Second-Lien Debt

What Is Second-Lien Debt?

The term second-lien debt alludes to a form of borrowing that happens once a first lien is put into place. Put essentially, on the off chance that a borrower defaults, any second-lien debt gets compensated after the first or original first lienholder is paid off in the event of bankruptcy of asset liquidation. As such, second-lien is second in line to be fully repaid on account of the borrower's insolvency. Thusly, this type of debt has a lower repayment priority than other debt that is senior and positioned higher.

Seeing Second-Lien Debt

A lien is a legal claim that is generally settled against a piece of collateral by a creditor when a borrower takes out a debt. For example, a house is utilized as collateral when somebody takes out a mortgage and a vehicle is utilized as collateral for an automobile loan. On the off chance that the borrower doesn't meet their financial obligations, the lender (otherwise called the lienholder) can enforce the lien.

Liens can have various tranches or levels. So the primary lender in a mortgage is the first lienholder. Another bank that concedes a second mortgage expects the job of the second lienholder. In that capacity, a second-lien debt is subordinate to the collateral pledged to secure a loan.

In the event that a default of debt or a forced liquidation happens, debt holders get compensated in the following order:

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

The majority of second-lien debt is viewed as senior. In any case, as noted above, it falls second to some other senior positioning debt and is distinct from unsecured forms of credit and junior or subordinated debt. The last option is any debt that is left after any remaining debts are paid.

A senior lienholder may receive 100% of the loan balance from the sale of any underlying assets. Be that as it may, the second-lien holder might receive just a fraction of the outstanding loan amount in the event that there isn't sufficient money left finished.

Special Considerations

Because of the subordinated call on pledged collateral, secondary liens carry more risk for lenders and investors than senior debt. Because of this raised risk, these loans generally have higher borrowing rates and follow more severe processes for endorsement.

For instance, in the event that a borrower is in default of a real estate loan with a second mortgage, creditors might dispossess and sell the home. Following the full payment on the balance of the first mortgage, the distribution of any leftover proceeds goes to the lender on the second mortgage.

Investors in subordinated debt must know about their position in line to receive full repayment of principal on account of insolvency of the underlying business.

Risks of Second-Lien Debt

There are numerous risks associated with holding second-lien debt. Furthermore, the risks stretch out to borrowers, lenders, and investors. We've framed the absolute most common ones below.

Borrowers

Borrowers might utilize secondary liens to access property equity or to add capital to a company's balance sheet. Pledging assets to secure a second lien likewise represents a risk to the borrower. Should the borrower stop paying the debt, that lender might start procedures to force the sale of the pledged asset.

For instance, on the off chance that a homeowner has a second mortgage in default, the bank can start the foreclosure cycle. Foreclosure is a legal cycle that allows the lender to assume command over the property and starts the most common way of selling the asset. It happens when a borrower can't make full, scheduled principal and interest payments as illustrated in the mortgage contract.

Businesses generally have a more extensive scope of assets to pledge as collateral, including real property, equipment, and their accounts receivables (AR). Similar as a second mortgage on a home, a business might be at risk of losing assets to liquidation in the event that the second-lien lender dispossesses.

Lenders

The primary risk to lenders is lacking collateral if default or bankruptcy occurs. Second-lien lenders as a rule evaluate large numbers of similar factors and financial ratios as first-lien lenders. These financial metrics include:

Credit scores
Earnings
Cash flow

A borrower's debt-to-income (DTI) ratio is likewise a vital measurement, as it shows the percentage of month to month income dedicated to paying debts. Borrowers with a low risk of default receive ideal credit terms bringing about lower interest rates.

To moderate risk, second-lien lenders must likewise determine the amount of equity accessible in excess of the balance owed on senior debt. Equity is the difference between the market value of the underlying asset less the outstanding loans on that asset.

For instance, in the event that a company has an outstanding $1,000,000 first-lien on a building, and the structure has a assessed value of $2,500,000, there is $1,500,000 in equity remaining. The second-lien lender might support a loan for just a portion of the outstanding equity, say $750,000 or half. The first-lien holder might have expectations based on their credit conditions that set limitations about whether the company can take extra debt or a second mortgage on the building.

Lenders likewise survey the market value of the building, the potential for the underlying asset to lose value, and the cost of liquidation. The size of second-liens might be restricted to guarantee the cumulative balance of the outstanding debt is altogether not exactly the value of the underlying collateral.

