Your Guide to a Subordination Agreement

Your Guide to a Subordination Agreement

What Is a Subordination Agreement?

There are times when it becomes necessary for one financial obligation levied on a piece of property to take precedence over another. In these cases, a subordination agreement is created. A subordination agreement can be its own document, or it can be a single clause in another contract. What exactly does the agreement do?

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Why Is It Important?

A subordination agreement sets the priority of debts, and it is crucial for a variety of reasons. For starters, it gives an older obligation the security of payment should there be a default and collection ensues. Second, it completely sets the order every subsequent debt will be handled in. It gives assurance to everyone that if the debtor should default, they will be paid in due time. That time, however, is contingent on the order outlined in a subordination agreement.

When Is a Subordination Agreement Used?

A subordination agreement is used in any circumstance where many debtors hold an interest in a piece of property.

Mortgage Refinance

The most common use of a subordination agreement is in refinancing an existing mortgage when there is more than one mortgage on the property. For instance, when you purchased your home, you may have been given access to a second mortgage or equity line of credit. This second mortgage was granted based on the value of your home. If you purchased a house for $120,000, you probably took out a mortgage for about $96,000 (demonstrating 20% down payment); however, the home may have appraised for $175,000. That difference is considered the equity in your home. It is the value your second mortgage is based on. In this instance, you may have taken out a second mortgage for $55,000.

A few years down the road, you decide to refinance that first mortgage, the funds that allowed you to purchase the home in the first place. When dealing with debts, the oldest debt typically takes priority, followed by subsequent obligations in the order they were presented. Your first mortgage is the oldest debt on your property followed by the second mortgage. However, if you refinance the first mortgage, it becomes newer, in a sense, than the second mortgage. In the order of debts, as it exists, if you file bankruptcy, the second mortgage will take priority and get paid back first.

To stop this from occurring, first mortgage holders will request, as part of the refinance, that you obtain a subordination agreement from the holder of the second mortgage. It will be up to you to contact the second mortgage holder, explain about the refinance and that the first mortgage company wants a subordination agreement, acknowledging the priority of the first mortgage over it, even in the case of refinancing. The holder of your first mortgage will not allow you to refinance without any subsequent debtor executing a subordination agreement. They do not want to lose their spot in line if you wind up not paying them back for whatever reason.

Liens

Aside from mortgage liens (as stated above), other liens or levies may be placed against your property during your ownership. These lienholders will all have to agree that they are subordinate to your first mortgage in the case of refinancing.

If you have a lien placed against your property, in many cases, the lienholder already has a clause in there stating it knows and understands it is subordinate to the first mortgage and even the second. The language for this is commonly set forth within the body of the lien, which is usually already pretty short. It will reference mortgages filed in the public records and acknowledge it is subordinate to these debts. When refinancing, it will become necessary for these liens to now recognize they are subordinate to the new mortgage. It is essential to read the liens placed against you as they may stop you from being able to go through with a refinance for many reasons.

One reason is they may demand payoff upon the payoff of the first mortgage. A refinance is technically a payoff of the first mortgage because you are closing one mortgage loan to open another. While it applies to the same property, it is, nonetheless, a payoff. Some liens, such as those levied by the local property tax clerk due to insufficient payment or those placed by homeowner's associations for unpaid assessments, may bar you from being able to get the refinance until they are paid in full due to this payoff verbiage. Along with that, the mortgage company you are trying to get the refinance through may not allow you to go through with the process until those liens are paid in full, and satisfaction and release of the lien are signed and recorded.

In a mortgage refinance, it is difficult to continue forward if there are liens in place. It is less likely a lienholder will agree to be subordinate to a new mortgage, even if it just a refinance of the first one.

Lease

A lease subordination agreement is not necessarily a common document; however, it is important to understand the impacts of it. If you have ever rented a home from a private landlord and not an apartment complex, you may have executed a lease subordination agreement and not have even understood it or known what it meant.

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The lease subordination agreement's primary role is to ensure a tenant can continue leasing the property even if the current landlord doesn't own it. It is a document that protects the tenant should the owner of the property sell it to a third party. It allows the tenant to continue out the terms of the original or amended lease (as applicable) without being ousted within the term set out. It may also be referred to as a non-disturbance agreement document or clause within a lease.

For example, say that you find the perfect house in an ideal neighborhood, and the price is reasonable enough that you can afford. When you sit down to talk to the realtor, you find out that the home is being leased out, and that the tenants have another year left on the lease. If the tenants have a lease subordination agreement, then you as the prospective purchaser cannot force them to vacate before that. However, if they do not have any such agreement, it is possible you can demand the current owner give them notice to move within 30 days of a purchase agreement being executed.

The implications for a prospective home purchaser, if there is a subordination agreement, is you can't live in the home for at least the period as outlined in the lease agreement. You are legally bound, by the lease subordination agreement, to allow the tenants to continue the terms of the lease for as long as the lease is valid. You may be able to offer the tenants an incentive to terminate the lease sooner, but if they reject it, you have no legal recourse to force them out.

One possible bright side to this situation for the purchase of a home subject to a lease is you will, however, be the one now assigned the rental payments for the remainder of the lease. Depending on the amount of money being collected, that might prove to be a year well spent.

Is a Subordination Agreement Good or Bad?

Being able to conclude whether a subordination agreement is good or bad is difficult as it depends on which side of the deal you're on.

In the case of mortgage refinance, you as the property owner may find it bad as it may force you to pay off liens that have been levied against you to refinance your mortgage. If there are no liens, it may force you to as a second mortgage holder to take a backseat to a now newer debt, even if that debt is replacing the one that was first in line. Not being able to obtain the subordination agreement from other debtors (mortgage or lien) will result in the refinance being rejected. No first mortgage company is going to allow other debts to take priority to it. If you declare bankruptcy, they want their money first.

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In the case of a lease subordination agreement, if you are a tenant, it gives you peace of mind that you won't be uprooted in the middle of your tenancy due to a change in ownership. On the other hand, if you are trying to purchase the property subject to the lease, you may be frustrated by the lease subordination agreement, and you may decide to move along in your hunt. Good for tenants, bad for a prospective purchaser.

If you ever have to sign a document with a subordination agreement or clause, it is essential to understand what it means. While it doesn't have a direct impact on you (unless in the case of the lease subordination), it may impact your ability to refinance your home. At the end of the day, it's all about protecting the interests of those parties who have agreed to give you the money for the property in the event a financially-devastating event occurs and you are unable to pay the debt back.