A Detailed Guide to Writing a Subordination Agreement
Money lending companies and individual money lenders should consider drawing up a subordination agreement to protect their interests in case the borrower incurs additional debt. If you’d like to write a subordination agreement, but you’re not sure how to do it, you’ll find all relevant info in this article.
What Is a Subordination Agreement?
A subordination agreement is a legal contract used to prioritize one debt—known as senior debt—over another—junior debt. Lenders require subordination agreements to ensure they will get the money back even if the borrower declares bankruptcy.
The agreement recognizes that one lender’s claim is more important than the debt owed to another party. When the borrower’s assets get liquidated, the primary lender will get paid in full while the subordinated lender(s) will get the rest of the money. This means that the junior debt might not be fully claimed if there are not enough funds after liquidation.
Since junior debts are riskier, lenders usually require higher interest rates as a condition for approving the loan. Some lending institutions might reject your loan if the risk of being a subordinated party is too high.
Subordination Agreement Examples
Suppose a borrower owes $200,000 to the first lender and $120,000 to the second one, but his or her asset value is $260,000. In that case, the first debtholder will get a full repayment, while the subordinated lender will get only $60,000 in case the debtor declares bankruptcy.
Lending companies usually require a subordination agreement when a borrower wants to use the loan for property purchase. Since many people tend to have two mortgages, the lenders want to secure the debt and ensure their loan gets repaid first. Once you sign the agreement, the lender will record a “first mortgage” to get a lien on the property in question.
While liens that are recorded first have an advantage once the assets of the borrower get liquidated, the property tax liens get the priority automatically. This means that the borrower’s liquidated assets will be used to repay the property tax debt before the one resulting from the senior mortgage.
What Happens When a Debtor Refinances the First Loan?
If a borrower with two mortgages wants to refinance the first one, the refinancing institution has the right to request a subordination agreement. If lenders don’t require a subordination agreement, the debts will be paid in chronological order. The general rule is that the first recorded loan is superior to every loan recorded later. This is the order in which the debs get paid if no one signs a subordination agreement:
- First mortgage
- Second mortgage
- Refinancing loan
In case the second mortgage lender signs the subordination agreement, the refinancing loan will become superior to the second mortgage. While second mortgage lenders usually accept the subordination agreement, some of them might refuse to sign it. If this happens to you, the best option is to hire a real estate lawyer to help you out.
Subordination Agreement Types
There are two types of subordination agreement:
|Subordination Agreement Type||Description|
Executory Subordination Agreement
|A subordinating lending company accepts to subordinate its interests to another lender’s claim. This is just a promise of accepting the agreement in the future, which means that the executory subordination agreement can become challenging to enforce|
Automatic Subordination Agreement
|The main and subordination agreements are implemented and recorded simultaneously. The party that signs the subordination contract automatically agrees to become a secondary debtholder if the borrower gets a new loan|
How To Draw Up a Subordination Agreement Yourself
Most people choose to consult a lawyer when dealing with a subordination contract. If hiring an attorney is too expensive for you, you could find some subordination agreement templates online and try to write the contract yourself.
Bear in mind that the agreement needs to be understandable and professional. Online contract templates usually outline general terms. You should adjust the agreement to your needs and the laws of the state you operate in.
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