What Is Second-Lien Debt?

Second-lien debt refers to a form of borrowing that occurs after a first lien has been put into place. Second-lien debts are paid after the first or original first lienholder is paid off if the borrower defaults and suffers bankruptcy or asset ❀liquidation. They're second in line to be fully repaid in the case of the borrower's insolvency.

This type of debt has a lower repayment priority than other debt that's senior and ranked higher.

Understanding Second-Lien Debt

A lien is a legal claim that's generally established against a piece of 澳洲幸运5官方开奖结果体彩网:collateral by a creditor when a borrower takes out a loan. A home is used as collateral when someone takes out a mortgage and a vehicle is used as collateral for an automobile loan. The lender, also known as the lienholder, can enforce the lien if the borrꦜower doesn't meet their financial obligat♌ions.

Liens can have different tranches or levels. The primary lender in a mortgage is the first lienholder. Another bank that grants a 澳洲幸运5官方开奖结果体彩网:second mortgage assumes the role of the second lienholder. A second-lien debt is subordinate to the collateral pledged to secure a loan.

Debt holders are paid in a designated order when a default of debt or forced liquidation takes ꦺplace:

• First-lien creditors
• Second-lien creditors
• Unsecured creditors
• All others, including stockholders (if any)

The majority of second-lien debt is considered senior. It does fall second to any other senior-ranking debt, however, and it's distinct from unsecured forms of credit and junior or 澳洲幸运5官方开奖结果体彩网:subordinated debt. The latter is any debt that's left after all other debts are paid.

A senior lienholder may receive 100% of the loan balance from the sale of any 澳洲幸运5官方开奖结果体彩网:underlying assets but the second-lien holder may receive only a♏ fraction of the outstanding loan amount if there isn't enough money left over.

Special Considerations

Secondary liens carry more risk for lenders and investors than senior debt due to the subordinated call on the pledged collateral. These loans usually have higher borrowing rates and follow more stringent processes for approval as a result of this elevated risk.

Creditors may foreclose and sell the home if a borrower is in default on a real estate loan with a second mortgage. The distribution of any remaining proceeds goes to the lender on the second mortgage following full payment of the balance of the 澳洲幸运5官方开奖结果体彩网:first mortgage.

Risks of Second-Lien Debt

Many risks are associated with hol꧑ding second-lien debt. They extend to borrowers, lenders🐈, and investors.

Borrowers

Borrowers may use secondary liens to access property equity or to add capital to a company's 澳洲幸运5官方开奖结果体彩网:balance sheet. Pledging assets to secure a second lien also poses a risk to the borrower. The lender may begin procedures to force the sale of the pledged asset should the bo✱rrower stop paying the debt.

The bank can begin a foreclosure process if a homeowner has a second mortgage in default. Foreclosure is a legal process that allows the lender to take control of the property and begin the process of selling the asset. It happens when a borrower can't make full, scheduled 澳洲幸运5官方开奖结果体彩网:principal and interest꧑ payments as outliꦡned in the mortgage contract.

Businesses generally have a wider range of assets to pledge as collateral, including real property, equipment, and their 澳洲幸运5官方开奖结果体彩网:accounts receivables (AR). A business may be at risk of losing assets to liquidation if the second-lien lender forecloses, much like a second mortgage on a home.

Lenders

The primary risk to lenders is insufficient collateral if default or 澳洲幸运5官方开奖结果体彩网:bankruptcy occurs. Second-lien lenders usually assess many of the sam𒉰e factors and financial ratios as first-lien lenders. These financial metrics include:

• 澳洲幸运5官方开奖结果体彩网:Credit scores
• Earnings
• Cash flow

A borrower's 澳洲幸运5官方开奖结果体彩网:debt-to-income (DTI) ratio is also a very important metric because it shows the pe🍌rcentage o💝f monthly income dedicated to paying debts. Borrowers with a low risk of default receive favorable credit terms resulting in lower interest rates.

Second-lien lenders must also determine the amount of equity available in excess of the balance owed on senior🌞 debt. Equity is the difference between the market value of the underlying asset and the ou𓂃tstanding loans on that asset.

