What Is Preferred Debt?

Preferred debt is a financial obligation that is considered more important or has priority over other types of debt. This form of debt obligation has to be paid first. Its lien position takes precedence over other debt and equity positions. For example, a first mortgage would be a preferred debt over a second mortgage or mortgage-backed security holding the mortgage.

BREAKING DOWN Preferred Debt

Interest from preferred debt is tax-deductible. The main types of preferred debt include interest on mortgages, equity loans, and equity lines of credit. Taxes owed to the IRS and first position in other personal loans would be considered preferred debt as well.

Ways Preferred Debt Can Affect the Resolution of a Bankruptcy

In the liquidation of a debtor’s assets, the obligations of preferred debt must be discharged first especially. The holders of mortgages and other forms of preferred debt could be classified as secured creditors in a bankruptcy proceeding. 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. Loans of vehicles could also qualify the title holder as a secured creditor, with the outstanding obligation possibly qualifying as preferred debt.

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 businesses, preferred debt can affect overall valuation and the ability to secure financing.

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 what cash assets 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.