What Is Subordinated Debt?

Definition and examples of subordinated loans

Definition

Subordinated debt is secondary debt that is paid after all first liens have been paid in the event of a default. Because subordinated loans are secondary, they often have higher interest rates to offset the risk to the lender.

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Definition and Example of Subordinated Debt

In the case of default or bankruptcy, subordinated loans are only paid after any primary loans are paid in full. Lenders that offer subordinated loans are aware of the risk they take when offering these loans, so they usually charge a higher interest rate.

This loan subordination is often detailed in a subordination agreement or clause. The purpose of a subordination agreement in a mortgage is to protect the primary lender on the home. This is most often the bank or financial institution that holds the first mortgage. That institution stands to lose the most in the case of default or foreclosure. The subordination clause protects this first lender, and simply assures that the first mortgage holder will be paid if the home goes into foreclosure.

For instance, if you already have a mortgage and then take out a home equity line of credit (HELOC), that HELOC becomes a subordinated loan. In other words, it is secondary to your primary mortgage.

  • Alternate name: Junior debt

Note

If a first mortgage is paid off, a second mortgage then becomes the first mortgage.

How a Subordinated Loan Works

In real estate, the mortgage taken out first and used to buy the property is the first mortgage. This primary loan is also called senior debt. If the property, at a later time, has either a home equity loan or home equity line of credit 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 there is a greater risk that the owner will default, or a greater chance of foreclosure. If the home goes into foreclosure, the lender that holds the first mortgage will get paid first since it is the senior debt. The lender that holds the HELOC will get paid with what’s left over, since it is the subordinated debt. In some cases, there may be nothing left at all to collect.

Note

If the homeowner needs a home equity loan or a HELOC and applies to the same bank or financial institution that made the first mortgage, there is usually no problem with regard to subordination. The home equity loan will automatically be subordinated debt.

Senior Debt vs. Subordinated Debt

 Senior debt Subordinated debt
Primary debt Secondary debt
Paid first in bankruptcy or default Paid second in bankruptcy or default
Likely to be secured with collateral May be unsecured
Less risky for the lender Riskier for the lender

Comparing senior debt to subordinated debt helps clarify which debt would be repaid first in the event of a bankruptcy or foreclosure. Senior debt takes priority, and must be repaid first. The next in line would be subordinated debt, which would be repaid with what funds are left over.

Senior debt is the primary debt, and since it is more often secured with collateral, it's less of a risk for a lender than subordinated debt, which is often unsecured.

Refinancing and Resubordination

If you have a first mortgage plus a HELOC and you want to refinance, then you have to go through the resubordination process. Resubordination is often shortened to just “subordination.” Refinancing is when you take out a new loan, with new terms, and use it to pay off the first loan. It wipes out the old mortgage and puts a new first mortgage in its place. Because the original mortgage loan is no longer there, the HELOC moves into the primary or senior debt position—unless there is a resubordination agreement in place.

The lender that holds the HELOC has to agree that its loan will be second in line with the new first mortgage loan through a resubordination agreement. Most banks and financial institutions will agree to this setup as long as the property holds enough value to cover both loans.

Additional Hurdles

Since being second in line to collect debt carries more risk, lenders will take extra measures to protect their end of the bargain, such as:

  • There will be charges or other fees to pay to cover administrative costs.
  • You must be in good standing with your lenders on all of your payments.
  • There are limits set on the amount of your total monthly mortgage payments.

When Might a Lender Refuse?

There are two cases when lenders 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 is when you use the equity in your house as collateral to take out a loan for cash. The money you borrow is lumped into the first mortgage, which makes for a larger first debt. When there's more debt to pay, the lender who is second in line to collect assumes the greater risk.

The second instance when 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, there's not enough value in your claim to the home, and the lender worries that you won’t be able to repay the loan. Again, you pose a greater risk.

What It Means for You

If you wish to refinance your home and you have a HELOC in place, your new lender will insist that the HELOC be resubordinated. The lender of the HELOC that you already have is not required to do this, but most do. If that lender does not agree to fall second in line, you may have to wait and try again once you've built up more equity in your home.

The state of the housing market may also factor in the lender's decision. The lender of the HELOC is going to look at the loan-to-value ratio of both the new first mortgage and the mortgage it holds, combined. 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 current HELOC, you can try refinancing that loan. Refinancing a second mortgage can be easier than refinancing a primary mortgage.

Key Takeaways

  • Subordinated loans are secondary to any primary loans, meaning they are only paid off after the primary loan is fully paid off, in the case of a default.
  • They typically have higher interest rates than primary loans.
  • If you have more than one loan against a property, it can be tricky to find a lender who will refinance your primary loan.
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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Quicken Loans. "Understanding Mortgage Subordination."

  2. U.S. Bank. "What Is a Subordination Agreement, and Why Does It Matter?"

  3. Fannie Mae. "Selling Guide: Fannie Mae Single Family," Pages 180-181.

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