Advantages of Secondary Mortgage Financing

The secondary loans are subordinated to the first mortgage, hence the term secondary. Examples of secondary financing include second mortages, seller financing, and wraparound mortgages. Secondary mortgage financing can help property investors enhance returns, if used appropriately:

1) It can help property investors reduce equity requirements. Secondary financing may make feasible property investments that otherwise may not be feasible simply because the investor does not have equity capital required for the transaction without using secondary financing. For example, consider the case that the investor can get a first mortgage no higher than 70% of the value and his/her equity capital can cover only 10% of the acquisition price. In such a case the investor needs there is a gap of 20% that needs to be financed with secondary financing for the deal to go through. One choice is to use a second mortgage, but this option has a very high financing cost (interest rate) because is considerably more risky for the lender.

Another option for the investor is to try to convince the seller to provide financing for the remaining 20% of the price, at better terms than the investor would get a second loan from the bank. In other words, the investor may convince the seller to provide the second mortgage loan, in exchange of monthly installments based on an agreed interest rate and term. The wraparound mortgage can help the investor avoid dealing with the existing lender, if there is an existing loan. In the case of the wraparound mortgage, the seller accepts a mortgage for the amount of the remaining balance of the first loan plus the additional amount needed that would add up to agreed price with the buyer minus the agreed equity to be paid by the investor. The seller gets a monthly payment from the investor part of which is used to pay the lender of the first mortgage. The remaining amount from the payment made on the wraparound mortgage is pocketed by the seller as repayment for the loan made to the buyer to cover the gap between the remaining balance of the first loan and the equity put by the investor.

2) By lowering the equity put by the investor in the deal, secondary mortgage financing can help enhance investor returns, or equivalently result in positive leverage, under certain conditions. The basic condition that needs to be met in order to achieve higher investment returns when borrowed funds are used instead of investor equity, it is that the cost of financing is lower than the return the investment can produce without using borrowed funds. Within this context, property investors should avoid in general using secondary financing if it results in negative leverage (reduces investment returns).

3) Secondary mortgage financing, if obtained at terms better than those prevailing in the marketplace can enhance property value and help the investor resell the property at a higher price.




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