There are 9 risk categories associated with investing in trust deeds or becoming a private lender and the one we will be discussing here is the risk associated with senior encumbrances.
A senior encumbrance is a claim against the property that has a higher priority than your investment in the property. Whenever you lend on a property that has a senior encumbrance you need to be concerned about some additional risks associated with those senior encumbrances.
Specifically, if a senior encumbrance is not paid as agreed by the borrower, to protect your investment as a junior lien holder and minimize the potential of loss, you must pay the amounts necessary to cure the default and keep the senior encumbrance in good standing. If you fail to do so, you could lose your entire investment if the senior lien holder forecloses.
So, how do we significantly reduce that risk as a private lender? Well, the first thing that comes to mind is to opt for investments where you are the senior encumbrance. Be cautious when you are presented with an opportunity to invest where you are not the most senior position. Can you be in first position as the most senior lien holder and have someone jump you in line? Usually no, but there are exceptions like property taxes. If your borrower fails to pay property taxes on the property than the county can put a lien on the property and that lien is a priority lien above mortgages. So, even in first position you need to be aware of what can happen and what you will need to do to protect your investment.
It is also important to review senior encumbrances before lending in a junior position since some can include clauses that forbid junior liens completely or insist that the senior encumbrance be paid off entirely if certain conditions are breached.
While there is definitely risk associated with senior encumbrances when investing in trust deeds, often the higher, fixed rate of return still makes these investments very attractive to investors.