Subordination Agreements: Who Gets Paid First?

Whether you’re taking out a new loan or refinancing your house, your lender might have mentioned the need for a subordination agreement. Subordination agreements usually only come into play if you default on your loan (like a mortgage) or if you declare bankruptcy. 

Generally, subordination agreements assign the order of priority to who can collect on a debt and when they can collect. If you’re considering taking out a loan, especially a second mortgage, you’ll want to understand how these agreements work. 

Understanding Subordination Agreements

Subordination agreements are legal documents that assign which debt holders get paid first for purposes of repayment. They’re generally applied when one of two things happens: a debtor either defaults on a secured loan, or they declare bankruptcy. 

When a debtor defaults on a secured loan, like a mortgage loan, the subordination agreement determines who gets paid from the sale of the asset that secured the loan. In the case of a mortgage, the agreement determines who gets paid first from the sale of the house. This is possible because lenders have liens on the asset. The lien position determines which lien holder gets paid first.

Similarly, when a debtor declares bankruptcy, all of their assets are liquidated, meaning they’re sold to obtain money to pay debt holders. The subordination agreement determines who gets paid first from the liquidation of these assets.

Senior vs. Junior Debts

Subordination agreements prioritize debts as senior debts and junior debts. Junior debts are subordinated debts, meaning they have lower priority than other debts. A senior debt is a debt a borrower owes to their primary lender. Legally, senior debts must be paid back first before any junior debts. 

Subordinated debts are considered riskier for lenders since they don't have priority. If a foreclosure on a mortgage, a bankruptcy, or a liquidation of assets doesn't produce enough money to pay all lenders back, the lower priority debt holders may receive little or no repayment. To offset the increased risk, lenders usually require higher interest rates, origination fees, and other fees on loans considered junior to other debts.

A common example of a junior debt is when a borrower takes out a second mortgage on their home, often as a line of credit. To do this, the borrower uses their home equity to secure the second mortgage. The original mortgage is senior to the second because it was taken out first. If the borrower were to default, then the lender who holds the first mortgage must be paid first. 

How a Subordination Agreement Works

Lenders use subordination agreements to protect their interests by preventing their debt from becoming subordinated debt in case of default.

Here’s how it works: 

First, a person borrows money from a lender, like a bank. Before approving the loan, the lender asks that the loan be secured by something of value. This means that the person has to give the lender the legal right to take the item of value if they can’t pay the loan back.

If the person borrowing the money agrees to secure the loan with something of value, then the lender has a security interest in the item of value. This is why secured loans are sometimes called “security instruments.”

Once the lender approves the loan, they start receiving compensation on the interest payments from the loan. To keep making money, the borrower must keep making payments to the lender.

When the lender gives the borrower the loan, in addition to requiring collateral, they might also require a subordination agreement. This way, if the borrower stops making the required payments on the loan, the lender will be first in line to get paid back.

For example, say a borrower takes out a $200,000 mortgage to buy a house. The lender, a bank, asked them to sign a subordination agreement to guarantee that they are the senior debt.

Then the borrower, also called a mortgagor, takes out a second mortgage of $150,000 from a new lender and uses the same house as collateral. This second mortgage is considered subordinated debt because it’s second in line to the first mortgage. 

Two years later, the borrower receives a notice of default on both mortgages. They owe $150,000 on the first mortgage and $140,000 on the second mortgage. Because the house was used as collateral, the lender can force the sale of the house through foreclosure. 

Assume the house sells at a foreclosure sale for $270,000. The lender of the first mortgage must be paid their $150,000 first: 

$270,000 - $150,000 = $120,000

This leaves $120,000 to repay the lender of the second mortgage, who is owed $140,000. 

Here, the second lender will only receive the remaining $120,000, which means they lose out on $20,000.

When Subordination Agreements Are Used

Subordination agreements are usually used in issues of real estate, specifically mortgage loans. Some states use a loan agreement called a deed of trust for loans involving real property. Mortgages and deeds of trust function mostly the same. 

Generally, if the homeowner gets a second mortgage, that debt has a lower priority than the original mortgage. But the order of priority can be changed if the homeowner refinances their first loan. This happens because, when the borrower refinances the original mortgage, they’re actually paying off the original mortgage and then replacing it with a new mortgage loan. 

Since the refinanced mortgage is actually a new mortgage, it’s now second in line to any other loans that were taken out before refinancing. Assuming there was a second mortgage loan taken out before the first was refinanced, this second mortgage moves up to become the first mortgage. 

Lenders Use Subordination Agreements To Keep First Priority 

Lenders who were originally first in line don’t want to become second in line. To stop this from happening, they use a subordination agreement. Through the subordination agreement, as a condition of refinancing the mortgage, the lender will require the other lender to agree to remain second in line. Then, even after refinancing, the original mortgage lender will stay first in line. 

Since the subordination agreement changes the priority interests of each creditor, it must be notarized by a notary public and recorded in the county records office to be enforceable.

Why Subordination Agreements Matter

Subordination agreements are important to you because they can impact whether you can refinance a loan. For example, if you take out a second mortgage on your house, you may not be able to refinance your first mortgage because the lender of the second loan may not agree to the subordination agreement. 

If you’re considering bankruptcy, it’s important to know that, typically, only the creditors with higher priorities can participate in any bankruptcy proceedings.

Let's Summarize...

Subordination agreements determine which lenders have the highest priority for purposes of repayment when a borrower defaults on their loan or files for bankruptcy. Lenders have to collect on their debt according to the agreement. Since subordinated debts are riskier, lenders typically require a higher interest rate.

These agreements are common in mortgages, especially if you try to refinance your mortgage.