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 foreclosure.
Two other minor notes to consider. The government always gets paid first; for example, if there are any tax liens on the property due to unpaid property taxes, then the IRS would get an 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 riskier 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. 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?
What Is a Junior Lien Holder?
A junior lien holder is somebody who has loaned money to a borrower and taken a second position on the property as collateral for the loan. In other words, they're a creditor who ranks below the senior lien holder in the event that the borrower defaults on their loan and the property is foreclosed.
It's important to note that junior lien holders don't always have to take a second position on the property. Sometimes, they may actually be in the first position, but their loan is for a smaller amount of money than the senior lien holder's loan.
How Junior Liens Work
For example, suppose you took out a $500,000 mortgage to purchase a home. You then took out a $50,000 home equity line of credit (HELOC) using your home as collateral. In this case, your mortgage would be considered the senior loan because it was taken out first. Your HELOC would be considered a junior loan because it was taken out second and is subordinate to your mortgage.
If you were to default on both loans and your home was sold for $600,000 at foreclosure, your bank would first use the proceeds to repay your mortgage in full because it's the senior loan. The HELOC lender would only receive $50,000 because it's subordinate to the mortgage—the remaining proceeds would go toward repaying your outstanding balance on the HELOC.
How Junior Lien Holders Differ from Senior Lien Holders
The main difference between junior lien holders and senior lien holders is their position in line when it comes to getting paid back. If a borrower defaults on their loan and the property is foreclosed, the senior lien holder will be first in line to receive any proceeds from the sale of the property. The junior lien holder will only receive their money after the senior lien holder has been paid in full.
This can obviously create some problems if the proceeds from the sale of the property aren't enough to cover both loans. In that case, the junior lien holder may not receive any money at all—or they may only receive a partial payment. That's why it's generally considered to be riskier to lend money to somebody as a junior lien holder than as a senior one.
What Is a Senior Lien Holder?
A senior lien holder is someone who has a superior claim to your property relative to other creditors. In the event of a default, the senior lien holder would be paid before the junior lien holder and unsecured creditors.
The most common type of senior lien holder is a first mortgage lender. If you have a first and second mortgage on your property, the first mortgage lender would be considered the senior lien holder and the second mortgage lender would be considered the junior lien holder.
In the event of a foreclosure, the proceeds from the sale of the property would be used to pay off both mortgages in full; however, if the proceeds from the sale of the property were not enough to cover both mortgages in full, the first mortgage would be paid off before the second mortgage.
What Is an Unsecured Creditor?
An unsecured creditor is someone who does not have a claim on your property. In other words, if you default on your loan, an unsecured creditor would not be entitled to any portion of the proceeds from the sale of your property.
Unsecured creditors are typically paid after all senior and junior lien holders have been paid in full; however, in some cases, unsecured creditors may be paid before junior lien holders if there are not enough funds available to pay all creditors in full.