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A "subordination agreement" is a contract to prioritize one debt over another for repayment. The agreement establishes that one party's claim is superior to another party's interest. Subordination agreements happen all the time in mortgage refinancing transactions. Say you have two mortgages on your home and want to refinance your primary mortgage. The refinancing lender will probably require a subordination agreement from the second mortgage lender as part of the process. The subordination agreement adjusts the priority of the new and older second mortgage to ensure that the refinancing lender gets paid first if a foreclosure happens.
When you take out a loan to buy a home, the lender will probably require you to sign a mortgage or deed of trust to secure the debt. (In this article, "mortgage" and "deed of trust" mean the same thing.) The lender then records the mortgage, called a "first mortgage," in the land records, creating a lien on your property.
If you take out another loan, like an additional mortgage, home equity loan, or home equity line of credit (HELOC), that lender will record it and also get a lien on the property. That second mortgage is called a "subordinate lien" or "subordinate mortgage."
The ranking order (first, second, third, etc.) of the mortgages and other liens is called "priority."
Lien priority determines the repayment order after a foreclosure sale.
Mortgage liens follow the "first in time, first in right" rule. This general rule says that whichever lien is recorded first in the land records has a higher priority than later recorded liens. So, mortgage liens have different priorities based on their recording dates.
A first mortgage has higher priority than a subordinate second mortgage. The first lien is always paid first out of the foreclosure sale proceeds. A lien recorded second has second priority and will be paid next, and so forth.
Some liens, like property tax liens, have automatic priority over essentially all other liens—even if the property tax lien attached to the property after another lien. However, judgment liens , for example, don't get priority over previously recorded liens.
Because a limited amount of money is available after a foreclosure sale, subordinate (low priority) liens might not get paid after a foreclosure.
Example. Say you owe $300,000 on your first mortgage, $75,000 on a second mortgage, and $2,000 to a creditor who got a judgment lien. You stop paying your first mortgage, and that lender forecloses. The property sells for $310,000 at the foreclosure sale. The first mortgage lender gets fully repaid ($300,000), the second mortgage lender gets $10,000, and the judgment creditor gets nothing.
"Refinancing" is the process of paying off an old mortgage by getting a new one. If you have two mortgages on your property and refinance the first mortgage, the second subordinate mortgage automatically moves up in priority when the first mortgage is paid off. The second mortgage becomes the first lien, and your new mortgage becomes the second lien. (Remember, mortgage liens follow the first in time, first in right rule.)
But conventional mortgage lenders won't agree to refinance a first mortgage unless they're guaranteed to be in first position. So, refinancing a property with multiple mortgages only works when any subordinate mortgage holders agree to change their positions.
To adjust their priority, subordinate lienholders must sign subordination agreements, making their loans lower in priority than the new lender. A subordination agreement puts the new lender into first position and reassigns an existing mortgage to second position or third position, and so on.
Subordination agreements are common in mortgage refinancing deals. Here's an example of the process: Say you want to refinance your $300,000 first mortgage to get a lower interest rate. You also have a $75,000 HELOC on the property, which is a subordinate mortgage. Your house is worth $400,000.
When you refinance the first mortgage, you pay it off with a new loan, and the first mortgage lender releases its lien. When the refinance loan gets recorded, the second mortgage (the HELOC) would normally move into the first position because it's the oldest mortgage still recorded on the property.
However, the refinancing lender providing $300,000 requires its loan to be in first position. So, it asks the HELOC lender to do a subordination agreement. The HELOC lender agrees because the home has enough equity to cover both loans if a foreclosure happens.
By signing the subordination agreement, the HELOC lender agrees to give up its lien priority and remain in second position. The new lender gets priority even though the HELOC lien was recorded before the refinancing.
The new lender benefits from a subordination agreement because it moves up in rank ahead of any other mortgages that agree to be subordinated. Because it's not to their benefit, existing lienholders won't automatically agree to be subordinate to a new first mortgage. And if an existing lienholder won't agree to subordinate its mortgage, the new lender might not refinance the first mortgage.
However, most subordinate mortgage holders will agree to sign a subordination agreement if the home's equity will cover its loan. So, again, subordination agreements happen relatively often in the lending industry.
The new lender prepares the subordination agreement in conjunction with the subordinating lienholder. Then, the parties typically sign the agreement. But in some cases, just the subordinating lender will need to sign the paperwork.
Again, if you're refinancing your first mortgage and the property also has a subordinate mortgage, the refinancing lender will usually handle getting the necessary subordination agreement. But you need to ensure that the required subordination agreement is completed before the new loan's closing date.
If the second mortgage holder doesn't sign the agreement promptly, consider hiring a real estate attorney to help you through the process. Contact a foreclosure attorney if you have questions about lien priority in a foreclosure.