A junior lien is any loan that does not have first priority in the foreclosure process. This includes second and third loans. While it is true that a tax lien has ultimate priority over the order of liens, a first mortgage is not considered a junior lien, because a junior lien refers to any lien outside a tax lien and first mortgage.
A junior lien requires a borrower to have sufficient equity in their property to take out a second mortgage. Banks typically do not lend on second mortgages with less than 30% equity. There are different kinds of second mortgages. They include home equity loans and equity lines of credit and open end second mortgages (HELOC). In an open-end mortgage, the borrower can cash out to the maximum eligibility requirement as needed. This means they won’t take out the full amount at once but have the ability to take out the maximum eligibility amount at any time. This typically applies to people who are developing property or want to pay down debt.
Junior Lien Specifics
A junior lien typically refers to a second mortgage. The term second mortgage means that the priority of the lien is second in line. If a property that has a second mortgage goes through foreclosure, the junior lien will be paid after the first mortgage because they are a junior lien holder and not a senior loan. If the home does not have sufficient equity to pay down both the senior and junior lien, the second loan might not get paid the full amount, if any.
Junior liens have higher interest rates than first mortgages because they are paid second in the event of a foreclosure. This added risk is the reason why they charge higher interest rates. When a borrower takes out a second mortgage or junior lien, they are adding to the overall principal balance of the mortgage.
Be Careful When Taking on Junior Liens
The higher overall debt causes mortgage payments to increase. Because a second mortgage adds to the principal balance of the borrower, if the property owner decides to sell the property, they will make less money on the sale. The reduced equity of the property after taking on a junior lien can cause some borrower unforeseen circumstances such as not being able to afford mortgage payments, reduced ability to get financing in the future, and the higher potential to lose a property through foreclosure because of the higher payments.
Borrowers should be careful when taking on a second mortgage with the intent of paying off other debt. Even if the other debt has higher interest rates, a second mortgage on a property can cause the borrower to lose their property.
Subordination Agreement, Junior Liens, and Lien Priority
A subordination agreement establishes the order of lien holders and their superiority/inferiority to each other, designating first, second, and third lien holders. In the event that a property forecloses, lien holders will recoup their debts in the order established in the subordination agreement.
In California, courts typically adhere to the “first in time, first is right” rule. This means that they determine lien holder rights based on which lien was first placed on the property. A senior lien holder is the first loan, thereby giving it first lien position.
Priority of Liens
An antimerger clause is a provision in a mortgage contract that states that the senior lien holder has priority over other liens, whether personal or secondary mortgages. In the event an antimerger clause is present and the property is foreclosed, the senior lien holder will be paid first. Any remaining proceeds will be used to pay off junior liens.
Traditional lenders typically do not fund loans in which they are not the senior lien holder. It is common for lenders to initiate a subordinate agreement in order to put themselves as the first lien holder of record. Therefore, it may be advantageous for a property owner to subordinate the position of the liens in order to obtain a loan. Junior lien holders must agree to the proposed subordination, however.
A junior lien holder is the second or third loan, therefore they are considered a secondary loan. Junior lien holders face a precarious situation when trying to recoup their investment from a borrower who defaults on a senior lien. If the senior lien holder decides to foreclose, the sale proceeds go to them first; only if there is leftover money does a junior lien holder get paid. However, the debt is still owed to these junior lien lenders, who can take other legal actions in an attempt to recover their investment.
The problem junior lien holder’s face is that because auction sales can only be paid in cash there are very few capable buyers who purchase the property. This causes the property to be sold at below cost, significantly affecting the junior lien holder’s ability to recoup lost investment.
How a Junior Lien Holder Can Recoup a Debt
It is common for the junior lien holder, if they have the financial means to do so, to pay down the debt of the defaulted borrower to postpone the foreclosure. This postponement of the mortgage gives the junior lien holder time to initiate their own foreclosure process.
A junior loan can make a request for a notice of default to be provided to them. The terms of the default will help the junior lien holder determine the best route to recoup the lost investment. If the junior lien holder is awarded the property in auction, they become full owner of the property unless there are other senior liens ahead of their junior lien. It is therefore advantageous for a lien holder to be among the first loans to ensure their financial interests in the event a property is foreclosed and sold.
Determining Loan Priority
A subordination agreement may also be used to rearrange the order of lien holders for the purpose of designating loan priority. A subordination clause stipulates that a current claim on any debts takes precedence over newer, junior liens. This is commonly used in mortgage contracts.
Conversely, a dragnet clause is a clause in a trust deed that permits future liens to take precedence over other liens by attempting to get as much collateral and money as possible for the lender.
The standard order of lien holders in a subordination agreement are as follows:
Tax liens
Obligatory advances in construction loans
Senior lien holder
Junior lien holders
Unrecorded liens
