Subordination is the process of ranking home loans according to priority. Ranking can be done for various types of loans, including a home equity loan or mortgage loan.
When a person buys a home, the first mortgage taken to finance the purchase is the most important and senior mortgage. However, what about other subsequent loans that one takes out? These are subordinate loans, and they work differently than the first mortgage.
In this post, you’ll learn about subordinate financing and what to know about these loans for the real estate exam.
What Is a Subordinate Loan?
A subordinate loan is a secondary or subsequent debt that is paid after the primary or initial loans have been paid. It has the lowest ranking and usually higher interest rates than other loans. Subordinate loans are riskier because they are repaid only when the other loans are repaid.
Subordinate loans can be secured or unsecured, but subordinate mortgages are always secured. When it’s a subordinate mortgage, we consider it a secured loan as the loan is backed by collateral. On the other hand, subordinate loans without collateral are unsecured loans.
A subordinate loan is also known as a ‘second mortgage,’ as it is a subsequent loan that ranks below the first mortgage or senior loan.
The first mortgage or senior loan is the initial loan that one borrows for buying a real estate property. However, homeowners sometimes take out second mortgages on their property while the first or primary mortgage is still being repaid. Similar to the first mortgage, the subordinate mortgage is secured by collateral. The lender places a lien on the property until the loan amount has been repaid in full.
Features of Subordinate Loans
Subordinate loans have the following features:
- Unsecured debt: Subordinate loans can be secured or unsecured. Even if these loans are secured, if the lender puts a lien on the property, there will be another claim for the senior mortgage before this lien. Thus, these loans are mostly unsecured as there is very little protection in case of default. Moreover, the subordination agreement mostly doesn’t require any collateral as a part of the financing deal.
- Fixed interest rate: Subordinate loans are mainly offered with fixed-interest rates, especially High-Yield Bonds. These are high-interest rates because of the risk involved with the loans. The interest rate remains the same even if the prevailing market conditions are not favorable. On the other hand, variable interest rates keep fluctuating according to economic conditions.
- Early repayment fees: Early repayment fees are a penalty that most lenders charge when a borrower pays off this type of loan too early. This happens when the borrower pays the lender before the agreed loan term is over. Most borrowers do this to switch to another lender that offers a lower interest rate. However, the lender will charge an early repayment fee to cover the total cost of the loan.
Types of Subordinate Loans
People or businesses getting a loan for the first time usually choose traditional bank loans. However, sometimes additional loans are needed that the lenders are not comfortable offering. There is an upper limit to how much the lender can provide a loan. In such cases, subordinate loans are helpful as they allow the borrowers to finance their additional expenses. Following are some examples of subordinated debt:
- High Yield Bonds
- HELOC (Home Equity Line of Credit or Home Equity Loan)
- 2nd Lien Subordinate Notes
- Payment in Kind (PIK) Notes
- Convertible Debt
- Mezzanine Financing
A senior mortgage is the first or primary mortgage that is taken for purchasing a property. Subordination of loans is common when the borrowers want to take additional funds. In these cases, additional agreements take place for subordinate loans. These loan agreements take place when home buyers take additional loans on their property. In such a situation, the first mortgage or primary loan becomes senior, and the second mortgage becomes junior. A senior mortgage is higher in priority than a junior mortgage. Hence, the senior mortgage providers keep their entitlement in the first position to receive the repayment first. To sum it up, senior mortgages are of the highest property, and the lenders are first-lien debt holders.
Since subordinate loans have a lower rank for repayment, they are called junior mortgages. Their repayment terms are less favorable for junior mortgage lenders as compared to senior mortgages.
Senior Mortgage vs. Junior Mortgage
To better understand how a subordinated debt works, let’s understand how these loans are categorized relative to other loans. Following is the ranking of loans in a capital structure:
- Senior mortgage (Revolver, Term Loans)
- Subordinate (junior) mortgage (Mezzanine financing, High Yield Bonds)
- Equity (Common Stock, Preferred Equity)
Suppose the borrower defaults on the loans, and the lender files for their money. In that case, the Bankruptcy court will prioritize the loans in the above order. The claims held by senior mortgage providers will be prioritized, and they will be paid first. In bankruptcy or liquidity scenarios, the claims held by senior debt providers are of the highest priority. These loans are of lower risk than the junior debt and have lower interest rates too. Junior mortgages or subordinated loans don’t have this level of protection, and in the case of bankruptcy, mortgage lenders are more likely to face a loss.
When Is Subordinate Loan a Good Option?
