Subordinated loans are secondary loans that are paid after all first liens have been paid in the event of a default. Because they are secondary, they often have higher interest rates to offset the higher risk taken by the subordinated lender, as compared to loans from primary lenders.
If there is a first and second mortgage loan on a property, the second mortgage is usually subordinate to the first mortgage. This ranking of debts becomes significant in the event that the borrower defaults or declares bankruptcy. Learn more about how subordination loans work and what it means if you try to refinance.
- Subordinated loans are secondary to any primary loans, meaning they are only paid off after the primary loan is fully paid off, in the case of a default.
- They typically have higher interest rates than primary loans.
- If you have more than one loan against a property, it can be tricky to find a lender who will refinance your primary loan.
What Is a Subordinated Loan?
In the case of default or bankruptcy, subordinated loans are only paid after any primary loans are paid in full. Lenders that offer subordinated loans are aware of the risk they take when offering these loans, so they usually charge a higher interest rate.
This loan subordination is often detailed in a subordination agreement or clause. The purpose of a subordination agreement in a mortgage is to protect the primary lender on the home. This is most often the bank or financial institution that holds the first mortgage. That institution stands to lose the most in the case of default or foreclosure. The subordination clause protects this first lender, and simply assures that the first mortgage holder will be paid if the home goes into foreclosure.
- Alternate name: Junior debt
If a first mortgage is paid off, a second mortgage then becomes the first mortgage.
How a Subordinated Loan Works
In real estate, the mortgage taken out first and used to buy the property is the first mortgage. This primary loan is also called senior debt. If the property, at a later time, has either a home equity loan or home equity line of credit (HELOC) placed on it, that is called junior debt.
The home equity loan, or HELOC, almost always has a higher interest rate than the first mortgage because there is a greater risk that the owner will default, or the chance of foreclosure. If the home goes into foreclosure, the lender that holds the first mortgage will get paid first since it is the senior debt. The lender that holds the HELOC will get paid with what’s left over, since it is the secondary debt. In some cases, there may be nothing left at all to collect.
If the homeowner needs a home equity loan or a HELOC and applies to the same bank or financial institution that made the first mortgage, there is usually no problem with regard to subordination. The home equity loan will automatically be made subordinate to the first mortgage.
Refinancing and Resubordination
If you have a first mortgage plus a HELOC and you want to refinance, then you have to go through the resubordination process. Resubordination is often shortened to just “subordination.” Refinancing is when you take out a new loan, with new terms, and use it to pay off the first loan. It wipes out the old mortgage and puts a new first mortgage in its place. Because the original mortgage loan is no longer there, the HELOC moves into the primary or senior debt position—unless there is a resubordination agreement in place.
The lender that holds the HELOC has to agree that its loan will be second in line with the new first mortgage loan through a resubordination agreement. Most banks and financial institutions will agree to this setup as long as the property holds enough value to cover both loans.
Are There Additional Hurdles?
Since being second in line to collect debt carries more risk, lenders will take extra measures to protect their end of the bargain, such as:
- There will be charges or other fees to pay to cover administrative costs.
- You must be in good standing with your lenders on all of your payments.
- There are limits set on the amount of your total monthly mortgage payments.
When Might a Lender Refuse?
There are two cases when lenders may not agree to resubordinate. The first is if you have a large amount of equity in your home and want to do a cash-out refinancing. This is when you use the equity in your house as collateral to take out a loan for cash. The money you borrow is lumped into the first mortgage, which makes for a larger first debt. When there's more debt to pay, the lender who is second in line to collect assumes the greater risk.
The second instance when you might have a problem getting a resubordination agreement when you refinance a mortgage is when you have little or no equity in your home. In this case, there's not enough value in your claim to the home, and the lender worries that you won’t be able to repay the loan. Again, you pose a greater risk.
Resubordination Issues to Consider
If you wish to refinance your home and you have a HELOC in place, your new lender will insist that the HELOC be resubordinated. The lender of the HELOC that you already have is not required to do this, but most do. If that lender does not agree to fall second in line, you may have to wait and try again once you've built up more equity in your home.
The state of the housing market may also factor in the lender's decision. The lender of the HELOC is going to look at the loan-to-value ratio of both the new first mortgage and the mortgage it holds, combined. If home values are rising, this is less of a problem. If they are falling, this could cause you to hit a bump in the road.
If you have any problems resubordinating your current HELOC, you can try refinancing that loan. Refinancing a second mortgage can be easier than refinancing a primary mortgage.