In a rising interest rate environment, borrowers are not looking to refinance out of the low rates they’ve locked in over the course of the past three to five years. With commercial-property values continuing to move upward, however, borrowers are gaining equity in their portfolios with no viable way of tapping into it.
This is when a second mortgage through a private lender becomes a valuable tool in any commercial mortgage broker’s toolkit. A cash-out refinance often comes with a higher price than a rate-and-term refinance, so it makes sense to look at the blended overall payment amount and take out a second mortgage instead.
A second mortgage with a short term of one to five years can create many opportunities for borrowers who own businesses, or for those who simply want to convert equity into downpayment funds for another investment. In general, however, private-money loans require a different approach to underwriting than their institutional-lender counterparts.
There are six attributes to be considered in regard to the borrower and their property with respect to a second mortgage. In order of importance, these attributes include the following: contributed equity, the location of the property, the property’s condition, the borrower’s ability to repay, their exit strategy and their credit report.
There are several extra steps and considerations when applying for and processing a private-money second mortgage. At the time of the loan submission, it is a good idea to include a copy of the first-mortgage note and the most recent first-mortgage statement. If a lender is taking the added risk of a second-lien position, they will want to know the exact loan terms of the first mortgage they will be subordinate to.
The most recent mortgage statement is important to make available, so the second-mortgage lender can verify the loan balance, interest rate and monthly payment amount of the first mortgage, as well as the senior lender’s contact information in the event they need authorization or verification of any items. In the event of default, the junior lender will be responsible for paying the senior lender until the foreclosure process is completed.
Having all of the information for the first mortgage will assist the junior lender in providing an accurate loan amount and will speed up the approval process. Along with the new deed of trust, the junior lender also will record a document known as a “request for notice,” which requires the county recorder’s office to notify the junior lender if the senior loan goes into default.
Commercial mortgage brokers should view the second-mortgage product through the eyes of an underwriter and ask a key question: Why would the underwriter fail to approve the loan request?
First, take a look at the underlying debt on the first mortgage and compare it to the requested second-mortgage amount. A good rule of thumb is a ratio of 4-to-1 or higher. If the first-mortgage balance is $400,000, for example, it does not usually make sense to grant a second loan of less than $100,000. In this case, a second loan of $100,000 or more would make sense, assuming it falls within the junior lender’s other guidelines.
Take a look at the interest rate on the senior loan. If the rate is high or the senior loan is through a private lender, this will hurt the borrower’s chances of approval. Is the rate fixed or adjustable? Usually, a private lender will only offer a second mortgage in conjunction with a fixed-rate first mortgage. It is too risky to have a loan in a subordinate position when the first mortgage’s interest rate — and its monthly payment — can increase. Additionally, junior lenders don’t want to be exposed to a large monthly payment on the first mortgage in case it goes sour, especially if their own investment is only yielding a small amount.
Identify the escrow or impound account on the first mortgage. This helps a borrower’s chances of approval because the junior lender can see whether taxes and insurance are being paid. Prepayment penalties, especially long-term ones, are viewed as a potential loan-to-value (LTV) increase because the second lender would have to cover that amount if they are forced to repay the senior loan before the penalty period is over.
The original borrowers on the first mortgage must be the same as those on the second loan, unless the first mortgage was formally reassigned. Otherwise, the junior lender risks having to pay the balance of the first loan if the due-on-sale clause is exercised. Also, in regard to acceleration, if the first loan goes into default, an underwriter will ask if it can be reinstated or cured, or if the senior lender can require the loan to be paid in full.
Sometimes a senior loan with modified terms looks better in the eyes of a junior lender, unless there’s a clause that cancels the modification terms if the borrower goes into default again. Any current or past delinquencies on the senior loan gives an underwriter a good idea of previous performance so they can properly assess borrower risk and price the loan accordingly.
All of the previously mentioned underwriting factors are important, and commercial mortgage brokers should think of them from a common-sense point of view of a junior lender. Will the junior lender be able to pay the loan balance of the first mortgage, plus property taxes and insurance, for an undetermined number of months in the event the senior lender had to file a notice of default to recoup its investment because the borrower stopped making payments?
To locate prospective clients and determine whether a second mortgage is in their best interest, reach out to real estate investors, commercial-property owners, small- and medium-size business owners, or just about anyone else who is locked into a strong first mortgage and has a need for cash for business or investment purposes. Once you’ve engaged a client, you can determine if a new cash-out first mortgage or a second mortgage will suit their needs.
Commercial mortgage brokers should view the second-mortgage product through the eyes of an underwriter.
Occupancy plays an important role in determining whether a private lender will approve a second mortgage. Typically, a private lender prefers to lend primarily for business purposes. In the case of bona fide business-purpose loans, a lender also may consider making loans secured by your borrower’s primary residence. You should be careful and use common sense in making this determination because the two loans will have different compliance guidelines.
A self-employed general contractor taking out a $200,000 loan to buy their third fix-and-flip property of the year, for example, makes sense to qualify as a business-purpose loan, but a $200,000 loan to a teacher for their at-home, after-school tutoring business does not make sense. The intent or purpose of a cash-out loan is important in today’s highly regulated lending environment.
Do the math
Once you have copies of a borrower’s first-mortgage note and statement, figure out the interest rate and monthly payment amount that goes toward interest. Next, determine the interest rate and the monthly interest payment for the second mortgage. Add the interest payments together, multiply by 12 (months of the year) and divide by the combined principal amount of the existing first mortgage and the new second mortgage to arrive at the blended interest rate.
You can use the blended interest rate calculation as an effective tool when comparing the costs, interest rates and payment amounts for a cash-out refinance of the borrower’s first mortgage, versus keeping their existing first mortgage intact and adding a second mortgage. Cost is one of the most important factors a borrower considers when they are taking cash out of a property they own. But what is the true cost of the money they are borrowing?
In the case of a second mortgage, the cost is typically much lower than a cash-out refinance of a first mortgage. This is mainly because of the size of the loans: Second mortgages typically cost 1 percent to 2 percent of the loan balance more than a refinanced first mortgage, but because second mortgages usually carry a smaller principal balance, the overall cost can be much lower. The interest rates are generally higher than those of first mortgages, but the same concept applies when you look at the smaller principal balance of the second loan.
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There are many people looking to turn equity into liquidity. Private-money second mortgages are one of the best ways to accomplish this goal under current market conditions. Small-balance second mortgages can create opportunities for larger deals for commercial mortgage brokers and now is the time to take advantage of these products.