What Is a Subordinated Loan?
A subordinated loan is paid after all first liens have been paid. If there is a first and second mortgage loan on a property, the second mortgage is usually subordinate to the first mortgage. In the case of foreclosure on the property, the bank or other financial institution that holds the first mortgage is paid first and the financial institution holding the second mortgage is paid second, if there is anything left with which to pay them.
Subordination and Mortgage Loans
In real estate, the mortgage taken out first and used to buy the property is the first mortgage. It 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. It has to carry a higher interest rate to compensate for this additional risk.
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.
What is a Subordination Clause in a Mortgage?
The purpose of a subordinate clause 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.
In times of lower interest rates, homeowners may build up equity in their homes quickly and home equity loans may be more common in order to take out the equity on the home. If a second mortgage is taken out, usually in the form of a home equity loan or HELOC, there is usually a subordinate clause that gives the first mortgage holder priority in case of foreclosure on the property.
If a first mortgage is paid off, a second mortgage then becomes a 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 their loan will be second in line to the new first mortgage loan through a resubordination agreement. Most financial institutions will agree since it is in the best interest of the borrower.
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.
- It’s possible that you won’t be able to consolidate debt or take cash out with the new first mortgage.
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 they hold. 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.