1. Protecting the Interests of Lending Institutions
2. Declaring Bankruptcy

A subordinate contract is a written agreement in which someone who has taken out a deed of trust or mortgage gets the property owner to accept that the loan is a lower priority than his or her other debt. This allows priority to be given to a new loan in the event of payoff or foreclosure. To be valid, this agreement must be notarized and officially recorded in county records.

Because most companies supplying first mortgages will not agree to refinancing without being guaranteed top position, refinancing transactions must be a result of the second mortgage holder agreeing to be the subordinate. Junior lien holders will normally agree to this, provided the property is valuable enough to cover both loans. As a result, subordination agreements are fairly commonplace.

These agreements are especially common in the field of mortgages. Typically, someone will apply to refinance the first mortgage in cases where there is also a second mortgage on the property. The second mortgage will be prioritized below the first mortgage, but refinancing the loan might change the order of priority.

Refinancing a first mortgage essentially means paying it off and signing a new loan agreement contract, which becomes the second priority. The pre-existing second loan then becomes the top priority and takes the position of the first loan. For this reason, the provider of the refinance of the first mortgage will generally require the provider of the second mortgage to sign a subordination agreement.

Protecting the Interests of Lending Institutions

When a business or an individual needs a loan, they typically approach a lending institution. If they are successful in getting a loan, they pay interest on the loan over time. In certain cases, however, that business or individual might default on those payments. The lender might, therefore, require a subordination agreement to protect his or her interests.

In cases with more than one mortgage, a senior debt and a junior debt are referred to. The senior debt is the one that has a greater claim to the property in question. The junior debt is the subordinated debt. Legally speaking, the lending institution that provided the senior debt has the right to have that debt paid in full before the person or company who took out the loans starts paying off the subordinated debt.

In many cases, the debtor does not have the means to pay all his or her debts, meaning the providers of subordinated debts might never get their money back or receive any interest.

Declaring Bankruptcy

To provide an example of this, consider a business that has a senior debt of $670,000, a junior debt of $460,000, and total assets of $900,000. When the company declares it's bankrupt, the following process will be carried out:

  • All assets will be liquidated at their market value.
  • $670,000 will be paid to the provider of the senior debt.
  • The remaining $230,000 will be split between all junior debtholders at a rate of 50 cents for every dollar.

For that reason, subordinate debts are considered riskier than senior debts. As compensation for this, lenders will charge a higher rate of interest. If the company that declared bankruptcy had shareholders, they would not receive anything from the proceeds of the liquidation. Payments to creditors are always prioritized above payments to shareholders.

Subordinate agreements are commonly used in many scenarios, such as the complex debt structures that corporations get into. Bonds that are not secured with collateral are considered to be subordinate to bonds that are secured. This means if the company goes bankrupt and defaults on its interest payments, secured bondholders will be paid what is owed to them first. On the other hand, the interest rate charged on secured bonds is generally lower than what is charged on unsecured bonds. That means greater returns on investment for unsecured bonds, provided the issuer pays regularly.

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