Covenants are ordinarily remembered for credit terms by lenders. They place limitations and diagram specific requirements for the borrower. On the off chance that a business falls behind on payments, loan pledges trigger that could require the sale of assets to pay down the debt.

Investors

Albeit second-lien debt investors get compensated before common stockholders in the event of a company's destruction, junior debt has its risks. On the off chance that the responsible company is insolvent, and through the course of liquidation, there aren't an adequate number of assets accessible to repay both the senior and junior debt, the second lien investors cause the loss.

Junior debt can offer investors a higher interest rate than traditional fixed-rate debt however they should know about the financial viability of the responsible company and the probability of being repaid.

Aftereffects of Defaulting on Loans

The two businesses and individuals have a credit score that positions their ability to repay loans. A credit score is a statistical number that assesses the creditworthiness of a borrower by considering the borrower's credit history.

On the off chance that an individual falls behind in payments or defaults on a loan, their credit score will fall. Low scores make it harder for these borrowers to borrow at a later day and may impact their ability to secure employment, apartments, and things like cell telephones.

For a business, negative credit history can mean they will experience issues finding purchasers of future bonds that they might issue without offering a raised coupon rate. Additionally, many companies utilize working capital credit lines for the operation of their business. For instance, a company could borrow from a line of credit (LOC) to purchase inventory. When they receive payment for their completed products, they pay off the LOC and start the interaction again for the next sales cycle.

One more consequence of default for a business is the impact on the company's cash flow. Cash flow is a measure of how much cash a company generates to run its operations and meet its obligations. Because of higher debt-overhauling costs and interest expenses from higher interest rates, the cash flow is diminished.

Illustration of Second-Lien Debt

Here is a speculative guide to show how second-lien debt functions. Accept Company XYZ has an outstanding loan on one of its truck-creating factories. The loan is roughly $10,000,000 while the property's recent assessment gives it a market value of $22,000,000. Subsequently, the company has $12,000,000 in accessible equity ($22,000,000 - $10,000,000).

The outstanding loan of $10,000,000 is senior debt and is the main goal 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 chooses to require out a second mortgage (or cause a second lien) on the property from another bank. Notwithstanding, the second bank will just loan half of the excess equity for second-lien debt. Accordingly, the company can borrow $6,000,000.

Expect a recession occurs, dropping the company's income from truck sales as well as the value of the property. Should the business not pay its debts, either lender might start liquidation to fulfill the loan. After liquidation and the payment of the balance from the first, $10,000,000 loan, the company has just $5,000,000 in leftover funds. As a junior debt, the second bank can't receive the full amount of the second-lien.

Features

Second-lien debt alludes to loans that are focused on lower than other, higher-positioning debt in the event of bankruptcy and liquidation of assets.
Junior debt can in this manner offer investors a higher interest rate than traditional fixed-rate debt, yet with greater risk.
Second-lien debt can assist a borrower with gaining access to much-required financing, however the risks must be gauged, and interest rates are frequently higher than on the primary lien.
Some second-lien debts are viewed as senior and are not the same as unsecured and junior debt.
In the event of default or forced liquidation, second lienholders just get compensated after first lienholders.

FAQ

How Do Second-Lien Debts Work?

Liens have various levels in light of where the lender falls in line. Second-lien debt is frequently viewed as senior however the lienholder just gets compensated after the first-lien debt is fulfilled. For example, a lender that gives a second mortgage on a buyer's home just gets compensated after the lender of the principal mortgage. Since the proceeds from the sale of the asset(s) are applied to first-lien debt before whatever else, the second-lien debt may not be paid in full.

What Is a Second Lien Mortgage?

A second lien mortgage is a home loan that happens after another mortgage — the first — exists. The lender of a second mortgage turns into the second lienholder against the mortgaged property. On the off chance that the borrower neglects to pay their mortgage and foreclosure happens, the second lender gets compensated solely after the principal lender receives the balance of the outstanding debt.

What Is a Lien?

A lien is a legal claim that is placed on a piece of property and gives the holder a guarantee. Liens are commonly placed on assets, for example, homes and vehicles when somebody applies for a new line of credit. These assets act as collateral where the lien is conceded to the lender. On the off chance that the borrower doesn't pay their loan, the lender can exercise the lien, make a legal move to repossess the property, sell it, and utilize the proceeds to pay off the loan.