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 of Second Lien Debt 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.
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.