Differences Between First & Second Position Loans
It is very important that you, as a real estate investor, know the differences between a first position and a second position loan. That you understand how they each come about, whether or not they are serviced, and what the differences mean to you in regard to your risk tolerance.
A first position loan is just like it sounds; it is the primary loan. This loan is usually the bulk of the money the borrower has on a particular property or project. For example, if the borrower has already purchased a property with cash that they plan to rehab and they need $170,000 for the renovation, then that would be the primary loan. Primary loans can also consist of acquisition and rehab.
A second position loan is a mortgage that is secondary to the first position loan, it is subordinate. Second position loans are typically for much smaller amounts. Second position loans are often in the range of $20,000-50,000.
A big difference between the two loans is that the first position loan has all the legal rights. The first position loan, as the primary creditor, has the right to foreclose if the loan goes into default. They will have first dibs to recoup as much of their loans before any other creditors get a piece of the pie.
In a foreclosure situation, it is only after the first position loan is satisfied that the second position loan has a chance at anything leftover. That is, if there is anything leftover to even go after. The second position loan can initial foreclosure proceedings, but it has to inform the first position lien holder – who can object – especially if they are still getting paid. This will most likely result in the 2nd lien holder getting a deficiency judgment.
As the bulk of the total loan amount on the project, the first position loan carries the most risk. However, the second position loan is not risk-free. While the amount of money is smaller, risk of loss is still present, so you shouldn’t write off risk completely.
Secondary loans are usually one of two different types, gap funding or finishing loans. Gap funding is often sought when borrowers need to find cash for closing. The primary lender is going to want the borrower to have some skin in the game so it’s much less likely that they will walk away from the deal. Often, when the borrower is without a capital partner, they seek a second position loan to close.
Finishing loans come in much later in the project. The project has already started and may have run out of money. As a second position finishing loan, you come in on the back end. For example, the rehab is almost complete, but they need to build a garage or add some additional high-end finishing touches to get the property to the desired value. Most of the project is done but they need a bit extra to make it to the finish line.
Gap funding can carry more risk than finishing loans. With a gap loan, the project hasn’t even started yet. This early in the game, you need to consider the borrower’s track record. What is their history with similar renovation projects? What is their credit history? Do they have any liens? Are they current with their bills? When deciding to do a gap loan, you will have to conduct more due diligence.
Since a finishing loan is much later in the project, there can be less risk. You can inspect the property; you can stop by and see exactly what they have done and how close they are to actually finishing the home. You can speak with their broker to get their opinions regarding how the property compares to similar properties in the area. Due diligence is still required, you just have to consider other factors – including whether the primary lien holder is still being paid and how much “room” is left in the project. Meaning the difference between the expected sales price and the total amount of expenses on the project.
The first and second position loans can both be dispersed at the title company. Although it doesn’t have to occur this way, dispersing the secondary loan at the title company at the same time offers some additional protections. The title company takes extra steps before they close on the primary loan and doing both at the same time ensures that a second loan isn’t closing before the primary.
The title company will issue a title policy that clearly states the primary lender. Epic Impact Investors is a primary lender and we will close at a title company. Title companies also offer other protections like an investigation of the borrower and the seller making sure there are no hidden outstanding debts like tax liens.
Second position loans can be dispersed directly to the borrower without going through a title company. However, there is some risk associated with this method, especially if you don’t know much about the borrower. Every investment carries risk and real estate is no different but dispersing at the title company offers just another layer of protection.
We have discussed Epic Impact Investors’ policies and practices for loan serving in a prior video. We service our own loans, as a primary lender we do all the ongoing maintenance of that loan. Being a local loan servicer is part of our mission because that allows us to build a relationship with the borrower. We can see what is happening with the project and disperse funds based on how much of the project has been completed to make sure the money doesn’t get ahead of the work.
Servicing our own loans, as the primary lender, helps mitigate risk for our investors as well. If the borrower fails to pay, and we are servicing the loan, we are in a better position to step in and work with the borrower. Before putting the loan into default we can contact the borrower to see what is going on. We can open a line of communication to find out what has happened and what could possibly be done to get them back on track.
First positions loans usually have quite a bit of paperwork that comes along with them. Don’t skip over all the paperwork with a second position loan though, protect your investment. Have a mortgage, guarantee, and promissory note signed then have those documents recorded with the County Recorder of Deeds. Having a recorded mortgage on file means you will know when the property is sold. These documents are best prepared by an attorney.
A second position loan will not have the same loan servicing which is one of the reasons Epic Impact Investors prefers to lend only for primary loans. If we are not doing the loan servicing then we won’t have that communication or status updates on the property. Servicing a loan takes time and for that time a fee is charged. As the primary lender, we have a fee of 3% to cover the costs of servicing the loan.
On occasion, we may let our investors know about an opportunity to invest as a secondary lender. However, we are not servicing these loans because that loan did not run through Epic Impact Investors. We are simply informing you about an opportunity and giving you some information so you can decide if it is something you are interested in.
I hope this was helpful and an informative breakdown of the difference between the first and a second position loan. That you now understand what is involved with each and the differences in the risk. Both are very viable ways to invest in real estate provided you understand the conditions and that the associated risk is within your tolerance level.