As loan qualification requirements become harder to meet, more buyers are looking at owner financing as a source of funds to purchase real estate. This article focuses on transactions in which a seller of real estate is asked to carry a purchase money loan secured by a second lien against the property. The discussion will apply to wraparound loans provided by the seller as well as more traditional second liens.
Sellers asked to carry a purchase money second lien (including wraparound financing See Wraparound Financing Basics) must consider the relationship between a first lien holder and a second lien holder. Under Texas law, a lien holder who is going to foreclose on a real estate lien must give notice of the foreclosure to all parties who are liable on the loan secured by the lien. The holder of the second lien is usually not liable on the first lien (unless the second lien is wraparound financing).
Financial privacy laws cause first lien holders to be hesitant to give any information regarding the status of the first lien note to anyone other than the borrower. Therefore, a second lien holder who is not a borrower on the first lien will usually find it very difficult to determine the status of the first lien note, i.e., whether it is current and if not what may be required to cure a default.
When a first lien is foreclosed on, the title transferred as a result of the foreclosure is generally free and clear of the claims of all junior lien holders including wraparound mortgage holders. Therefore, if the first lien is foreclosed on, the second lien holder is left with an unsecured note. Collecting an unsecured note can be very difficult given the broad nature of Texas laws making assets exempt from seizure.
In the event a second lien holder forecloses on the second lien before a default under the first lien, the second lien holder must again deal with the first lien holder. Often, the first lien documents will contain provisions allowing the first lien holder to accelerate the maturity of the first lien note upon a sale of the property subject to the first lien. The foreclosure of the second lien is such a sale. Therefore, the act of foreclosing on the second lien may give the first lien holder the right to demand payment in full of the first lien note. If such demand is made, the purchaser at the second lien foreclosure will need to obtain funds in a short period of time or suffer a foreclosure by the first lien holder on the recently obtained property.
In addition to these concerns of being in a second lien position, a seller carrying a second lien must also consider all of the issues of carrying any purchase money loan. These issues include the cost of foreclosure, the possibility of the borrower filing bankruptcy and the difficulty of re-selling the property if is reacquired through foreclosure.
Most sellers who carry a note are the holders of only that one note. If that note is defaulted on or becomes uncollectible, one hundred percent of the seller’s loan portfolio is in trouble. There are not other loans to absorb the costs. Sellers should keep this in mind and “price” their loans accordingly. Loans secured by second liens and those made to unqualified or under qualified borrowers are riskier than those secured by first liens and made to well qualified borrowers, therefore, they may justify higher interest rates. It is also important that the purchase and sale contract set out all of the terms and requirements of any note a seller is to carry as that contract is, in essence, a loan commitment.
Holders of wraparound mortgages may be better able to control some of the risks of secondary financing because they are usually borrowers under the first mortgage and have access to information about that loan including notice of a default under the loan. They are also in a better position to insure that payment of the first mortgage is kept current since they are primarily responsible for payment of the loan.