No matter if you are just educating yourself or studying for your real estate exam, understanding the subordination clause is important.
Once a home undergoes foreclosure, it’s possible that mortgage lenders require a subordination clause. It helps in establishing the priority of claims to a home.
In this article, we cover subordination clauses, its benefits, risks, and why it happens.
What is a Subordination Clause?
In real estate, a subordination clause controls the order of priorities in claims for your ownerships or assets. These financial claims are also called liens.
Subordination means “to yield priority.” A clause, meanwhile, is a specific section in a contract. You see this language in legal agreements.
You might also come across it as a “subordinate clause.” They’re the same!
It is a ranking system in place for claims against a property.
When Do You Need A Subordination Clause?
There are multiple situations where you might need a subordination clause.
First, Some Definitions:
A mortgage is a loan taken out to buy a property. A home can be costly, and many people can’t pay upfront. Most pay a small percentage, take out a home loan, and then repay it in future years.
Mortgage lenders require a payment schedule and collateral.
What About a Trust Deed?
A deed of trust serves the same purpose as a mortgage. It ensures the repayment of loans. It also adds another party: a trustee. The trustee, if ever, starts the foreclosure process.
Some places use a deed of trust instead of a mortgage. When a traditional lending service, like a bank, isn’t being used, lenders use a deed of trust.
The property is the collateral for the loan. If the borrower can’t repay a lender, the lender may repossess the home. Eviction can happen, and the house would be on a foreclosure sale.
A foreclosure sale aims to sell off the repossessed home to recover the unpaid funds.
The actual process may take place after several continuous failures to pay off debts. It also varies from lender to lender and from state to state.
We’ve defined liens above as financial claims. For the foreclosure process to even be possible, the lender secures a lien on your property.
It provides lenders security. Once a person decides not to pay, a simple written promise or signature is not much leverage for mortgage lenders. With liens, lenders ensure their rights of:
a.) getting the loans repaid, or;
b.) taking legal action to get their funds back.
These financial claims are part of the public record. Other possible mortgage lenders can see a person’s existing loans and debts.
4. Home Equity
Home equity, in the real estate definition, is the portion of the property that you own.
If you took out a loan to pay for your home, then the lender has some interest in your home until you pay off debts. You are, however, still considered the homeowner.
Your equity is a valuable asset. It’s the market value of your home. Renovations can make equity go up with price appreciation. Loan repayments contribute as well.
What’s a Home Equity Loan or Second Mortgage?
Yes, you can borrow against your equity!
A home equity loan works just like a mortgage. The term “second mortgage” originates from the fact that the purchase mortgage is the first in line to be repaid if foreclosure happens.
A second mortgage also uses your home as collateral. It has a set repayment term. If the homeowner ends up failing to pay off the debts, the house will then end up foreclosed.
How Does a Home Equity Loan Work?
Second mortgages can come in a lump-sum or as a line of credit. With a lump sum, you have a one-time home equity loan to be gradually paid off.
A second mortgage, like any traditional mortgage, often comes with fixed monthly payments and an interest rate.
A home equity line of credit sets up a pool of money to loan from whenever you need it. The lender sets the maximum borrowing limit. You can borrow until you reach that loan limit, pay then borrow over and over.
This kind of home loan comes with a fixed or variable interest rate.
When you refinance, you replace an existing mortgage on your property with a new loan.
For example, you can revise existing terms and agreements on a mortgage. The modification agreement can include clauses about interest rates and payment schedules.
These loan terms are all revised to be favorable to the borrower.
Refinancing often happens when the interest-rate environment changes. After all, it is cyclical. Once the rate drops, you can choose to reach out to your bank and discuss refinancing options.
The Subordination Clause: A Situation
Imagine a property on a foreclosure sale. Mortgage lenders require a payment schedule, and the homeowner didn’t follow through. Think of the financial claims, or the liens, all lined up and waiting for repayment.
Usually, the money generated from the sale goes towards paying off the first and primary mortgage.
It’s the oldest and the first loan in line. After one pays off the first mortgage, the money left over goes to the second mortgage, then the third.
The sale goes on in chronological order without a subordination clause. Whoever the first and oldest mortgage lender is gets repaid first.
But It Isn’t That Simple
Say the homeowner refinanced their first mortgage. Then, the lien priority order changes. Refinancing would create a new loan while the bank cancels the first one. The second mortgage would then be the primary mortgage.
Remember the line of liens? Now, the second mortgage lender gets paid first instead of the oldest and primary mortgage lender. This order is unfair to the first mortgage lender.
A Subordination Clause Keeps Priorities in Check
A refinance must go through the primary lender first. They won’t approve it – unless the second mortgage lender signs a subordination agreement.
This subordination agreement ensures that the second mortgage retains its secondary position.
Then, the finance claims of the primary mortgage lender supersede any other finance claims.
However, other mortgage lenders may disagree. For example, the second mortgage lender may refuse to subordinate.
So, the first and primary mortgage lender can’t use a subordination clause on their own. Other claim holders must agree to the subordination agreement first.
Exceptions to a Subordinate Clause
Like we mentioned above, concerned parties may not agree to refinance. One can’t reorder the financial lien then.
Other exceptions include the homeowner’s situation. They could file for bankruptcy, which would then put lien holders even more at risk.
They could also have unpaid taxes. Then, the IRS may put an involuntary lien on the real estate property.
Government revenue authorities impose an involuntary lien without any consent from the owner. They establish this after a certain amount of unpaid loans, taxes, or other duties.
The only time repayment is possible for a second mortgage lender is when foreclosure sale proceeds exceed the balance of the first loan amount.
Remember, this is the main issue of a subordination clause in a mortgage or otherwise: repayment.
Repayment can also become an issue in other ways. We mentioned bankruptcy and unpaid taxes becoming reasons above, and they apply here.
Once mortgage lenders are aware of that situation, those further down the lien position won’t approve refinancing. A subordination policy isn’t feasible if this is the case.
This risk is behind why many lenders don’t choose to sign a subordination clause.
Who Benefits From a Subordination Clause?
A subordination clause protects the primary lender first and foremost. By making other mortgage lenders subordinate, they retain the most security in getting repaid should foreclosure happen. In order of priority, they are the first in line.
What About the Other Mortgage Lenders?
Other mortgage lenders benefit from this, too! After all, they have their say on the clause.
If the real estate situation is favorable, they can sign the subordination clause. They should still have a good chance of repayment.
However, it’s different if the homeowner’s financial situation and overall real estate value of the property have declined.
It’s within their rights to choose not to comply with the subordination clause. Here, lenders protect themselves from being at risk.
Let’s Sum It Up
In real estate, a subordination clause comes after many processes. A homeowner takes out multiple mortgages. A second mortgage or home equity loan may happen. They can seek out refinancing.
Once foreclosure happens, then a subordination clause may be necessary.
Remember: a subordination clause in a real estate contract establishes the priority of financial claims!
Now, with this information, you can decide what’s best for your home. You can also ace your real estate exam with everything we’ve covered. Comment away with questions!