If tapping into your home’s equity is in your future, so is a whole lot of paperwork. And whether you’re taking out a home equity loan or a home equity line of credit (HELOC) (both are types of second mortgages or junior liens), you may be presented with a subordination agreement to sign at closing.
Do a quick search for “subordination” online, and you’ll likely find many results that define the term as the act of being or placing something in a lower position or rank (think: parent/child, coach/player or sergeant/private).
For our purposes, it’s helpful to visualize mortgage subordination this way. But we can do more than help you visualize the term. We can explain what mortgage subordination is, how it works and when you might run into it.
What Does Subordination Mean in Real Estate?
Mortgage subordination prioritizes lien holders in chronological order (lien position). It determines which lien holder gets paid first in the event of a default, bankruptcy or foreclosure.
Aside from a rare exception like a construction loan, a home buyer typically takes out one loan to purchase a home – a mortgage. When you take out a mortgage, the lender records a lien on your property. The lien gives the lender the legal right to repossess your home in the event of mortgage default, bankruptcy or foreclosure.
If there are no other liens on the property, the lender is the only lien holder on the deed. Mortgage subordination only comes into play when you have multiple liens on the property. When you take out a second mortgage, like a home equity loan or a home equity line of credit (HELOC), mortgage subordination makes the second mortgage junior to the first.
For example, let’s say a few years after buying your home you decide to take out a HELOC to pay for kitchen renovations.
Because you took the HELOC out after the original mortgage, if you end up defaulting on the mortgage, the HELOC lender’s claim for repayment will be subordinate to the original mortgage lender’s claim because repayment is prioritized in the order the liens were recorded. If a loan is subordinated, it’s been ranked lower in repayment order.
Subordination is handled by the lenders who help you refinance an existing loan or obtain new loans. The subordination clause in a mortgage loan agreement protects a lender in case a borrower defaults. It states their lien is the senior lien and would take repayment priority over any liens recorded after their lien. The language is often written in a way that allows for flexibility.
Liens placed on a property after a senior lien are subordinate (or junior) liens. In the event of a home sale triggered by a default, bankruptcy or foreclosure, the senior lien holder would be paid first and in full from the proceeds of the sale. Any leftover proceeds would be applied to the subordinated liens in chronological order.
How Does Mortgage Subordination Work?
Mortgage subordination ranks each lender’s repayment priority in recorded lien order.
A second mortgage is subordinate to your primary mortgage loan. This makes sense because they are usually smaller loans or lines of credit with higher interest rates. Lenders of these loans assess the risk of being a subordinate lien holder and set your interest rate accordingly.
There are times when the lender of a second mortgage might only be willing to issue a loan if their loan “jumps the line” and becomes the primary loan.
For example, let’s say you’ve paid off most of your primary mortgage, and you want to take out a second mortgage that’s larger than the amount left on your first mortgage. Because the second mortgage will be larger than the first mortgage, the lender for the second mortgage may require your primary mortgage lender to agree to subordinate their lien as a condition of issuing the loan.
The second mortgage could get held up at this stage, this is usually a smooth process because the primary lender doesn’t want to lose your business. They know you could turn around and refinance your primary loan with a new lender, cutting them out of your financial life completely.
Mortgage subordination may seem complex, but it’s not. And it happens regularly without much involvement from the borrower. Your new lender and your existing lender collaborate behind the scenes to handle the subordination process. And, in case you’re wondering, if you get your first and second mortgage with the same lender, the subordination process should be relatively quick because no other lenders are involved.
Mortgage subordination can take anywhere from a few days to a few weeks. It will depend on the number of lien holders or other factors in play. There might be a delay if the primary mortgage and the second mortgage are for similar amounts. Both the primary lender and the new lender you are refinancing with will need to determine which one faces the biggest risk and whether to give up their place in line.
What Does Mortgage Subordination Mean for Borrowers?
Mortgage subordination might look like a game of leapfrog on paper, but it can have a few meaningful effects on borrowers.
Subordination and mortgage refinancing
Mortgage subordination plays a key role if you refinance your mortgage.
When you refinance, you’re taking out a new loan that pays off your outstanding mortgage debt. If there is a second mortgage on your home, the refinance is technically subordinate to the second mortgage. The lender that refinances your loan typically won’t accept a junior position, and they’ll request that the second mortgage lender agrees to subordinate their loan.
Subordination and second mortgages
If you’re planning to take out a second mortgage on your home, subordination will likely come into play if the second mortgage is larger than your first mortgage. In this case, the lender of the second mortgage will likely want to be first in line for repayment because the greater size of the loan increases their risk.
The second lender’s debt will only rank over the primary lender’s debt if the primary lender agrees to subordinate their loan. The second lender may require this as a condition for granting the loan.
Any back-and-forth between lenders may add more time to the loan process, but again, it is usually handled behind the scenes.
Tying It All Together
Let’s try a “real-life” example. You’ll play the borrower. Steadfast Mortgage, Inc. will play the lender for your primary mortgage. And Your New Favorite Lender, Inc. will be the lender you use to get a HELOC.
You currently owe $200,000 on your primary mortgage and your home is worth $350,000. You decide to apply for a $50,000 HELOC with Your New Favorite Lender, Inc. to renovate your kitchen.
Your New Favorite Lender, Inc. approves the HELOC knowing that their loan is subordinate to your primary mortgage loan with Steadfast Mortgage, Inc. That’s typical with a HELOC, so the approval process goes through without a hitch.
Now, let’s fast forward a few years. You’ve paid your primary mortgage down to $175,000, and your HELOC has a balance of $50,000. But you want to take advantage of the low interest rates you saw advertised on Refi-Rific Mortgage’s website.
Refi-Rific Mortgage agrees to refinance your first mortgage on the condition that their loan ranks first in debt repayment order. Refi-Rific Mortgage will not move forward with the refinance until Your New Favorite Lender, Inc. agrees to subordinate their loan (the HELOC).
Your New Favorite Lender agrees to subordinate, the loan goes through and everyone is happy. The refinance will be your new primary mortgage, and your HELOC will remain the subordinate loan.
Don’t Be Afraid of Mortgage Subordination
While mortgage subordination may seem like a daunting concept, it’s a way to ensure each lender is aware of their place in line for repayment. In most situations, it’s a behind-the-scenes process most borrowers are not aware of until they sign a subordination agreement at closing.