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In a NutshellSubordination agreements assign the order of priority to who can collect on a debt and when they can collect. They come into play when borrowers default on their mortgage or declare bankruptcy. There are often subordination agreements for second mortgages or home loan refinancing.
Whether you’re taking out a new loan or refinancing your house, your lender might have mentioned the need for a subordination agreement. Subordination agreements usually only come into play if you default on your loan (like a mortgage) or if you declare bankruptcy.
Generally, subordination agreements assign the order of priority to who can collect on a debt and when they can collect. If you’re considering taking out a loan, especially a second mortgage, you’ll want to understand how these agreements work.
Subordination agreements are legal documents that assign which debt holders get paid first for purposes of repayment. They’re generally applied when one of two things happens: a debtor either defaults on a secured loan, or they declare bankruptcy.
When a debtor defaults on a secured loan, like a mortgage loan, the subordination agreement determines who gets paid from the sale of the asset that secured the loan. In the case of a mortgage, the agreement determines who gets paid first from the sale of the house. This is possible because lenders have liens on the asset. The lien position determines which lien holder gets paid first.
Similarly, when a debtor declares bankruptcy, all of their assets are liquidated, meaning they’re sold to obtain money to pay debt holders. The subordination agreement determines who gets paid first from the liquidation of these assets.
Subordination agreements prioritize debts as senior debts and junior debts. Junior debts are subordinated debts, meaning they have lower priority than other debts. A senior debt is a debt a borrower owes to their primary lender. Legally, senior debts must be paid back first before any junior debts.
Subordinated debts are considered riskier for lenders since they don't have priority. If a foreclosure on a mortgage, a bankruptcy, or a liquidation of assets doesn't produce enough money to pay all lenders back, the lower priority debt holders may receive little or no repayment. To offset the increased risk, lenders usually require higher interest rates, origination fees, and other fees on loans considered junior to other debts.
A common example of a junior debt is when a borrower takes out a second mortgage on their home, often as a line of credit. To do this, the borrower uses their home equity to secure the second mortgage. The original mortgage is senior to the second because it was taken out first. If the borrower were to default, then the lender who holds the first mortgage must be paid first.