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.
