Second-Lien Debt: Definition & Overview
Second-lien debt is borrowed money that must be repaid after a borrower repays first-lien debt. In other words, second-lien creditors are second in line to be repaid if the borrower becomes insolvent and assets are liquidated.
Generally speaking, second-lien debt has a higher interest rate than first-lien debt because it is considered to be more risky. Second-lien debt is typically used by businesses to finance growth or expansion.
Table of Contents
- Second-lien debt is a type of loan that gets prioritized for repayment at a lower ranking than other types of debt if bankruptcy or the liquidation of assets occurs.
- Second-lien debts are often considered to be senior debts, which makes them different compared to junior or unsecured debts.
- Second-lien debt can help borrowers access additional financing, although interest rates are typically higher compared to the first lien.
What Is Second-Lien Debt?
Second-lien debt is a specific type of debt that coincides with senior debt. It relates to payment before acceleration and it also holds the same level of protection and low risks that senior debt has.
Basically, it’s a form of borrowing that happens after a first lien gets put into place. So if a borrower ends up defaulting as the result of asset liquidation or bankruptcy, a second-lien debt would get paid after the first original lienholder is paid off.
To keep things as simple as possible, a second lien becomes the second in line to become repaid if the borrower faces insolvency. This is why second-lien debt observes a lower repayment priority compared to senior secured debt.
How Do Second-Lien Debts Work?
It’s important to first understand that a lien is a legal claim. It’s usually established by a creditor against a specific piece of collateral when someone takes out a debt. For example, homes are often used as collateral when someone takes out a mortgage. Similarly to how a vehicle would get used as collateral when someone takes out an automobile loan.
So, if the borrower somehow isn’t able to meet their financial obligations the lender, or the lienholder, can enforce the lean to ensure the debt can be paid off.
There are various tranches or levels of liens. For example, if a mortgage is taken out, the primary lender is the first lienholder. If a second bank or financial institution issues a second mortgage, they then assume the role of the second lienholder.
If a forced liquidation happens or if there’s a default of debt, debt holders are going to get paid in a specific order. It would start with the first-lien creditors, then the second-lien creditors, followed by any unsecured creditors, and finally any stockholders if there are any.
In most cases, second-lien debt is often considered secured debt. However, it’s worth noting that it will fall below other senior secured ranking debt. In this case, a senior lienholder would end up receiving 100% of the loan balance from the selling of any underlying assets if there isn’t any left to pay the second lienholder.
The second lien holders would only be paid from the leftover amount after the first lien holders are paid.
Risks of Second-Lien Debt
As is the case with any type of debt, there are always going to be some risks associated. But the more you know about the risks beforehand, the more you can do to help mitigate them. With second-lien debt, risks are going to extend to investors, lenders, and borrowers.
Let’s take a closer look at some of the most common risks associated with second-lien debt.
The majority of the time, second-lien debt investors are going to be paid before any stockholders if a company faces insolvency. But if the issuing company ends up becoming insolvent and there aren’t enough assets to repay the junior and senior debts, investors will take the loss.
While everyone involved in second-lien debt faces risks, lenders might face the most. Their main risk is having insufficient collateral if a company defaults or files for bankruptcy. They will usually look into the same financial ratios and factors that a first-lien lender would to and avoid this.
Those financial metrics would typically include things like credit scores, cash flow, and earnings. As well, a borrowed debt-to-income (DTI) ratio is an important metric that can get taken into account for the purchase price.
It shows the percentage of monthly income that is dedicated to paying off their debts. Borrowers who end up having a lower risk of default are going to often receive the most favorable credit terms, including lower interest rates.
To help reduce their risk exposure, second-lien lenders also need to look into how much equity is available compared to the balance that’s owed on any senior debt.
A secondary lien can get used by a borrower to add capital to a company’s balance sheet or to gain access to property equity, for example. When this happens, they’re going to have to provide assets as collateral to secure the second lien.
This poses a risk to the borrower and if they aren’t able to pay off the debt, the lender might start the process of selling the assets to cover the costs.
What Are the Advantages and Disadvantages of a Second Lien?
Like any type of financing, there are always going to be advantages and disadvantages to be aware of. So if you’re looking into a second lien, always weigh the pros and cons to determine the best way forward. That said, here are some of the biggest advantages and disadvantages of a second lien.
- It can be a large loan, meaning you can take out more compared to other types of loans
- There’s usually a good interest rate when considering other kinds of debt, such as credit card debt
- There can be tax deductions in some cases
- You can lose equity in the case of taking out a mortgage on your home
- There can be added fees that you might have to pay when it comes to things like origination fees or credit checks
- It can increase your overall debt burden
Example of Second-Lien Debt
Let’s say that Company A has an outstanding loan on its factory, which is $5 million. A recent assessment of the property shows a market value of roughly $10 million. Essentially, this means that the company has $5 million in equity available.
The first payment priority goes to the outstanding loan of $5 million since it is considered senior debt. Since the bank is the first lienholder, it charges roughly 2% interest on the original loan amount.
However, the Company chooses to take out a second mortgage on its property from a different bank. This bank only offers the Company 50% of the remaining equity, or $2.5 million. The company ends up not being able to repay its debts and begins liquidation. The company will sell the factory for $10 million and will pay off the first lien debt of $5 million leaving $5 million remaining.
A second lien is issued by a creditor against collateral that’s offered by the borrower, usually in the form of an asset. It’s a form of borrowing that can happen after a borrower has taken out the first lien. The second lien would then get utilized if the borrower ends up having to file for bankruptcy or faces asset liquidation.
But it’s important to note that second-lien debt would only get paid after the first original lien holder receives their payment. The second lienholder only ends up receiving what’s left of the loan amount if there isn’t enough money leftover.
Frequently Asked Questions
Simply put, a lien is a type of claim on collateral that’s used to help secure financing that’s offered to a borrower. The first-lien debt that’s issued would end up having the first claim on any collateral, and the second lien would have the second priority claim.
Types of second lien loans are specific types of secured debt. And unlike unsecured debt, a second lien loan benefits from a wide range of potential assets that the borrower can offer as collateral. As well, second lien loans rank behind senior debt ahead of junior debt.
Second-lien debt is able to be subject to a specific amortization schedule. However, there’s usually a bullet payment that’s required once it reaches maturity. Plus, the second lien is often likely to be much later compared to the maturity of senior debt.
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