There's $1,500,000 in equity remaining if a company has an outstanding $1,000,000 first lien on a building and the structure has an 澳洲幸运5官方开奖结果体彩网:assessed value of $2,500,000. The second-lien lender may appr🎃ove a loan for only a portion of the outstanding equity such as $750,000 or 50%. The first-lien holder may have stipulations on their credit terms that set restrictions about whether the company can take additional debt or a second mortgag🌱e on the building.

Lenders also review the 澳洲幸运5官方开奖结果体彩网:market value of the building, the potential for the underlying asset to lose value, and the cost of 澳洲幸运5官方开奖结果体彩网:liquidation. The size of second liens may be restricted to ensure that the cumulative balance of the outstanding debt is significantly less than the value of the underlying collateral.

Investors

Second-lien debt investors get paid before common stockholders in the event of a company's demise but junior debt has its risks. There aren't enough assets available to repay both the senior and junior debt if the issuing company is 澳洲幸运5官方开奖结果体彩网:insolvent so the second-lien investors incur the loss through the process of liquidation.

澳洲幸运5官方开奖结果体彩网:Junior debt can offer investors a higher interest rate than traditional fixed-rate debt but they should be aware of the financial viability of the issuing company and the likelihood of being repaid.

Results of Defaulting on Loans

Businesses and individuals have credit scores that rank their ability to repay loans. A credit score is a statistical number that evaluates the 澳洲幸运5官方开奖结果体彩网:creditworthiness of a borrower by tak💯ing the borrower's credit history into account.

Their credit score w꧅ill fall if an indi𓆏vidual falls behind in payments or defaults on a loan. Low scores make it harder for these borrowers to borrow at a later day and may impact their ability to secure employment, apartments, and items like cell phones.

A negative credit history for businesses can mean that they'll have difficulty finding buyers for future bonds they may issue unless they offer an elevated coupon rate. Many companies use working capital credit lines for the operation of their businesses. A company might borrow from a 澳洲幸运5官方开奖结果体彩网:line of credit (LOC) to purchase inventory. They p🦩ay off the LOC and begin the process again for the next sales cycle when they receive payment for their fin🔯ished products.

Another result of default for a business is the impact on the company's cash flow. 澳洲幸运5官方开奖结果体彩网:Cash flow is a measure of how much cash a company generates tᩚᩚᩚᩚᩚᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ𒀱ᩚᩚᩚo run its operations and meet its obligations. Cash flow is reduced as a result of higher debt-servicing costs and interest expenses from higher interest rates.

Example of Second-Lien Debt

Here's an example to show how second-lien debt works. Assume Company XYZ has an outstanding loan on one of its truck-producing factories. The loan is approximately $10,000,000. The property's recent assessment gives it a market value of $22,000,000. The company has $12,000,000 in available equity ($22,000,000 - $10,000,000) as a result.

The outstanding loan of $10,000,000 is senior debt and is the first priority to be paid in 💫the event of default or liquidation of the company. The bank charges 2% interest on the $10,000,000 note in return for being the first lienholder.

The company decides to take out a second mortgage or i♊ncur a second lien on the property from another bank. The second bank will only lend 50% of the remaining equity for second-lien debt, however. The company can borrow $6,000,000 as a result.

Now assume a recession occurs, reducing not only the company's income from truck sales but also the value of the property. Either lender may begin liquidation to satisfy the loan should the business not pay its debts. The company has only $5,000,000 in remaining funds after liquidation and the payment of the balance from the first $10,000,000 loan. The second bank can't receive the full amount of the second lien because it's a junior debt.

The Bottom Line

Second-lien debts can be a critical issue when a borrower defaults and suffers liquidation or bankruptcy. Lenders holding second-lien debts receive payment only after the debts ♌of all first-lienholders have been paid. Their loans are nonetheless superior to junior and unsecured debt in the payment hierarchy.

This has various implications for lenders and borrowers alike. Their lesser payment status puts second-lien lenders in the precarious position of not receiving the full amount they’re owed if the borrower can't or doesn't pay. Borrowers can anticipate paying higher interest rates on these types of loans. Investors may see higher interest rates, too, but that’s associated with greater risk.