Income Property Financing
What To Do With Your Second Liens, By Tom Henderson
By Tom Henderson
Jun 15, 2005, 01:06

You bought a property, expertly rehabbed it, and sold it for a nifty profit. However, for one reason or another, your buyer did not qualify for the entire amount of the loan, and you had to take back a small 2nd to make the deal go. A small 2nd behind a large 1st is very hard to sell in the open market. The reason is if the first starts going bad, the risk of having to make the 1st current, or pay it off entirely, outweighs the small reward of a 2nd lien. To add to risk, the payments on these notes are generally below $100. Although this might make good walking around money, it is not worth the risk of buying into a second position should the 1st lien go bad. These notes are often referred to as "throw away seconds" or “desperation seconds". When you go into the market place to sell these notes, the note buyers that do not laugh at you, will offer 20% to 30% of face value, and sometimes lower. This is very discouraging, and you wonder, "Can I maximize the value of my second?" The answer is YES!

Techniques that will allow you to get full value for your note, or lower the discount

If you want to minimize the discount, go to the payor and offer to discount the note if they will pay it off within a short period of time, in say one or two months. For example, say you had a $7000 second lien. Note buyers would only offer you $2000 to $3000, if that, to purchase your note. Not wanting that much of a discount, you go to the payor and offer to discount the note $2000 if they would pay the note off early. Because it is such a low amount, often the payors will be able to borrow, or somehow come up with the funds to save $2000 plus interest. It is an easy sell to multiply the number of payments, times the amount of payments to show how much the payor would save. A win/win deal, wouldn’t you agree. You get a maximum value, and the payor gets a discount.

Another technique, this is my favorite, is to trade this note, AT FACE VALUE, for real estate or other personal property. For example, there is a property in pre-foreclosure worth $100,000. The owner has received offers of $50,000. You, however, are going to offer the distressed seller $57,000...$50,000 cash plus $7,000 in your 2nd lien note. This will give the seller the feeling he is receiving $7,000 more for his property. If you had the choice of receiving $50,000 or $50,000 plus a $7,000 note, which would you take?

By using your note as money, you will prevent a hefty discount. This will serve two purposes. Number one, it will give you extra ammunition to offer the distressed seller. Adding your 2nd lien note as a sweetener to the deal is often the deciding factor for the distressed seller to pick your offer over others. However, more importantly, you are able to trade your once worthless note for real estate at FACE VALUE. This same concepts will work with boats, cars, or other personal property where the owner is a don't wanter. There are tax ramifications on this technique and ways to get around them. This will be in a future issue of my NOTE PROFESSOR Newsletter. Look for it. Be sure to check with your attorney and CPA.

Another powerful technique is to use your 2nds as an option. Say you found a property that is a sleeper, but do not have the funds to acquire it at the moment, but you do not want to let this deal get away. Why not assign the payments as a continuing option on the property. Or you could offer the note itself for a longer option. Another method would be to offer the property owner a continuing option by making monthly option payments yourself as option consideration. You could make your option payments to the property owner the same as the payments you receive from your 2nd lien. This is a form of compensating notes. Of course, you will have a problem if your payor quits paying. You would then have to guarantee the payments of the note... notice I said guarantee the payments, not the entire note. There is a big difference. There is a more detailed explanation of this technique in OPTIONS USING NOTES in THE NOTE PROFESSOR NOTEBOOK.

Here is a quickie of what you can do with your "throw away second". Simply give it to charity and take a tax deduction. Many foundations and churches will gladly accept your note as a contribution. Again, check with you tax advisor.

Sometimes you can make that 2nd more marketable, especially if the buyer has put little or nothing down. Ask, and in some cases even demand, the payor put up more collateral, or have others sign on the note. A good example would be a young couple buying their first home. Although they came up with some down payment, there still was not enough to make the deal fly without your taking a small second. Insist they secure your 2nd with other property, have others co sign on the note, or even better, BOTH. Frequently the payors can convince one of their parents to allow your note to be secured by other property the parent own, as well as your property. The parents would then not only sign on the note, but your collateral would be enhanced. As an incentive for the parents to sign on your note, perhaps they could receive 10% ownership in the property. Perhaps one of the parents would even allow your small second be moved entirely to property they own, which could move your 2nd lien into a 1st. Now, not only do you have a marketable 1st lien, but you also have the parents on the note. The parents might very well be in a position to purchase your note at a small discount at some time in the future. You would then receive much more for your note than if you were selling it on the open market.

There is one other strategy you can use on your "throw away" seconds... just do nothing. That is right... do nothing. This is what most do anyway, because they know of nothing else to do. The only difference is they worry about it. If you structured your real estate deal correctly from the start, you already made a profit when you sold your house. The 2nd lien was only icing on the cake. Maybe you miscalculated either on the value of the property, or the amount it would take to rehab your property. As a result, you had to take back a 2nd to get out quickly and minimize your losses. Either way, just sit back. If the payments come in, so much the better. You also have the possibility they will refinance or sell in a short period. But what do you do if the payments quit coming in, and taking the property back is not feasible? Instead of getting all upset and throwing good money after bad, sit back and relax. The $60 or $70 monthly payments are not worth loosing sleep. The time and energy spent worrying, could be channeled into finding and transacting more deals. Just let the foreclosure procedure take its course. Look on the bright side. Someone might bid the price up at the foreclosure auction. Remember that bids over the amount of the 1st lien will go to the 2nd lien holder (That is you !!!!) This will make the blood pressure stay low and keep you from getting ulcers. Just as in any enterprise, you are going to have a certain amount of losses and undesirable things happen. Real estate is no different. Why not just take the small loss and move on?

Whichever technique you use, act out of knowledge, and not out of ignorance or fear. You now know what to do with your seconds. You know that you do not need to throw them away. Keep them, they may have more value than you thought.