Understanding Subordination Agreements: Definition, Purposes, and Examples

What Is a Subordination Agreement?

A subordination agreement is a legal tool that establishes one debt as ranking behind another in priority for collecting repayment from a debtor. The priority of debts can become extremely important when a debtor defaults on their mortgage payments or declares bankruptcy. The higher a debt's priority, the more likely it is to be repaid, which affects any subordinated debts.

How a Subordination Agreement Works

Individuals and businesses turn to lending institutions when they need to borrow funds, and they may take on multiple debts for a variety of purposes. If they declare bankruptcy, there may not be enough money to repay all of their creditors. When that happens, a trustee appointed by the court will attempt to repay as much of the debt as possible, starting with the debts that have the highest priority. Those are often referred to as senior debt.

Lower on the priority list are obligations classified as junior debt or subordinated debt.

Senior debt lenders have the legal right to full repayment before subordinated debt lenders receive any payment. As a result, the lenders with lower-priority debts might receive only partial repayment or none at all.

When a lender accepts a subordination agreement, it acknowledges in advance that another party's claim or interest will take precedence over its own in the event that the borrower's assets must be liquidated to repay the debts.

Why would any lender agree to that? One reason is that they may receive a higher interest rate from the borrower in return for taking on the greater risk. They may also receive fees.

Examples of Subordination

Subordination can come into play when either a business or an individual declares bankruptcy.

In the case of a business, suppose a public company has $670,000 in senior debt, $460,000 in subordinated debt, and total assets with a value of $900,000. The business files for Chapter 7 bankruptcy, and its assets are liquidated at market value—$900,000.

Senior debt holders receive full payment, and the remaining $230,000 is divided among subordinated debt holders, often worth only a fraction of the amount owed. Those may include investors who own any bonds the company had issued earlier. An exception would be secured bonds, which entitle the lender to claim whatever collateral was used to back them.

Stockholders usually receive nothing during liquidation since they are last in line, behind all other creditors.

When an individual declares bankruptcy, their obligations are paid off in a specified order. For example, alimony and child support are among the items at the top of the list. The person's senior debts would be paid off ahead of any junior or subordinated debts.

Individuals most often encounter the concept of subordination, and subordination agreements, with mortgages. Suppose a person has both an original mortgage and a home equity line of credit (HELOC) on the same property. Both lenders will have liens on the home, but the mortgage will have the first lien (and first claim on the collateral) because it came first. The HELOC lender will have a second lien, putting it in a subordinate position. In the event of a foreclosure, the mortgage lender would be paid back first.

Now, suppose the homeowner decides to take out a new mortgage to refinance the old one. When the old mortgage is paid off, the HELOC would normally move up into the first lien position because it is now the older debt. However, the lender of the new mortgage may not agree to those terms and instead insist that the HELOC lender accept a subordination agreement. The HELOC lender may do so in return for a fee, as is most likely outlined in the terms of its contract with the homeowner. It also has the option to refuse, in which case the deal may fall through.

The Bottom Line

Subordination agreements are legal tools used to establish the order in which debts are to be repaid in the event of a foreclosure or bankruptcy. They are used to prioritize debts and protect senior creditors. These agreements should be notarized and recorded, as it makes them more enforceable.

In return for the agreement, the lender with the subordinated debt will be compensated in some manner for the additional risk it assumes. Consumers will often encounter a subordinated debt agreement if they have more than one mortgage on their home and decide to refinance it.

If you're considering accepting a subordinated agreement, it's essential to consult a legal expert or financial advisor to ensure it's in your best interests.