Borrowing on equity in a home: It may pay -- if you know the risks

As inflation boosts the equity value tied up in homes, second and sometines third deeds of trust have become popular. Second deed of trust is shorthand terminology for a subordinated, or junior, lien on a house used as collateral for a loan. The transaction involves a homeowner with a substantial equity -- the difference between net market value and the outstanding loan and an investor.

A homeowner may want to raise cash for any of numerous purposes -- funds to send children to college, fix up a house or build an addition.

Borrowing cash against the equity in your home to invest for income can be a risky and uncertain business. Risky, because you may lose the capital invested and still owe the money; uncertain, because few opportunities exist for investing cash with sufficient return to pay back the loan and leave a profit worth the risk.

An investor who understands the risks and rewards can often earn a higher yield on funds lent through junior deeds of trust than on T-bills, money-market certificates, or money-market mutual funds. An investment in junior deeds of trust is akin to these fixed-return investments, because deeds of trust offer no opportunities for appreciation. They represent a fixed-return loan -- with some variations.

Junior deeds of trust, whether second or third, mean that the first mortgage holder retains first claim to any cash realized when a house is sold. After the first lien holder is paid, second and third lien holders are paid in turn.

A deed of trust is similar to a mortgage, but usually affords quicker access to the collateral if the homeowner fails to keep up payments. Rules vary in different states. Before investing in any sort of junior trust deeds, make sure you check with your attorney and that you fully understand your rights.

Junior trust deeds may return 12 to as much as 25 percent yield. Some states , such as Washington, impose a ceiling on interest rates. However, penalties for early repayment can bump up the actual yield to 15 or 16 percent, even in states with interest ceilings. Loans tend to run from 3 to 5 years -- sometines as high as 10 years. Repayments, usually monthly, represent interest only. The principal is paid in full at the end.

Brokers may bring borrowers and lenders together in an organized approach to trust deed lending. Persons with money to lend may contact brokers who advertise, usually in the financial pages of local newspapers. Borrowers with a substantial equity may approach brokers because junior loans may not be available from banks or savings and loans. The broker arranges loans between willing lenders and willing borrowers but takes no part of the security. Brokers may also collect payments and forward them to lenders for a fee. The borrower also pays an up-front fee to the broker for arranging the loan:

Individual loans may also be arranged through classified ads without a broker as intermediary. Reliable brokers will usually check out a borrower's credit and the facts of the first mortgage or deed of trust to ensure that the equity is really there. If you are a lender and deal directly with a borrower, you must check his credit worthiness and the actual equity available as collateral.

A junior deed of trust is filed as a lien against the title, and any previous liens should also be checked. An attorney well versed in real estate law is a must in these transactions.

Junior-deed-of-trust loans may yield substantial returns, but they can be risky and are illiquid. You must consider your funds to be tied up for the term of the loan, as reselling junior trust deed loans can be costly.