Until this post I have only talked about 1st position notes. From a control standpoint, they are the best investment — you have the right to foreclose on the property. That means you essentially have the right to control the asset and your ownership of the note is the highest priority. Now, consider this: Some investors like the low prices of 2nd position notes as an entry point to note investing. So what exactly is a 2nd position note anyway?
A 2nd position note is subordinate to a 1st position note. That means, to protect your investment in case of a foreclosure, you would need to maintain or satisfy the note of the 1st position note holder. Think about it as a way to play defense on your return. You become the note payer to the 1st position note holder. You could also foreclose on the homeowner (think of a home equity loan) and then you are obligated to either pay the balance of the note to the 1st position note holder or step in the place of the now foreclosed homeowner to make the payments to the 1st position mortgage note holder. Is your head spinning yet?
So what are the benefits of buying a 2nd mortgage?
#1 – Find a 2nd position note that can be bought at a great price and have a detailed understanding of what the remaining balance of the 1st position mortgage is (in case you need to buy them out). Imagine being able to buy a 2nd position mortgage of a $50,000 home equity loan at a great discount. You pay $25,000 for the note on a property that is worth $200,000 and they have a remaining mortgage of $50,000 to the 1st position mortgage. This is a protected investment. If they default to the first position mortgage holder you have the option to pay off their interest and you now control a $200,000 asset. Conversely the 1st position could also buy out your $50,000 loan so they control the asset. They have a higher priority than you do so they get to make the first offer to you and not vice versa.
#2 – The ‘Dream’ Situation: Many investors really love 2nd position notes because of this….. Imagine paying $75,000 (your $25,000 investment, and the $50,000 payoff to the 1st position note holder) for a $200,000 asset. Amazing returns and amazing results! The danger lies in buying a 2nd position note based on the discount purchase price and with no regard for the underlying asset and the debt that has priority above you. If you use the same example above; you buy the $50,000 2nd for $25,000 on a $200,000 property. The problem is the 1st position mortgage is for $205,000. Guess who loses in this situation? Everyone! The homeowner gets foreclosed, the 1st position note holder gets an asset that is worth less than their note, and you as the 2nd get nothing! So do your homework!!! … It can really pay off or really not pay at all.
This brief introduction can be a bit confusing and it’s important to fully understand the pros and cons of investing in these types of notes. If you are just getting started or have questions, it’s always a good idea to consult with someone who understands this kind of transaction. I am always happy to share my experience with investors. Happy Investing!