Everything You Need to Know About Lien Positions and Seller Financing Transactions
Have you heard the term “lien position” or “lienholder”? This article sheds light on lien positions and why they’re crucial as you consider seller financing .
To understand what a lien position is, let’s start with some background on how a mortgage transaction works.
Most people who buy a first home have not saved enough money needed to pay cash for the property. Even if they had, it wouldn’t make much financial sense to sock the entire $200,000 in cash into a home.
When interest rates are 4%, and the stock market is returning 10%, you make better returns on investment by borrowing money to buy a house, and realizing a net 6% return on your cash.
Since most first-time buyers don’t have that kind of money, they turn to institutional mortgage lenders.
Mortgage lenders lend large sums of money to borrowers to receive a return on their investment from the interest they charge. Mortgage loans are backed by collateral, so if a borrower defaults, the lender can foreclose on the property and resell it.
A lienholder is a lender who is owed money and holds a claim on real property.
For example, the bank that lent money to buy real estate is the first lienholder. If the buyer defaults, the lienholder position signifies the bank’s legal standing to recover money from their investment.
The primary lender on a home is usually the first lienholder. That’s because they are the first entity to lend money to a buyer to buy a property. The 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. If the borrower continues to borrow money, subsequent lenders are in the third, fourth and so on lien positions – all in the order of when the lien was recorded.
When might there be a second lienholder? One example is when 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” since it makes them less likely to walk away from payments later on.
The idea is that any borrower who’s put $20,000 of their own money down will hesitate to walk away from a mortgage. Why? Because they’d lose $20,000.
But, if a buyer doesn’t have money for a down payment, they may need to borrow.
When this happens, the second lender – a bank, family member, or the seller of the property – takes a second lienholder position. The second lienholder has legal recourse to try to recoup their money should the borrower default – but they’re second in line.
What About Home-Equity Loans Against the Property?
Equity is the difference between what someone owes on a mortgage loan and the value of a 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, now the buyer has $30,000 in equity. The owner can borrow that amount, if needed. The lender provides a home equity loan and takes a lienholder position.
If a borrower does a significant renovation on a home, the building contractor may take out a lien temporarily, to get a guarantee they’ll be paid in full for their work.
If the borrower has a tax debt, the taxing authority may take out a lien position as well.
How Can Lien Positions be Changed?
Factors That Allow Lien Positions to Change
As noted above, lien position is determined by seniority. When the lien is recorded determines the lienholder position. But lien positions can change.
For example, let’s say a borrower has a first mortgage on their loan and a second home equity loan. If they refinance the first mortgage to get a lower 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, which usually is not 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 bother?
Usually, 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 risk. 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 a property owner agrees to sell a property to a buyer and carry the mortgage in place of a traditional bank. Seller financing can be relatively simple or more complicated.
Scenario #1 – Seller Finances the Entire Loan Amount
In its simplest form, a seller who owns a property outright agrees to provide full financing for a buyer. The buyer gives the seller a down payment, then makes monthly principal and interest payments to the seller for a period of time.
In this case, the seller holds a first lien position on the mortgage.
However, the transaction gets more complicated if a buyer finances some costs through traditional lenders and others through the seller.
Scenario #2 – Seller Agrees to Finance a Portion of the Loan
Suppose a seller wants to sell their home for $200,000, but they still owe $100,000 on it.
A potential buyer can secure a traditional mortgage, but the bank is only willing to lend $160,000. To get the house sold in a weak market, the seller may agree to finance the remaining $40,000, taking a second lien position.
In this situation, the seller receives $160,000 at closing from the buyer’s lender. Then $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, plus a second loan to the seller for the remaining $40,000.
If the buyer stops making payments and triggers a foreclosure, it’s dangerous. The bank is first in line to receive any proceeds from the foreclosure. The seller may end up losing some (or all) of their $40,000.
Another danger is if the buyer pays only the first lienholder. The seller’s only recourse to capture the money they’re owed is to initiate foreclosure proceedings.
But, they can’t foreclose 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 likely don’t have enough money.
So they may lose whatever portion of the original $40,000 loan hasn’t been paid.
Protect Yourself Against the Pitfalls of Second Lien Positions
If you consider offering seller financing for a portion of a home’s purchase price, it’s crucial to perform due diligence. You may want to set a higher interest rate on the loan to help mitigate your risk.
Even a comprehensive examination of a buyer’s credit and employment history can’t guarantee protection for a seller. But, it’s an important step to safeguard your assets.
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