What Is Preferred Debt?

Preferred debt is a financial obligation that is considered more important than–or make take priority over–other types of debt. For example, the first–or senior–mortgage would be considered preferred debt (when comparing the first and second mortgage). This form of debt obligation typically has to be paid first because it carries more significance than other types of debt. Interest on preferred debt is typically free from any taxes.

Understanding Preferred Debt

The main types of preferred debt include interest on mortgages, equity loans, and equity lines of credit. Any taxes owed to the IRS are considered a form of preferred debt as well.

Key Takeaways

  • Preferred debt is often classified as a higher priority than any other type of debt.
  • First mortgages and taxes owed to the IRS are examples of preferred debt.
  • For a business, the amount of preferred debt that it carries on its books, along with other liabilities, could affect its overall valuation and ability to secure additional financing.

In a bankruptcy proceeding, the holders of mortgages and other forms of preferred debt are typically classified as secured creditors. Designation as a secured creditor often means there is a physical piece of property the debt is derived from, such as real estate, in conjunction with a mortgage. In the liquidation of a debtor’s assets during a bankruptcy proceeding, the obligations of preferred debt must be discharged first. Loans of vehicles could also qualify the title holder as a secured creditor, with the outstanding obligation possibly qualifying as preferred debt.

With preferred debt that is based on the physical property, it might be possible to recoup some, if not all, of the owed value by repossessing the property. For instance, a home or car could be seized, then resold to pay off the debt. It is possible that the real property no longer holds enough value to cover the related debt. If this is the case, the holder of the preferred debt might then seek to claim a portion of the cash assets that remain from the borrower as the liquidation proceeds.

It is possible, depending on what assets are available, that recompense for preferred debt leaves no capital to pay other, subordinate debts or shareholders in liquidation. Even preferred securities are placed after preferred and senior debt in terms of repayment order. Preferred securities would still be paid before common shareholders receive any compensation. The amount of preferred debt that a company carries on its books, along with other liabilities, could affect its overall valuation and ability to secure additional financing.

Those who own preferred debt, such as the holder of a first mortgage, for example, are in a greater position to see a return on the financing. This makes ownership of preferred debt more lucrative than owning subordinate, secondary debt.