Subordination in finance, banking, or real estate refers to the order of priorities and claims that have to do with either ownership or assets. To make it official, you need a legal agreement – and that would be a subordination clause.
Now, there’s much more to this document than just assigning priorities. In the event of foreclosure or even bankruptcy, this document becomes vital to future homeowners and tenants.
If you’re new to real estate and wish to know more about this agreement, don’t go anywhere.
We’ll be talking about different types of subordination clauses and how they work in real life. And by the end of our guide, you’ll have a much clearer picture of clause subordination, their ranking system, and subordinate loans.
What Is Subordination In Law?
Since most terms that you come across in real estate have their roots in law, it’s certainly useful for anyone entering real estate to touch on their primary meaning. And today’s subject is subordination. The question we’re going to start with is:
What is subordination in law, and how does it correlate to real estate?
In law, subordination refers to the act of lowering the payment priority of a claim or right with respect to the other claim or lien formed in other agreements. That is the definition you’ll find in the books – but that’s just theory. You need a real-life example to understand it:
Many companies will issue bonds as a means to raise capital. When they do, the investor (bondholder) essentially becomes a creditor – meaning that the company must pay back the principal value of the bond in the future.
Now, if they do so with a subordination clause, it ensures that the current bond issue will have priority over others, guaranteeing that the senior bondholders will be the first ones to be paid. In that sense, a subordination clause protects the investor; they’ll have better chances of getting their principal back this way than with bonds issued without subordination.
Subordination Clause In Real Estate – Key Focus
A subordination clause, or, in other words, a subordination agreement, is a type of legal document that stipulates that the current claim on debts will take priority over any other claims that are – or will be – formed in the foreseeable future.
In simple terms, a subordination clause effectively makes one debt the first priority over another and ensures that the primary lender retains their first-position rights, superseding other mortgages and claims.
The crucial thing to note is that a subordination agreement changes the lien position.
Types Of Subordination Agreements
There are two types of subordinate clauses in real estate – executory and automatic subordination clauses.
Executory Subordination Clause
Within the executory subordination agreement, the subordination party consents to subordinate their interest to the existing security interest of another (future) succeeding interest.
This type of agreement could pose a possible problem because it relies on a promise of agreeing in the future. A contract breach could occur if the other party refuses to sign the agreement and subordinate their interest – which is a possible outcome.
Automatic Subordination Clause
As for the automatic subordination agreement, recording and execution of both main and subordinate agreements are done concurrently. This type of subordination clause can become rather complex due to including other provisions such as a lease agreement – which we’ll circle back to in a moment.
Here’s an example:
Suppose you have a trust deed that includes a subordination agreement. In that case, it should be stated that the lien of the trust deed, once it has been recorded, will automatically be placed second priority to another deed. So, essentially, a subordination agreement acknowledges that the claims of one party are prioritized over another party in the event of liquidation of assets.
Subordination Clauses In Lease Agreements
A subordinate clause does not only have to do with homeowners. It can be applied to tenants, as well – in the form of a subordination lease.
Subordination of lease is a term that denotes the tenant’s consent to subordinate their legal rights over a property to the bank holding the mortgage. That’s the main purpose of creating these types of leases.
When a landlord leases a property, the tenant will probably want to invest a certain amount of money in the real estate property or to rely on the possession of the property until their lease expires. And if a default occurs, the tenant could bear serious consequences – real losses.
What we described here is a scenario that is a genuine possibility if the lease becomes subordinate to the mortgage claim. However, if you want to avoid this situation, here’s what you can – and should – do:
Sign an agreement in which the lease is given priority. If you don’t, the subordination clause effectively makes the current claim senior to any other agreements that come along.
How Does Subordination Clause Work?
Let’s move on to some real-life situations regarding subordination clauses – and shift our attention to how they work.
A subordination clause becomes a topic of interest when there are two mortgages in the game, and the mortgager needs to refinance their first mortgage. That automatically shows that one party’s interest is superior to another in the event that the borrower’s assets need to be liquidated in order for the debt to be repaid in full.
With that said, lenders of superior debts have the legal right to a full repayment before the lenders of the mentioned subordinated debts receive their payment. That’s an example of a subordination clause at play.
But what if the debtor has no funds?
Where the debtor is in deficit with the funds required for payment, the subordinate lender shall receive less to no repayment at all. And if there are limited funds – or no funds – available after the foreclosure takes place, liens with low priority stand a chance of not receiving any payment.
