What Is a subordination agreement and why does it matter?

Loan products from financial institutions often offer you the convenience of making a large purchase without needing the entire amount up front. Instead, you're offered the flexibility of making smaller payments until the debt is paid in full, with a little extra interest added to provide the bank with a profit. But what happens if you default on one or more of your obligations?

Falling behind on your loans doesn't make them go away, and a subordination agreement is the loan holder's guarantee they won't be left with nothing. Even if you default on multiple debts, having a subordination agreement enforces the bank's claim to some portion of your assets, like savings accounts and investments.

What is a subordination agreement?

Subordination refers to the ranking of things, so what is a subordination agreement, and what does it have to do with your loans? A subordination agreement lays out the pecking order for your debts, establishing which ones would be given priority in the event you would default. In simpler terms, the subordination lets everyone know who gets paid first, leaving the other debts to share whatever might be left over.

For example, imagine you own a business and you've taken out a loan to cover your first year's operating expenses. After the first year, you're still not making a profit, so you're approved for a second, smaller loan from a different bank. Often, the initial lending bank would include a subordination agreement to give priority to the original loan for the operating expenses.

If your business files for bankruptcy and you default on these loans, any business assets that have value, such as bank accounts or equipment, will be liquidated for cash. Once the final amount is determined, the money generated would first go toward paying off the original loan. Any funds remaining would go toward the balance of the second loan, so if there isn't enough to cover them both, the second loan isn't paid in full.

Why is subordination important?

Subordination is automatic in real estate transactions, making it an important part of the lending process when you buy a home. By default, your primary mortgage is set at the top of the repayment food chain, and any additional loans are given priority in the order they were taken out. This means opening a home equity line of credit (HELOC), commonly referred to as a second mortgage, would create a secondary lien to protect the interest of the original loan.

A mortgage default often results in the sale of the home, and any amounts recovered from this transaction would go to the original loan first. Secondary debts, like the HELOC or second mortgage, end up with whatever is left over. It's important to note that the balances left on these liens would still be owed by the borrower.

Since the primary loan on a subordination agreement has the best chance of recovering money in default, banks consider secondary loans to be riskier. This is why the interest rates on a second mortgage or HELOC are often higher than what you're offered on a first mortgage. Sometimes the bank increases the rate on the second loan to make up for the extra risk being taken on the first loan.

Subordination: real estate refinance

When it comes to lien subordination, real estate lending relies on them heavily, but this becomes extra important when you decide to refinance. Since subordination in real estate goes in order, refinancing can change the structure of this layout when there's already a secondary lien. Drafting a subordination agreement can prevent this.

Refinancing your home pays off your original mortgage, eliminates the primary lien, and creates a new loan. If you already have a HELOC in place, it would move into the primary lien position and hold repayment priority. That would leave the new mortgage in the back of the repayment bus, and that's not something banks are comfortable with.

To prevent this, banks will require a subordination agreement that designates the new financing as the primary lien. This ensures the large loan provided to finance the purchase of the home is always in the best position for repayment if you should default.

Navigating lien subordination

In many cases, lien subordination is enacted automatically, giving preference to the first claim established on an asset. However, this can get tricky over time as additional loans are added, making it less clear who has the priority should you default. If you've taken out multiple loans using the same asset as collateral, there's a good chance a subordination agreement was put in place.

If multiple loans that share collateral are taken from the same lender, the subordination agreement was likely created in-house to establish the primary lien. If more than one bank is involved, the holder of the primary lien must sign a subordination agreement to transfer priority to a lien from another bank. This is common when refinancing is done through a different lender than the bank holding the original mortgage.

Involving two different banks in this process could lead to delays in finalizing the loan, as extra time is needed to draft and sign the lien subordination agreement.

Sometimes there are fees that are assessed with this process, so be sure to ask about these upfront so there are no surprises. Also, be prepared to temporarily lose access to your HELOC funds until the agreement is signed and the new loan is financed.

What does this mean for you?

If you're concerned about the possible need for a subordination agreement, don't be. It's generally handled between financial institutions and is a common practice, so it isn't likely to torpedo your refinancing plans. In fact, it's likely you wouldn't even know it was a factor unless told directly or asked to pay a subordination fee.

For most people, subordination agreements have little impact on their lives. Even if you were to default on a mortgage, subordination doesn't change the total amount you owe and only lets the banks know who gets paid first.