A subordination clause is a clause in an agreement which states that the current claim on any debts will take priority over any other claims formed in other agreements made in the future. Subordination is the act of yielding priority.
Breaking Down Subordination Clause
When a home is foreclosed and liquidated for cash, the first mortgage lender gets first dibs on the sale proceeds. Any money that remains is used to pay down a second mortgage, and so on. The further down the mortgage tier a claimant sits, the less chance it has of recovering its loan amount. To adjust the priority of a loan in the event of default, a lender may demand a subordination clause, without which loans take chronological precedence.
A subordination clause effectively makes the current claim in the agreement senior to any other agreements that come along after the original agreement. These clauses are most commonly seen in mortgage contracts and bond issue agreements. For example, if a company issues bonds in the market with a subordination clause, it ensures that if more bonds are issued in the future, the original bondholders will receive payment before the company pays all other debt issued after it. This is added protection for the original bondholders as the likelihood of them getting their investment back is higher with a subordination clause.
Subordination clauses are most commonly found in mortgage refinancing agreements. Consider a homeowner with a primary mortgage and a second mortgage. If the homeowner refinances his primary mortgage, this in effect means canceling the first mortgage and reissuing a new one. When this happens, the second mortgage moves up the tier to primary status, and the new mortgage becomes subordinate to the second mortgage. Due to this change in priority, most first lenders require that the second lender provide and sign a subordination agreement, agreeing to remain in its original secondary position. Normally, this process is a standard procedure of a refinance. But, if the borrower’s financial situation has worsened, or if the value of the property has significantly declined, the second mortgage creditor may be unwilling to execute the subordination clause.
If the second lien holder provides a subordination clause, it allows the primary mortgages on the same property to have a higher claim. Should repayment become an issue, such as in bankruptcy, the subordinate loans would fall behind the original mortgage, and may not be paid at all.