How do second-lien lenders price risk differently than first-lien lenders in refinancing scenarios?

Hi there,

Welcome to my weekly newsletter. This is approximately a 4-minute read.

In today's newsletter, we’re going to go over how second position lenders price risk differently from first positon lenders.

We are going to go over…

1. Unsecured lender pricing

2. Secured lending price

3. Different criteria of the lending loophole

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Actionable Tips

When a lender prices a loan out, he needs to take into consideration the current debt service.

That means he has to consider how much money you're already paying to your current lender and subtract that from your monthly cashflow.

If there’s no room to lend with 15%(1.15 or more) margin afterwards, then most lenders will stay away from the deal.

Here’s the debt service coverage formula.

Total monthly cashflow(profit) / Total monthly debt service = 1.15 or more

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Unsecured Lending Pricing

This type of lending is a term loan or MCA(Merchant cash advance). Using the formula above, you would need to have room to service 1.25 or more for most lending institutions doing unsecured term loans. For MCA you would just need 1.0 or exactly break even free cashflow to service the debt. Additionally, MCA lenders don’t measure the debt service coverage ratio formula over a year but only over the last 3-6 months typically. Now, as you move down the later to second position of more the same DSCR coverage will apply. However, some lenders will increase their risk appetite and decrease the DSCR needed for a deal by increasing the rates. Regardless, most loans priced after the first will always be slightly more expensive than the previous because as a junior noteholder, they will only be paid back after the former in court.

Secured Lending Pricing

The principle laid out in the former paragraph applies here. You typically will have a higher rate and shorter term loan for a second lien holder. The difference with secured debt is that the DSCR requirement will typically be lower, like 1.15 for an SBA.

Different Criteria Of Lending Loophole

If you were saddled with MCA debt, you probably believe that you would not be able to get unsecured lending. That’s not true though. If you had 700+ credit and went to Chase bank, you could secure 0% interest credit cards up to 250k. That’s because the two underwriters are looking at two very different criteria for lending and Chase(in this example) will completely overlook your debt service coverage ratio.

Also, if your P&L and BS were terrible from different loans, you could still go do a no doc cashout refinance for a real estate you own. Why? Because the no doc loan won’t look at income. Just the asset value and occupancy. 

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