Who Benefits From Subordination?
The primary lender.
If you go for the second mortgage, the subordination clause will ensure that the primary lender retains its priority over the second lender loses priority, superseding any other financial claims.
Mortgage Refinancing Agreements
We must assume that not everyone is well-versed in the subordination clause and its role in real estate. So, let’s use this chance to go over some relevant terms you could come across in mortgage refinancing agreements.
A mortgage agreement is a legal contract between the borrower – i.e., the mortgager – and the lender, i.e., the mortgagee. A lien is created on the property as a way to secure the repayment of the loan.
On a related note, mortgage refinancing agreements can help with lower interest rates and paying off your mortgage faster.
Let’s put this into a real-life example:
Suppose that a property owner currently has two mortgages registered to the same property, but these mortgages have separate lenders – that is, separate mortgage contracts. In that case, the primary mortgage is connected with Lender A, and the second mortgage is connected with Lender B.
Now, let’s say that the property owner intends to refinance their first mortgage with the primary lender. If so, then the lender would have to discharge the first ranking mortgage and register a new mortgage on the property.
Next, the second mortgage will automatically move up to first-ranking since the primary one will no longer exist – and the initial first-ranking lender will now have a new mortgage, but this time, ranked second priority.
In this scenario, the first-ranking lender may require the second lender to sign a subordinate clause and agree to remain second-ranking. Should they refuse, Lender A could choose not to refinance the mortgage and take on the second-ranking position.
Primary Mortgage And Secondary Mortgage
Within this agreement, you have the terms primary and secondary mortgage. The “first mortgage” or primary mortgage is the primary lender’s lien that secures the mortgage. The term “second mortgage” applies to the money borrowed against home equity with the intention of financing other projects and expenditures.
A primary loan pays for the property and has priority over all other mortgage agreements.
Subordinated Loans – What Are They?
Subordinated loans represent the loan amount paid out to first liens that have been compensated in the event of default. Since this is not the original primary loan, it’s characterized by higher interest rates to neutralize the higher risk of the subordinated lender.
The ranking of debts becomes even more crucial when the borrower declares bankruptcy. In such cases, subordinated loans are paid after primary loans are paid in full. Lenders that offer these types of loans must be aware of the risks.
Since you’re second in line to collect debts, here are some additional info that you should know:
- You’re looking at extra charges to cover the administrative costs.
- You must be in good standing with your lenders.
- There’s a set limit on the number of monthly mortgage payments.
Who Can Be The Primary Lender?
Before mentioning the lenders, it’s essential to note that a mortgage market is where borrowers obtain financial support from lenders. Mortgage brokers, banks, mortgage lenders, and credit unions can all play the role of a primary lender.
As a homeowner, you’ll have the opportunity to make a deal directly with the lender when applying for a mortgage. The mortgage professional at a local bank should educate the borrower about the different types of mortgages and quote the interest rate depending on the chosen loan.
Many future home buyers start the process by reaching out to the mortgage originator first. That’s the person that will help you select the right mortgage in your real estate contract. Of course, you should have some money saved up from your sale proceeds (the money that’s obtained by the homeowners after the sale is closed).
There’s one other thing you should keep in mind before applying for a mortgage:
The Consumer Financial Protection Bureau has implemented certain regulations that have to do with the compensation of the broker. In the event of a default or financial crisis, brokers receive compensation from both the lender and the borrower.
Subordination Clause – Summing Up
That would be it – but let’s go over the key points of the subordination clause once again.
In summary, a subordination clause is a legal agreement stipulating that the current claim on existing debts will take priority over other claims. The subordinate clause could be executory or automatic. Either way, it’s crucial to remember that these clauses do not only apply to homeowners; tenants can sign this agreement, as well.
Often, the property owner has two existing mortgages and wants to refinance their first mortgage with the primary lender. So, they will have to discharge the first-ranking mortgage and register a new one on the property.
Does anyone benefit from the subordination clause? Yes – and that would be the lender. On that note, primary lenders can be anyone from mortgage brokers and banks to credit unions.
Lastly, you have subordinated loans. That is the amount that is paid out to first liens. Since they incur more risk, they generally have higher interest rates.
Oh, and there’s one more thing we’d like to add before we close off today’s topic:
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