What Is Subordinated Debt?

Updated on January 19, 2023

Reviewed by

Fact checked by David Rubin

Woman reviewing loan paperwork with lender — Photo:
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Definition

Subordinated debt is secondary debt that is paid after all first liens have been paid in the event of a default. Because subordinated loans are secondary, they often have higher interest rates to offset the risk to the lender.

Key Takeaways

Subordinated loans are secondary to any primary loans, meaning they are only paid off after the primary loan is fully paid off, in the case of a default.
They typically have higher interest rates than primary loans.
If you have more than one loan against a property, it can be tricky to find a lender who will refinance your primary loan.

How Subordinated Debt Works

In real estate, the mortgage taken out first and used to buy the property is the first mortgage. This primary loan is also called senior debt. If the property, at a later time, has either a home equity loan or home equity line of credit (HELOC) placed on it, that is called "subordinated debt."

The home equity loan or HELOC usually has a higher interest rate than the first mortgage because there is a greater risk that the owner will default, or a greater chance of foreclosure. If the home goes into foreclosure, the lender that holds the first mortgage will get paid first since it is the senior debt. The lender that holds the HELOC will get paid with what’s left over, since it is the subordinated debt. In some cases, there may be nothing left at all to collect.

Note

If you need a home equity loan or a HELOC and you apply to the same bank or financial institution that gave you your first mortgage, the home equity loan typically becomes the subordinated debt.

Loan subordination is often detailed in a subordination agreement or clause. The purpose of a subordination agreement in a mortgage is to protect the primary lender on the home. This is most often the bank or financial institution that holds the first mortgage. That institution stands to lose the most in the case of default or foreclosure. The subordination clause protects this first lender, and simply assures that the first mortgage holder will be paid if the home goes into foreclosure.

Since being second in line to collect debt carries more risk, lenders may take extra measures to protect their end of the bargain, such as:

There will be charges or other fees to pay to cover administrative costs.
You must be in good standing with your lenders on all of your payments.
There are limits set on the amount of your total monthly mortgage payments.

Senior Debt vs. Subordinated Debt

Senior debt	Subordinated debt
Primary debt	Secondary debt
Paid first in bankruptcy or default	Paid second in bankruptcy or default
Likely to be secured with collateral	May be unsecured
Less risky for the lender	Riskier for the lender

Comparing senior debt to subordinated debt helps clarify which debt would be repaid first in the event of a bankruptcy or foreclosure. Senior debt takes priority, and must be repaid first. The next in line would be subordinated debt, which would be repaid with what funds are left over.

Senior debt is the primary debt, and since it is more often secured with collateral, it's less of a risk for a lender than subordinated debt, which is often unsecured.

Refinancing and Resubordination

If you have a first mortgage plus a HELOC and you want to refinance, then you have to go through the resubordination process. Resubordination is often shortened to just “subordination.” Refinancing is when you take out a new loan, with new terms, and use it to pay off the first loan. It wipes out the old mortgage and puts a new first mortgage in its place. Because the original mortgage loan is no longer there, the HELOC moves into the primary or senior debt position—unless there is a resubordination agreement in place.

The lender that holds the HELOC has to agree that its loan will be second in line with the new first mortgage loan through a resubordination agreement.

Important

In some cases, a lender may refuse resubordination, either because it may want first priority, or a refinance pushes your first mortgage's balance too high and increases the chance of payment default.

What Subordinated Debt Means for You

If you wish to refinance your home and you have a HELOC in place, your new lender will insist that the HELOC be resubordinated. The lender of the HELOC that you already have is not required to do this, but most do. If that lender does not agree to fall second in line, you may have to wait and try again once you've built up more equity in your home.

The state of the housing market may also factor in the lender's decision. The lender of the HELOC is going to look at the loan-to-value ratio of both the new first mortgage and the mortgage it holds, combined. If home values are rising, this is less of a problem. If they are falling, this could cause you to hit a bump in the road.

If you have any problems resubordinating your current HELOC, you can try refinancing that loan. Refinancing a second mortgage can be easier than refinancing a primary mortgage.

Frequently Asked Questions (FAQs)

What does it mean when debt is subordinated?

When debt is subordinated, it's placed in a lower priority than other debt. For example, if you have a mortgage and take out a home equity line of credit (HELOC), the HELOC would be subordinated. This means that it would be paid second after your mortgage in the event you default on your payments

What is a subordinated debt example?

A good example of subordinated debt is when you have a first mortgage and a home equity loan. The first mortgage is the senior debt, meaning it gets paid first in the event of default, and the home equity loan is subordinate.

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Sources

The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.

U.S. Bank. "What Is a Subordination Agreement, and Why Does It Matter?"
Fannie Mae. "B2-1.2-04, Subordinate Financing."
Fannie Mae. "Selling Guide: Fannie Mae Single Family," Pages 180-181.