Definition
A Subordination Agreement is a legal document executed between two parties wherein one party agrees that their current or future claims or interests are subordinate to the claims or interests of the other party. It is often used in financial contexts when an existing creditor is ranked lower to a new creditor in terms of debt repayment in case of default or bankruptcy. This agreement is particularly common in mortgage refinancing or restructuring.
Key Takeaways
- A Subordination Agreement is a legal document that establishes one debt as ranking behind another in priority for collecting repayment from a debtor. The priority of debts is extremely important in the event of a debtor’s bankruptcy or liquidation.
- Subordination Agreement is usually used in relation to secured loans. It assists in the ranking of claims and ensures that primary loans will be repaid before other loans if bankruptcy occurs. This is an essential tool for managing financial risk.
- While subordination agreements might promote financial risk management, it can also create a risk for subordinated lenders, who may not be paid back in the event of default by the borrower. As a result, such lenders may require higher interest to compensate for potential risk.
Importance
A Subordination Agreement is important in the financial world as it allows lenders to prioritize their claims on a borrower’s assets.
This means in the event of the borrower’s default, the lender with the subordination agreement comes secondary to the lender who has the primary claim on any repayment from the remaining assets.
This arrangement is vital in lending scenarios, particularly in real estate transactions or when a borrower is seeking additional financing.
The agreement thus helps to clearly define the hierarchy of lenders and reduces the risk for the primary lender, simultaneously making it possible for the borrower to secure additional financing under the assent of the primary lender.
Explanation
The main purpose of a Subordination Agreement in finance is to rearrange the priority order of existing debts. It’s primarily used when a borrower has more than one loan from different creditors, and these creditors need to agree on who will be paid back first in the event of a default.
This agreement ensures that there is a clear hierarchy of claims against the borrower’s assets and that all parties know where they stand in case of bankruptcy or asset liquidation. The borrower benefits from this arrangement by having the opportunity to secure additional financing that might otherwise be too risky for a creditor to provide.
A Subordination Agreement is commonly used in mortgage refinancing. For example, if a homeowner has a primary and a secondary mortgage from two different lenders, and then refinances the first mortgage with a new lender, the second mortgage, under a Subordination Agreement, will drop to third in line to be repaid, while the new loan takes the second place.
This protects the new lender by allowing them to step ahead of the second mortgage in a default scenario. Subordination Agreements, thus, enable borrowers to manage and potentially extend their debt obligations while ensuring lenders retain an agreed level of collateral protection.
Examples of Subordination Agreement
Home Mortgages: The most common form of subordination agreements occurs in the realm of home mortgages. When you take out a second mortgage, typically, the secondary lender will require a subordination agreement. They’ll ask the first lender to allow their loan to take priority in the event of default so that they can recover their expenses from any foreclosure sale. The first lender often doesn’t have an issue with this since they’ll generally be paid off first anyway.
Business Loans: Another instance where subordination agreements may be used is when a business takes on multiple loans. For example, a business might have an existing loan with a bank, and then it seeks additional funding from a secondary source such as an angel investor. In this case, the second lender might request a subordination agreement from the primary lender, meaning that the second lender’s claim to repayment is ranked lower than the primary lender’s claim.
Corporate Bonds: This would typically involve the issuance of senior and subordinate bonds. The senior bondholders are entitled to be paid back before the subordinate bondholders. To legally establish this creditor pecking order, the issuer might enter into a subordination agreement with the junior creditors, giving priority to senior creditors.
Subordination Agreement FAQ
What is a Subordination Agreement?
A subordination agreement is a legal document that establishes one debt as ranking behind another debt in the priority for collecting repayment from a debtor. The priority of debts can become extremely important if the debtor runs out of money or declares bankruptcy.
How does a Subordination Agreement work?
A subordination agreement acknowledges specifically, in a formal legal document, that one loan will be reimbursed only after other loans have been satisfied. This agreement is undertaken to encourage lenders to work with applicants who would otherwise be considered high-risk investors.
When is a Subordination Agreement used?
A subordination agreement is often used in the context of a mortgage. For example, if you have a first mortgage and a home equity loan, the home equity loan is subordinate or second, to the first mortgage. When you refinance the first mortgage, the existing home equity loan becomes the first loan unless the second lender gives permission to remain second.
What are the benefits of a Subordination Agreement?
The main benefit of a subordination agreement is that it allows homeowners to refinance their primary mortgage when it is less than the value of their homes. Additionally, subordination promotes financial lending by making high-risk applicants more attractive to lenders.
What are the risks of a Subordination Agreement?
The major risk associated with a subordination agreement is to the lender, not the borrower. Since the lender is giving up their right to be first in line to collect, they will be last in line to collect if there is a default in payment. The third party, such as a bank, could potentially lose its investment if it comes last in line.
Related Entrepreneurship Terms
- Secured Debt
- Mezzanine Financing
- Senior Debt
- Junior or Subordinated Debt
- Collateral
Sources for More Information
- Investopedia: A reliable source for finance and investing related definitions, tutorials, and articles.
- Legal Information Institute (Cornell Law School): Provides legal details and implications of various finance terms including Subordination Agreement.
- The Balance: This resource offers comprehensive financial advice including information on many finance concepts and terms.
- Nolo: It is a legal publisher that provides legal explanations in plain-English, including finance terms.
