Second Mortgage Financing and Property InvestingThe example discussed in the previous section (in the book Real Estate Investing for Double-Digit Returns) demonstrated that when there is positive leverage, the smaller the amount of the investor’s money (equity) used to acquire the property, the more dramatic the investor’s benefit in terms of total return (on a before-tax basis). The immediate question that comes to mind is whether the investor can finance 100% of the purchase with borrowed funds, thus using none of his/her own money. This can be done by using a second loan (second mortgage financing) to finance the down payment. The investor can use the same property as collateral for the second loan, but in this case, the lender will require a considerably higher interest rate. In such a case, the use of borrowed funds may result in negative leverage, that is, losses as opposed to gains.
Purchase Price = $300,000 The above calculations demonstrate that the use of second mortgage financing at a high rate leaves the owner with a very small positive net cash flow of $174, which does not provide any benefit to the owner for getting so heavily indebted. Furthermore, the borrower’s risk increases exponentially since, at the event of even a minimal decline in property income, NOI will not be sufficient to cover the loan payment. Unless the investor can secure a second mortgage at a significantly lower rate, which is unlikely, second mortgage financing makes the deal quite risky. Although the case presented is just an example, it reveals the typical problem with using a second mortgage on the property bought, which is the drain on NOI.
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