Second trust deeds, be they home equity loans or closed-end, amortizing mortgages carry a higher interest rate than first trust deeds because of the inherent risk associated with them. Borrowers often ask me what the risk REALLY is because they are smaller and often have good equity positions. Let me demonstrate to you the HUGE risk a lender takes when he takes a second-lien position.
Let's assume that the property was worth $400,000 in 2007 and declined to $300,000 today. The borrower owed $250,000 in 2007 and wanted $100,000 in cash. Two lenders offered solutions:
CalBank wanted to loan $350,000 at 5%, in a first-lien position and Fornia Equities offered a $100,000 second mortgage at 8%. Wasn't that extra interest Fornis Equities earned worth the risk associated with a second mortgage?
If the property goes through foreclosure, and the net proceeds are $300,000 today (forget the foreclosure and sales costs), CalBank would lose $50,000. CalBank would have earned some $52,500 in interest so their net earnings, over the three year period, would have been some $2,500.
Fornia Equities however, would have earned $24,000 in interest but lost $50,000 in principal. They would have suffered a $26,000 loss on a $100,000 investment. Not good.
The leverage associated with the second lien position, in a declining market, accelerates the losses.
To properly analyze this, we must understand that both CalBank and Fornia Equities would have spread the risks over 100 loans or so, First liens are defaulting at around 10% while second mortgages are defaulting at close to 20% today.
CalBank would have lost some $500,000 in principal but collected 5,250,000 in interest. They would have earned a net $4,750,000 on an investment of $35,000,000 or 4,5% annually.
Fornia Equities would have lost $1,000,000 and collected $2,400,000 in interest, from the 100 loans. Fornia would have had to advance another $5,000,000, to "cure" the twenty (defaulted) $250,000 first liens in a foreclosure. They would have lost the use of that money for about 6-8 months. Fornia had to invest a total of $15,000,000 to earn $1,400,000 in interest for an annual return of about 3%. To properly compensate Fornia Equities for the risk, they would have had to earn a net $2,000,000, or $600,000 extra. To achieve that, they should have been charging some 10%.
This is why there is a "spread" of 5-6% between the rate for a first lien and second lien.
If you have a need for a second mortgage, apply online here.
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