This post briefly considers the two main types of loans that borrowers currently offer GROUNDFLOOR investors--senior loans and junior loans--and examines some of the important differences between them and the implications for investors.
A lender will almost certainly put a lien on the property when providing a borrower with a loan. A lien simply means that the lender is establishing a claim on the property and, therefore, the property becomes collateral for the loan. So if the borrower defaults (i.e. in any way violates the terms of his loan agreement), then the lender can foreclose and force the sale of the property in order to recoup her investment.
There are often multiple loans on a single real estate deal, and each of these loans has a different lien priority or repayment priority. Senior loans (or “senior mortgages” or “first mortgage” or “first-lien” debt holders) are in first position (i.e. they have a first lien priority). Junior loans (or “junior mortgages” or “second-lien” debt holders or mezzanine capital) have a lower priority than a first or prior (senior) lender.
In addition to missing a payment, a borrower can trigger a default on the loan if they violate any of the terms of the loan agreement. In the event that a borrower defaults, the lien priority determines the order in which lenders are repaid. In general, senior lenders are always repaid first. It is possible that a borrower could default on a junior loan without defaulting on a senior loan. However, if the value of the property is less than (or equal to) the value of the senior loan, the junior lender will not likely choose to foreclosure since they wouldn’t recover any of their investment--the senior lenders would be paid from the proceeds first and there would be nothing left for the junior lenders.
Needless to say if a borrower defaults and the property is less than the senior loan, then any junior lenders are wiped out (i.e. they lose their investment). Even if the value of the property is more than the senior loan, junior lenders will often lose their investment since senior lenders only need to recover their investment in the case of a foreclosure.
Two other minor notes to consider. The government always gets paid first, so, for example, if there are any tax liens on the property due to unpaid property taxes, then the IRS would get automatic first position over all prior liens. Although junior debt holders may lose their security (or lien) on the property due to a foreclosure, the debt is still owed to these lenders who can take other legal actions in an attempt to recover their investment.
Ultimately, junior loans are, in general, far more risky than senior loans. As we’ve discussed in prior posts, investors should be paid more as an investment's risk increases. One of the primary benefits of investing in real estate is the ability for your investment to be secured by the property (also see our FAQs on secured lending). In the event of a default and a foreclosure, junior loans can become unsecured loans whereas senior lenders are always secured by the property and paid first (except in rare instances where the government has an unpaid claim). Consequently, investors should be compensated for this greater risk when investing in junior loans by requiring a higher interest rate (relative to a senior loan). How much higher? That may be a good topic for a later post, but for now we'd love to hear your thoughts.