What is 'Second Lien Debt'

Second lien debt refers to loans that are reimbursed only after loan balances on senior debts are repaid in full following a default. Due to the subordinated claim on assets, if a borrower defaults on a secured loan, the senior lien holder may receive 100% on the loan balance from the sale of the underlying collateral, while the second lien holder receives only a fraction of the loan amount on the subordinated debt.

BREAKING DOWN 'Second Lien Debt'

For example, in a real estate loan where a borrower in default also has a second mortgage, creditors can foreclose and sell the home, followed by full payment on the balance of the first mortgage and the distribution of any remaining proceeds to the lender on the second mortgage.

Second lien debt has a subordinated claim to collateral pledged to secure a loan. In a forced liquidation, a second lien may receive proceeds from the sale of the assets pledged to secure the loan, but only after senior debt holders have been paid. Due to the subordinated call on pledged collateral, second liens carry more risk for lenders than senior loans. As a result of the elevated risk, these loans usually have higher borrowing rates and more stringent processes for approval than senior debt.

Risks to Lenders

The primary risk to lenders posed by second lien mortgages is insufficient collateral in the event of a default or a bankruptcy filing. In the application process, second lien lenders usually assess many of the same factors as first lien lenders, including borrowers' debt-to-income ratios, credit scores and employment history. Generally speaking, borrowers perceived to pose low risk for default can be approved for larger loans that may exceed the value of the underlying asset.

To mitigate risk with less creditworthy borrowers, second lien lenders must also determine the amount of equity in excess of the balance owed on senior debt. This calculation usually includes variables such as the cost of liquidation and the potential for the underlying asset to lose value. In these circumstances, lenders may restrict the size of second liens to ensure the balance of cumulative loans is significantly less than the value of the underlying collateral.

Borrower Risks

Pledging assets to secure a second lien also poses risks to borrowers. Whether this type of debt is being used to access equity in a home or to add capital to a business's balance sheet, a lender can start the process of selling pledged assets in the event of a default on a second lien. For homeowners with a second mortgage in default, a lender's process to liquidate and recover the balance of loan may result in foreclosure. Businesses generally have a wider range of assets to pledge as collateral, including real property, equipment or accounts receivable. Much like a second mortgage on a home, a business may be at risk of losing assets to liquidation if the second lien lender forecloses.

RELATED TERMS
  1. Lien

    The legal right of a creditor to sell the collateral property ...
  2. Blanket Lien

    A lien that gives the right to seize, in the event of nonpayment, ...
  3. Property Lien

    A property lien is a legal claim on a tract of real estate granting ...
  4. Secured Creditor

    Any creditor or lender that takes collateral for the extension ...
  5. Collateral

    Property or other assets that a borrower offers a lender to secure ...
  6. Silent Automatic Lien

    A lien that does not appear in any public record. This is a method ...
Related Articles
  1. Personal Finance

    What Is Collateral?

    Collateral is property or other assets that a borrower offers a lender to secure a loan. If the borrower stops making the promised loan payments, the lender can seize the collateral to recoup ...
  2. Personal Finance

    What Does a Lender Do?

    A lender provides funds to another with the expectation those funds will be repaid with interest.
  3. Personal Finance

    Explaining Non-Recourse Debt

    Non-recourse debt limits a lender as to what it can and cannot pursue for collateral.
  4. Investing

    What are the Five C's of Credit?

    The five C’s of credit are what banks and other lenders evaluate about a potential borrower when making a lending decision. The five C’s are Character, Capacity, Capital, Collateral and Conditions. ...
  5. Investing

    Financing Basics For First-time Homebuyers

    If you're looking to get your first mortgage, there are many financing options available.
  6. Personal Finance

    What Is A Mortgage?

    A mortgage is a loan used to purchase a home, where the property serves as the borrower's collateral.
  7. Personal Finance

    What Happens in a Default?

    Borrowers are in default when they don’t honor a debt, whether their failure is intentional or not.
  8. Retirement

    Retirement Planning for Entrepreneurs and Small Businesses

    If your business has receiveables, here's a smart way to leverage them to build up your retirement fund fast.
  9. Personal Finance

    Mortgage vs. Home-Equity Loan: How They Differ

    Mortgages and home-equity loans both use the borrower's home value as collateral.
  10. Personal Finance

    Car Title Loan Requirements

    Here's a list of what you need to qualify for a car title loan. Most important: having sole ownership of your car with no liens.
RELATED FAQS
  1. What types of liens are seen as good and which are bad for my credit?

    Understand what a lien is and what types of liens are most common for individuals, and learn which types of liens are good ... Read Answer >>
  2. How do I avoid a tax lien on my property?

    Find out the best way to prevent the government from placing a lien on your property, including the consequences of having ... Read Answer >>
  3. What is the difference between a possessory and a non-possessory lien?

    Gain a basic understanding of a possessory lien and a non-possessory lien, the key differences between the two structures ... Read Answer >>
  4. What are the main categories of debt?

    Learn about the different types of debt available for consumers including secured debt, unsecured debt, revolving debt and ... Read Answer >>
Hot Definitions
  1. Trumpcare

    The American Health Care Act, also known as Trumpcare and Ryancare, is the Republican proposal to replace Obamacare.
  2. Free Carrier - FCA

    A trade term requiring the seller to deliver goods to a named airport, terminal, or other place where the carrier operates. ...
  3. Portable Alpha

    A strategy in which portfolio managers separate alpha from beta by investing in securities that differ from the market index ...
  4. Run Rate

    1. How the financial performance of a company would look if you were to extrapolate current results out over a certain period ...
  5. Hard Fork

    A hard fork (or sometimes hardfork) is a radical change to the protocol that makes previously invalid blocks/transactions ...
  6. Interest Rate Risk

    The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between ...
Trading Center