What is Premium for Tax Lien Certificates?
Premium is an amount over and above the tax lien certificate
amount that the investor will pay to the municipality to acquire
the lien. When premium is paid for a lien, it is not the lowest
interest rate that is bid that wins the lien, but rather the
highest premium. Premium is not bid in all states that sell
liens. In some states the interest rate is bid down and the lien
is sold to the investor who bids the lowest percent interest. In
other states the interest rate is kept constant while premium is
bid for the lien, thus lowering your return on the lien (since
in most states no interest is paid on premium).
Every state has its own rules regarding bidding and whether or
not premium is bid. New Jersey is unusual in that the interest
rate is bid down and once the interest is bid down to 0%,
premium is then bid. This means that the investor is getting no
interest on the certificate amount or the premium, significantly
lowering the returns on this investment. The only interest made
in this case is the interest paid on the subsequent taxes, which
in New Jersey is 18% for lien amounts over $1500.00.
In New Jersey the municipality holds the premium and if the lien
is not redeemed within a 5-year period, that money is not
returned to the investor. Of course the investor can start
foreclosure proceedings after 2 years, but if the property is
foreclosed on, the investor does not get his premium back. He
can get the property, but the premium will be forfeited and
considered part of the cost of the property. Rules about when
and if premium is paid back to the investor and whether or not
interest is paid on premium bid is different for every state.
Why does this happen?
At almost every tax lien sale that I attend, there is a local
investor, new to tax lien investing, who is confused and wants
to know what is going on. Why would anyone want to buy a lien,
pay more than the lien amount and not get any interest on their
initial investment? They assume that investors do this in hope
of being able to foreclose on the property.
The real reason that tax lien investors pay premium is that once
you are the lien holder, you then have the ability to pay the
subsequent taxes. In New Jersey you can earn from 8-18% on the
subsequent taxes depending on how much is owed. For amounts owed
over $1500.00 the interest rate is 18%, for anything under
$1500.00, the interest rate is 8%. Also as long as the lien is
redeemed after the certificate is issued, even though you didn't
get the certificate amount at an interest rate, there is an
additional redemption penalty that is paid to the lien holder.
The redemption penalty in New Jersey is 2% for certificate
amounts from $200.00 - $4,999.99, 4% for certificate amounts
from $5,000.00 - 9,999.99, and 6% for certificate amounts of
$10,000.00 or more. The homeowner must pay this penalty when
he/she redeems the lien, and the penalty is only on the
certificate amount, not on any subsequent taxes that the
lien-holder has paid. Each state also has different penalties
that may be applied in addition to the interest amount on the
lien.
In addition to all of this, some municipalities in New Jersey
have an additional year-end penalty for overdue taxes in excess
of $10,000. A penalty of 6% is added for amounts due over
$10,000.00 at the end of the year. This penalty only applies to
the subsequent taxes. So, if you are a lien holder and you've
paid over 10,000.00 in subsequent taxes, at the end of the year
the homeowner will have to pay you back at 24%, should he redeem
the lien, plus you will get the redemption penalty on the
certificate amount of your lien.
A Simplified Example
Let's look at a somewhat simplified example: Let's say you go to
a sale and purchase and a $5,000 lien on a property with annual
taxes of $10,000.00 (not unusual in some municipalities in New
Jersey) and you bid $10,000 premium. You pay the municipality
$15,000.00 (lien amount + premium) on the day of the sale. The
sale happens to be held in December 1st and last years
delinquent taxes are being sold. On December 11th you pay the
current year's taxes of $10,000.00. And let's assume that the
lien is redeemed December 11th of the following year and that
you didn't pay any more of the subsequent taxes. In order to
redeem the lien, the property owner must pay the certificate
amount plus the redemption penalty and the subsequent tax amount
at 24%. That's $5,000(lien amount) + $200(4% redemption penalty)
+ $10,000.00(subsequent taxes) + $2400.00(24% of subs) =
$17,600. The municipality has to give you back your premium of
$10,000.00. You collect $27,600.00. Your initial investment was
25,000.00. You have a total profit of $2,600.00 for a yield of
10.4%. This is a simplified example. Your actual yield will be a
little higher if you continue to pay the subsequent taxes until
the lien is redeemed.