Subordinated debt is a good option only when the borrower is a large corporation. Large corporations have significant cash flows, and the lender knows that the borrower will easily repay the amount. These corporations have better solvency than small companies and better financial leverage too. As a result, there are fewer chances of large corporations going bankrupt. Besides that, companies that have been in the business for a long time know the outcomes of going bankrupt. Thus, they are more vigilant and are the right partners for getting subordinated loans.
Subordinate Loan Example
Example 1: Let’s assume that a company has a subordinate loan of $200,000 and a senior debt of $650,000. Their real estate property has a value of $750,000, and the lender has placed a lien on that property for the repayment term. Unfortunately, the company defaulted on the loans due to the failure of its business operations and went bankrupt. Now, the company can’t repay the mortgage loan amount for the purchased property. In this case, the lender with senior debt will get the full amount of $650,000 after liquidating the property. On the other hand, the junior debt lender will get only $100,000 that remains ($750,000 – $650,000 = $100,000). In this case, the lender that provided a subordinated debt of $200,000 to the company is at a loss. For this reason, subordinated loans are riskier as they are paid only when the senior mortgage has been repaid in full.
Example 2: Now, let’s consider another example to understand subordinated loans and positions clearly. Let’s assume that Company X is a large corporation and issues two types of bonds; bond A and bond B. Besides that, the company also has equity and shareholders. Company X obtains a primary loan and a subordinate loan from two different lenders. For the primary loan or senior debt, the company issues bond A, and for the junior debt, it issues bond B.
Unfortunately, Company X faces a huge loss and goes bankrupt. In this case, the bond-B holder is not in favor of liquidating the assets as they know they will be given the last priority for repayment. Meanwhile, the senior debt lenders file a case in bankruptcy court to settle the issue and get the loan amount. After analyzing the debt priority and ranking, the bond A holders get a major portion of Company X’s assets. In contrast, the bond B holders incur a loss. However, bond B holders still get some amount compared to the company’s equity holders, who got nothing.
Subordinate Loan Frequently Asked Questions
Can Subordinate Loans Turn Into Senior Loans?
Yes, subordinated loans can be converted into senior loans once the existing senior loan or mortgage has been paid. Similarly, senior mortgages or loans can also turn to subordinate loans if another lender claims or puts a lien on the collateral. For example, suppose a person takes out a mortgage for a property, but later, he doesn’t pay the taxes for the property. In that case, the Internal Revenue Service will put a lien against the property. Due to unpaid taxes, when the Internal Revenue Service claims money, this lien will become the senior mortgage. After liquidation, the unpaid amount will be first paid to the IRS, and then the subordinate loans will be dealt with.
What Are the Requirements to Apply for a Subordinate Loan?
To apply for a subordinate loan, you must have at least 15 to 20% equity in your home, and the remaining mortgage must be below 85% of the property’s value. Besides that, you must have a good credit score (670 or higher). Lenders evaluate creditworthiness before offering a subordinate loan because they are very risky. Thus, they perform a credit check to analyze whether you’ll be able to pay back the loan or not.
Who Provides Subordinate Loans?
A bank or financial institution offers all types of loans, including subordinated loans. However, these loans can be obtained by any loan provider. A loan automatically becomes a subordinate loan if you acquire it while you’re already repaying your primary loan. Thus, you can get a subordinate loan from any lender or financial institution.
Why Would a Lender Offer a Subordinate Risk?
You must be thinking, why would a lender provide a subordinate loan knowing all the risks involved? There are different answers to this question, and as we say, the riskier it is, the more profitable it can be. Plus, in some cases, the lender might have a ‘cordial relationship’ with the borrower. When the borrower approaches the lender, the lender has to give a subordinate loan to help. Because of high risk, subordinated agreements happen mostly with large corporations.
What to Know for the Real Estate Exam
When preparing for a real estate exam, you will come across the term ‘subordinate loan’. A subordinate loan is a loan that is ranked behind another loan for collection of repayment from the borrower. The priority of loans is important as it states which lender will get the loan repayment first. Loans with higher priority are called senior loans, and they have a legal right to get full repayment of the amount before any other loan is repaid. In some cases, the borrower doesn’t have the money to pay all the lenders.
Hence, the senior loan provider gets all the money, and the subordinate loan providers get little or no amount. Thus, subordinate loans are very risky for lenders. Still, the lenders charge high-interest rates to compensate for the risk. Besides subordinate loans, there are many other terms related to loans that you must understand to prepare for the real estate exam. Our Real Estate Vocab has all the real estate terms presented in an easy-to-understand way.