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 compared to 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 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 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 sometimes make it difficult to 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 understand that this is inherently more risky, so they usually charge a higher interest rate for these loans.
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—usually, the financial institution holding the first mortgage. That institution will lose the most in the case of foreclosure. The subordination clause simply guarantees that the first mortgage holder will be paid first 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 of the possibility of foreclosure. If the home goes into foreclosure, the financial institution that holds the first mortgage will get paid first since it is senior. The financial institution that holds the home equity loan or HELOC will get paid with what’s left over, if anything.
If the homeowner needs a home equity loan or a HELOC and applies to the same financial institution that made the first mortgage, there is usually no problem with regard to subordination. The home equity loan is automatically made subordinate to the first mortgage.
Refinancing and Resubordination
If you have a first mortgage plus a home equity loan or HELOC and you want to refinance, then you have to go through the resubordination process. Resubordination is often shortened to just “subordination.” If you refinance, you pay off your first mortgage and put a new first mortgage in its place. Because the original mortgage loan is no longer there, the home equity loan or HELOC moves into the primary or senior debt position unless a resubordination agreement is in place.
The financial institution holding the home equity loan or HELOC has to agree that its loan will be second in line to the new first mortgage loan through a resubordination agreement. Most financial institutions will agree as long as the property holds enough value to cover both loans.
There are usually some requirements before a lender will agree to a resubordination agreement:
- There will be administrative charges to pay.
- You have to be in good standing with your lenders on your payments.
- There are limits on your total mortgage payments.
There are two instances where financial institutions 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 type of refinancing involves taking a large amount of cash out of the equity of the house and borrowing a larger amount of money for the first mortgage.
The second instance where 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, the lender worries that you won’t have the ability to repay the loan.
Resubordination Issues to Consider
If you refinance your home and you have a home equity loan or HELOC in place, your new lender will insist that the home equity loan or HELOC be resubordinated. The lender of the home equity loan or HELOC that you already have is not required to do this, but most do. If that lender refuses, you may have to wait to refinance until you build up more equity in your home to refinance.
The lender of the home equity loan or HELOC is going to look at the combined loan-to-value ratio of both the new first mortgage and the mortgage it holds. 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 existing home equity loan or HELOC, you can try refinancing that loan. Refinancing a second mortgage is much less difficult than refinancing the primary mortgage.