What Is Subordinated Debt?
DEFINITION
Subordinated debt is subsidiary debt that is paid after all primary debts have been paid in the case of a default. Since subordinated loans are secondary, their interest rates are often higher to reduce the lender’s risk.
Subordinated Debt Procedure
In real estate, the first mortgage is the one that was obtained originally and used to purchase the property. This primary loan is sometimes referred to as senior debt. A home equity loan or line of credit (HELOC) later placed on the property is known as “subordinated debt.”
As there is a greater risk of the owner defaulting or bankruptcy, the home equity loan, also known as a HELOC, frequently has a higher interest rate than the original mortgage. Although the first mortgage is the senior loan, it will be paid off first in the case of a home foreclosure. Since the HELOC is a subordinated duty, any remaining funds will be paid to the lender. There may be times when there is nothing left to collect.
Loan subordination information is usually included in a subordination agreement or provision. A mortgage subordination arrangement protects the primary mortgage lender on the property. Most of the time, the first mortgage holder is a bank or another financial institution. That institution would stand to lose the most in the event of failure or bankruptcy. The subordination provision only ensures that the first mortgage holder receives payment if the residence falls into default, preserving this first lender.
Lenders may go to more extraordinary lengths to keep their half of the bargain, such as:
- There may be taxes or other expenses to pay to cover administrative costs.
- You must be current on all of your payments to your lenders. While being second in line to collect debt carries a more significant risk, lenders may take further precautions to protect their part of the bargain.
- Your monthly mortgage payment is limited in total amount.
- Mortgage Refinancing and Resubordinating
- You must go through the resubordinating procedure to refinance and have a primary mortgage and a HELOC.
The term “resubordinating” is sometimes abbreviated to “subordination.” When you refinance, you take out a new loan with new words to repay your old loan. Because the prior mortgage loan is no longer in existence, a new first mortgage is established, and the HELOC becomes the primary or senior debt position unless a resubordinating agreement is in effect.
- A resubordinating agreement requires the lender who holds the HELOC to agree that its loan will be paid off after the new primary mortgage loan.
- What Does Subordinated Debt Mean for You? If you want to refinance your home and have a HELOC, your new lender will request that the HELOC be resubordinated. Although they are not required to, most HELOC lenders do so. If that lender refuses to take a back seat, you may need to wait and try again when you have more home equity.
- The housing market’s current state may also influence the lender’s decision. The HELOC’s lender will assess the loan-to-value ratio of the combined new first mortgage and its existing mortgage. If property values are rising, this is a less severe problem. They could fall, putting you in danger of hitting a pothole. If you’re having trouble resubordinating your present HELOC, consider refinancing it. A secondary mortgage may be easier to refinance than a primary mortgage.
What is an illustration of subordinated debt?
When you have a first mortgage, you have an example of subordinated debt.
A first mortgage is the primary loan against a property. When many mortgage loans fund a piece of real estate, the first loan is mentioned as the “first mortgage” or “first lien.” If the borrower defaults on the mortgage, the first lender has the first right to foreclose.
A home equity loan, as well. The home equity loan is subordinate to the primary mortgage. Thus it is paid first in the event of default.
