Subordination clauses are important for lenders because they determine which creditor gets paid first after a sale, foreclosure, or liquidation. A subordination clause can affect mortgage rates, additional mortgage loans, and other debt payouts.
Definition and Example of a Subordination Clause
In real estate, a subordination clause is the legal language establishing which lender gets paid first if a home goes into foreclosure. It most commonly appears in mortgage agreements and comes into play when a borrower refinances their home or takes out a home equity loan or a home equity line of credit (HELOC). There usually isn’t enough equity or money to pay off multiple loans, so a subordination clause establishes a lien hierarchy determining which lender gets paid first.
Essentially, the first or original mortgage is senior to any other agreements that come after it. Once it is paid off, the second lien automatically moves up to the first priority.
- Alternate name: Subordination agreement
For instance, say you buy a home with a mortgage. Later, you add a home equity line of credit (HELOC). Due to a subordination clause likely located in your original mortgage contract, your first mortgage ranks as the first priority or lien. Therefore, the HELOC is in the second position and is considered the subordinate mortgage.
How Does a Subordination Clause Work?
Subordination clauses are present in standard U.S. mortgage templates. However, a subordination clause is not a consideration until a second mortgage, or junior lien, is established, so the clause wouldn’t take effect until a borrower refinances their home or takes out a home equity loan or HELOC.
If you sell your home or go into foreclosure, the subordinate clause states that the lender in the first position must be paid in full before the lender in the second position sees a dime.
The subordinate lender only receives money once everyone in front of it in line has been paid in full.
Continuing with the above example, if you have a mortgage and a HELOC on your home, the original mortgage will be the first lien holder, and the HELOC will rank in the second position. If your home falls into foreclosure, the subordinate clause ensures that any money received from the sale will first go toward paying off the original loan in full. Any remaining money will go toward paying off the HELOC after that. If you have a third lien, it won’t receive any payment until the second lien has been paid in full.
There’s no guarantee that the second or third lender will receive any money, which means those lenders are at risk for losses. That’s another reason subordination clauses are important: They help lenders evaluate and estimate potential risk when approving loans.
How Subordination Clauses Affect Borrowers
While subordination clauses typically are for lenders, they do have an impact on borrowers.
“Subordination clauses don't affect borrowers directly. However, because they affect lender risk, borrowers are affected indirectly, often in the form of higher mortgage rates,” Dan Green, founder and CEO of Austin-based mortgage company Homebuyer.com, told The Balance by email.
Green said that lenders could charge higher mortgage rates to compensate for the risk of not getting paid off in a sale. Borrowers may see higher mortgage rates on subordinate liens when home prices are declining or if they have lower credit scores. In contrast, borrowers with higher credit scores during an improving market may be less affected.
In addition, Green said it’s important to remember that subordinate lien holders get veto power over changes to a home's lien structure. This means if you have a HELOC and a mortgage, you can’t refinance your first mortgage without getting written permission from the subordinate lien holders (in this case, the HELOC lender) in the form of a subordination agreement.
“The subordinate lien holder will evaluate the request to subordinate to the new first lien based on whether its lien position is strengthening or weakening,” he said. “Typically, a lienholder will agree to subordinate for a rate and term refinance and will reject a request to subordinate for a cash-out refinance.”
Subordination clauses and agreements are common throughout the world of finance. They can be applied to other debts, bonds, and contracts, and work the same way. Subordinated debt has lower priority, and senior debt or bonds must be paid and issued first.
- A subordination clause ranks lenders by payment-priority order in the event of foreclosure, sale, or liquidation.
- Subordination clauses are most common in mortgage refinancing agreements, home equity loans, and HELOCs.
- Subordination clauses don’t take effect until a second lien is made on a home.
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