What is a Subordination Clause?
What does it mean in real estate or in mortgage contracts?
What are the essential elements you should know!
In this article, we will break down the legal definition of a Subordination Clause so you know all there is to know about it!
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What Is A Subordination Clause
A subordination clause is a contractual provision where the parties prioritize a claim on debt over other debt claims.
The subordination of a claim or right is the legal ranking and establishment of priority over other claims or rights.
As the name suggests, “subordination” means that certain rights will be subordinated or ranked below the rights granted under the current contract.
In essence, the subordination clause in a current contract will render a claim (under the current contract) senior over other claims under subsequent contracts.
We see subordination provisions used quite often in real estate, mortgage contracts, and bond issue agreements.
For example, a mortgage agreement with a subordination clause will grant the creditor priority over subsequent creditors registering a lien or mortgage against the same property.
As a result, if the home or real estate property is foreclosed, the first mortgage lender will get liquidation proceeds first, then the second mortgage lender, and so on, until there are no more funds to distribute.
The subordination clause definition is as follows:
A subordinate provision in a contract or legal agreement ensures that the creditor’s rights under the contract supersede the rights of other creditors in case of default, foreclosure, or liquidation.
In essence, a contracting party benefiting from a subordination clause is given the assurance that it will be paid before others or its contractual rights will rank above that of other creditors.
The purpose of a subordination clause is to protect the interests of a lender over subsequent lenders.
In a real estate transaction, you may have a property owner who finances the purchase of a property.
To this effect, the primary lender will register a lien against the property as collateral to provide the borrower the needed financing.
With a subordinate clause, the primary lender will make sure that it remains in the first position to foreclose the property in case the property owner goes into default or goes bankrupt.
As such, the primary lender’s lien on the property will take precedence or supersede other mortgages registered on the property after the original lien was registered.
In real estate, the subordinate clause (also known as the subordinate clause) is the ranking of creditor claims for the ownership of a property or asset.
In essence, a subordination clause in a deed of trust or a real estate contract will establish priorities applicable to the lenders.
Lenders typically register a “lien” against a property when a borrower obtains financing to purchase a property.
The lien grants the creditor a “priority” in foreclosing the property or getting paid should the borrower default on the loan, mortgage, or financing terms.
When multiple creditors have registered a lien against a property, each will have a different priority ranking.
For instance, the first lender will have first priority, the second lender will have second priority and so on.
Using a “subordinate” clause or agreement, lenders can secure their ranking or agree between themselves to change their ranking position.
For example, a second priority lender can enter into a subordination agreement with the first ranking creditor to swap their positions.
It’s very common to see a subordination clause mortgage when dealing with mortgage refinancing agreements.
Imagine a property owner having two mortgages registered on their property (first ranking mortgage with Lender 1 and a second ranking mortgage with Lender 2).
If the property owner intends to refinance the first ranking mortgage with Lender 1, the lender will need to discharge the first ranking mortgage and register a new mortgage on the property.
However, by doing so, the second ranking mortgage (Lender 2’s claim) will move up to first ranking and the original first ranking lender will have a new mortgage ranked second in priority.
To avoid losing its first ranking position, the first ranking lender will require that the second ranking mortgage lender execute a subordination agreement agreeing to remain second ranking.
Should the original second ranking lender refuse to agree to sign a subordination clause, then Lender 1 may choose not to refinance the mortgage and assume a second ranking position.
If you are looking to get a second mortgage on your property, you should look at your original mortgage terms and conditions to assess your options.
Second mortgages are subordinate to the first mortgage that you have registered against your property.
As a result, lenders recognize that they are exposed to a greater risk having a “second” ranking priority on the property in the event of default.
In some cases, the lenders will refuse to provide financing with a second ranking lien on the collateral property.
In other cases, the lender will agree to borrow funds but at a significantly higher interest rate (to compensate for the added risk).
As a result, you may want to speak to a financial advisor or mortgage expert to assess your options.
Let’s look at a subordination clause example to illustrate the concept better.
Many companies raise capital by issuing bonds.
In essence, the investor (bondholder) is considered a creditor of the company as the company has an obligation to eventually pay back the principal value of the bond.
A company may use a subordination clause in the bond issuance to ensure that the current bond issue will have priority (or be senior) to other bond issuances guaranteeing that the current bondholders will be paid before the other bondholders are paid.
A subordination clause will provide “protection” to the bondholder as they have more chances of getting their principal back than bonds issued without subordination.
Subordination of Lease
In a commercial lease, a subordination clause will result in the tenant’s rights being subordinated to that of the bank holding a mortgage on the property.
When a lease is subordinated to a mortgage, the lender or the bank can potentially evict the tenant for the landlord’s violation of the mortgage terms (even if the tenant is compliant with the terms of the lease).
Banks will want to protect themselves when lending money to landlords (particularly in commercial real estate properties) to ensure their rights will supersede that of the tenant.
Subordination Clause Takeaways
What is a subordination clause in real estate?
Let’s look at a summary of our findings.
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