Why Does Lien Position Matter in Note Investing?

Imagine you’re in a race, but instead of starting at the front, you’re somewhere in the middle or even at the back. The chances of winning, or even finishing, diminish as more obstacles appear in your path.

Mortgage note investing is a lot like this, where your position—known as lien position—determines how likely you are to get paid. But what exactly is lien position, and why is it so crucial for investors?

Understanding Lien Position

When you invest in a mortgage note, you’re essentially buying the right to collect payments on a loan. The lien position indicates the order in which creditors will be paid if the borrower defaults and the property is sold. In simpler terms, it’s your spot in line to get paid.

There are two primary types of lien positions: first position and secondary position.

First Position Liens

A first position lien is like being first in line at a concert. If anything goes wrong—say, the borrower defaults on their loan—the holder of the first position lien gets paid before anyone else.

This lien is typically associated with the primary mortgage on a property. If the property is foreclosed, the proceeds from the sale are used to pay off the first position lien in full before any money goes to other creditors.

For example, let’s say a property sells for $300,000 at a foreclosure auction, but the borrower owes $250,000 on the first mortgage. The first position lienholder receives the full $250,000. If there’s any money left after that (in this case, $50,000), it goes to pay off secondary liens. If there’s not enough money to cover the first lien, those in the secondary position may get nothing.

Secondary Lien Positions

Secondary lien positions are like being second or third in line, and these are usually associated with second mortgages, home equity loans, or lines of credit. Being in a secondary position carries more risk because if the property is foreclosed and the sale proceeds don’t cover the first lien, there may not be enough left to pay the secondary lienholders.

For instance, consider a borrower with a $250,000 first mortgage and a $50,000 second mortgage. If the property sells for $270,000 in foreclosure, the first mortgage is paid off in full, leaving only $20,000 for the second mortgage. The holder of the secondary lien would suffer a loss because they would only recover part of their investment.

Why Lien Position Matters in Investing

Understanding lien position is vital because it directly impacts the risk and return on your investment. Here’s why:

1. Risk Assessment

First position liens are generally safer investments. This is why we prefer to be in first lien position. Since these liens are paid off first, the likelihood of recovering your investment is much higher. Conversely, secondary liens carry more risk because they are subordinate to the first lien.

If the property is underwater (worth less than the amount owed on the first mortgage), secondary lienholders may lose their entire investment.

2. Interest Rates and Returns

Because first position liens are less risky, they typically offer lower interest rates and, therefore, lower returns. On the other hand, secondary liens may offer higher interest rates to compensate for the added risk. New investors must weigh the potential returns against the higher risk of not being paid in full or at all.

3. Due Diligence

Before investing in any mortgage note, it’s crucial to perform thorough due diligence. This means understanding not just the property value and borrower’s creditworthiness but also the existing lien structure. Knowing whether you’re investing in a first or secondary lien will help you better understand the potential risks and rewards.

Real-Life Scenarios

Let’s say you’re considering investing in a note secured by a property valued at $200,000. The borrower has a $150,000 first mortgage and a $40,000 second mortgage. If you’re buying the first mortgage note, your position is relatively secure—unless the property’s value drops significantly.

But if you’re buying the second mortgage note, your investment is riskier, especially if the property’s value declines or if the borrower defaults.

On the other hand, imagine buying a first position lien on a property worth $200,000, with a loan balance of $120,000. Even if the property value falls to $160,000, there’s still enough equity to cover your lien, making it a safer bet.

Becoming a Master Lien-Lord

Lien position might seem like a technical detail, but it’s one of the most critical factors in mortgage note investing. First position liens generally offer more security, while secondary liens present higher risks with the potential for higher returns.

As a new investor, understanding where your investment stands in the lien hierarchy can help you make more informed decisions and ultimately succeed in the world of mortgage note investing. Remember, the position you choose will significantly influence the outcome of your investment.