell it to recoup their investment.
A lienholder refers to a lender who is owed money and has a claim to real property. In the case of our discussion, the bank that has lent us money to buy real estate property is the first lienholder. Should the buyer default, their lienholder position signifies their legal standing to recover money from their investment.
The primary lender on a home is usually the first lienholder, because they are the first entity to lend money to a buyer to purchase the property. Lienholder position is determined by the date the lien is recorded with the county land records office.
Second Lienholder and Beyond
Sometimes, a borrower needs to borrow money from a second entity using the real property as collateral.
The second entity becomes the second lienholder on the loan. And if the borrower continues to borrow money, the subsequent lenders would continue on, as third, fourth and so on lien positions. All in order of when the lien was recorded.
Common instances in which there might be a second lienholder include buyers don’t have enough cash for the down payment on a mortgage loan.
Many lenders require a down payment on the property the buyer wants to purchase. It may be as little as 5%, or as much as 20%. Banks want to know the borrower has some “skin in the game” or a financial investment of their own. It makes them less likely to walk away from their payments down the road.
The thought process is that a borrower who’s put $20,000 of their own money down, is going to be hesitant to walk away. Why? Because they would those their $20,000.
But, if a buyer doesn’t have money for a down payment, they borrow.
When this happens, the second lender, whether it’s another bank, a family member, or the seller of the property being purchased, takes a second lienholder position. Meaning they also have legal recourse to try to recoup their money should the borrower default, but they’re second in line.
What about when a buyer used a loan to access equity in their property?
Equity is the difference between what someone owes on the mortgage loan and the value of the house.
If a borrower has paid off $20,000 on the home and the house has risen in value by $10,000 over a few years, the buyer has $30,000 in equity. If needed, they can borrow that amount. The lender providing the home equity loan would take a lienholder position.
Sometimes, if a borrower has significant renovation work done on their home, the contractor will take out a lien. Just temporarily, as a means of providing some guarantee that they’ll be paid in full for their work. Sometimes, if the borrower has a tax debt, the taxing authority may take out lien positions as well.
Factors That Would Allow Lien Positions to Change
As we noted above, lien position is determined by seniority. Whichever lender recorded their lien first determines their lienholder position. But lien positions can change.
For example, lets say a borrower has a first mortgage on their loan and a second home equity loan. However, they refinance their first mortgage to achieve a better rate. The lender providing the home equity loan would move into the first lien position by default. Next, the new first mortgage lender would require the home equity loan lender to agree to move back into the second lienholder position. This is known as subrogation and usually doesn’t present an issue.
If a second lienholder wanted to move up into first lienholder position, their only recourse would be to pay off the full balance of the first lien. Even if they could afford to do this, why would they want to bother?
Most commonly, it’s because they aren’t getting paid by the borrower and want to initiate foreclosure proceedings.
The point of all of this? A second lienholder assumes some amount of risk that they may not be able to recoup the money owed to them.
Lien Positions and Seller Financing
Seller financing is a real estate transaction in which the owner of real estate property agrees to sell their property to a buyer and carry the mortgage in place of a traditional bank. It can be a relatively simple transaction, or it can end up being more complicated.
Scenario #1 – Seller Finances the Entire Loan Amount
In it’s simplest form, a seller who owns their property outright agrees to provide full financing for the buyer. The buyer gives the seller a down payment and then proceeds to makes monthly principle and interest payments to the seller over a period of time. In this case, the seller holds a first lien position on the mortgage. Pretty simple.
However, the transaction gets more complicated when the buyer finances some of the costs through traditional lenders. As well as some through the seller.
Scenario #2 – Seller Agrees Finances a Portion of the Loan
Suppose a seller wants to sell their home for $200,000 and they still owe $100,000 on it. A potential buyer can secure a traditional mortgage but the bank is only willing to lend them $160,000. The seller may, in their desire to get the house sold in a weak market, agree to finance the remaining $40,000, taking a second lien position in the transaction.
In this situation, the seller receives $160,000 at closing from the buyer’s lender, of which $100,000 is used to pay off the balance they owe, and $60,000 is pocketed.
The buyer now has a loan to their bank for $160,000. Along with a second loan to the seller for the remaining $40,000.
The danger is if the buyer stops making payments and triggers a foreclosure. The traditional bank is first in line to receive any proceeds from the foreclosure. The seller financer may end up losing some (or all) of their $40,000.
Another danger is if the buyer only been pays the first lienholder. The seller’s only recourse is to initiate foreclosure proceedings, capturing the money they’re owed. But, they can’t do this unless they have enough money to pay the first lienholder, moving into the first position.
If they only netted $60,000 from the original sale, they probably don’t have enough money to do this. Again, they’re out whatever portion of the original $40,000 loan hasn’t already been paid through principal and interest payments.
Protecting Yourself Against Pitfalls Associated with Second Lien Positions
If a seller considers offering seller financing for a portion of the purchase price of their home, one of the most important things is doing their due diligence. In addition, they may consider setting a higher interest rate on their loan. This would help mitigate their risk.
A comprehensive examination of a buyer’s credit and employment history won’t guarantee seller protection. But, it’s an important first step in safeguarding their assets.
Have questions about protecting yourself when offer seller financing? Want out of a second lienholder positions? Contact Alvernia Capital Management for a free consultation about your options.