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What is a Subordination Agreement?
A subordination agreement is a legal document that establishes one debt or claim as ranking behind another in priority for repayment. The priority of debt repayment can become very important if a company or individual defaults on their debt repayment obligations and declares bankruptcy.
Generally, a subordination agreement is used to rank debt priority by lenders to ensure repayment priority from the borrower.
Purpose of a Subordination Agreement
A subordination agreement is generally used when there are two mortgages and the mortgagor needs to refinance the first mortgage. It acknowledges that one party’s interest or claim is superior to another in case the borrower’s assets need to be liquidated to repay debts.
When multiple liens against a property exist, a subordinate agreement will set lien priority. Often lien priority will be decided based on date of mortgage, the first mortgage receiving priority over others. Some other liens, such as property tax liens also receive automatic priority. Lien priority determines the order in which debt will be paid if that prosperity is sold in a foreclosure sale.
Lenders of superior debts will have the legal right to full repayment before lenders of subordinated debts receive their repayments. In a case where the debtor doesn’t have the funds to make all repayments, the subordinate lenders might receive less or no repayments at all . For instance, when limited or no funds are available after a foreclosure sale, liens with low priority may not receive all or any repayments.
Therefore, a subordination agreement will adjust new loans’ priority so that when there is a foreclosure, it gets paid off in order of priority.
There are two main types of subordination agreements:
- Executory Subordination Agreement: In an executory subordination agreement, the subordinate party agrees to have their interest ranked at a lower priority to the security interest of another party. This provides a promise of agreement for the future and thus can be difficult to impose. In cases where the party refuses to sign the executory subordination agreement, a contract claim violation can occur.
- Automatic Subordination Agreement: In the automatic subordination agreement, the subordination agreement is agreed upon and executed simultaneously. For example, if a deed includes an automatic subordination agreement, it will generally be stated that once the lien of the deed is recorded will be automatically secondary to another deed.
Here is an article about the purpose of subordination agreements.
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Who Benefits from a Subordination Agreement?
Individuals and businesses need to borrow funds. For this, they turn to lenders or lending institutions. The lenders earn interest on borrowed funds till all repayments have been made. In case the borrower places other liens against the asset, such as a second mortgage, the lender would require a subordination agreement to protect its interests.
One might think why would other lenders agree to subordinate? Since conventional first-mortgage lenders do not agree to refinance a loan unless they are ensured priority in case of repayment, the only way refinancing works is through a subordination agreement. It provides ensured priority repayment to the first lender.
Second or junior lienholders do not agree to subordinate automatically unless the home equity is sufficient to cover all loans. Given these complications of refinancing, subordination agreements are relatively common practice in the lending industry. It benefits the homeowner by providing a lower interest on their property and also provides assurance to the primary lender that all debts will be repaid.
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When Subordination Agreements are Used
Subordination agreements are used when borrowers are trying to acquire additional funds while already having other loan agreements . It is generally used by property owners to take out a second or junior mortgage on their property to refinance their property.
Refinancing is the process of paying off an old mortgage and replacing it with a better one. Once the first loan is paid off, the second ranks up in priority automatically. Subordination agreements make this possible.
Here is an example of refinancing. For example, if you want to refinance a primary loan of $300,000 with 6.5% interest for a loan with lower interest rate. Let’s say you have a Home Equity Line of Credit (HELOC) on the property for $50,000. This would make the house worth $400,000. When refinancing, you would be paying off your first mortgage with a new loan. The HELOC would then technically move up in priority as it was made earlier. The second lender, which is helping you repay your first debt, would want to gain priority over HELOC so it would request HELOC to subordinate. Since the property has good equity to cover both loans, the HELOC lender would generally agree to give up its lien priority.
Apart from homeowners, subordination agreements are also used by businesses and corporations. A corporation would normally issue multiple types of bonds that are subordinated or unsubordinated debt. In case the borrower declares bankruptcy or defaults, the subordination agreement becomes important. All senior lenders are superior to subordinated lenders and shareholders in case of liquidation of company’s assets.
For example, a business has borrowed $400,000 from a primary lender and has $200,000 in subordinated debt. In case it declares bankruptcy, the company’s assets will be liquidated. If the company’s liquidated assets are worth $500,000, the primary debt of $400,00 will be paid first in full and the remaining $100,000 will be distributed among the subordinate lenders. Shareholders will receive nothing in this process.
Still unsure about what a subordination agreement is? Here is more on subordination agreements .
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