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The subordinated party will only collect on a debt owed when and if the
obligation to the primary lender has been fully satisfied in the event of
foreclosure and liquidation.
Lenders of senior debts have a legal right to be repaid in full before lenders of
subordinated debts receive any repayments. It often happens that a debtor
doesn't have enough funds to pay all debts, or foreclosure and sale doesn't
produce enough in the way of liquid proceeds, so lower priority debts might
receive little or no repayment at all.
A subordination agreement acknowledges that one party’s claim or interest is
superior to that of another party in the event that the borrower's assets must
be liquidated.
Example of a Subordination Agreement
Consider a business that has $670,000 in senior debt, $460,000 in
subordinated debt, and total asset value of $900,000. The business files for
bankruptcy and its assets are liquidated at market value—$900,000.
The senior debtholders will be paid in full, and the remaining $230,000 will be
distributed among the subordinated debtholders, typically for 50 cents on the
dollar. Shareholders in the subordinated company would receive nothing in
the liquidation process because shareholders are subordinate to all creditors.
Subordinated debts are riskier than higher priority loans, so lenders typically
require higher interest rates as compensation for taking on this risk.
KEY TAKEAWAYS
Special Considerations
Subordination agreements are most common in the mortgage field. When an
individual takes out a second mortgage, that second mortgage has a lower
priority than the first mortgage, but these priorities can be upset by
refinancing the original loan.
The mortgagor is essentially paying it off and receiving a new loan when a
first mortgage is refinanced, so the new, most-recent loan is now second in
line. The existing second loan moves up to become the first loan. The lender
of the first mortgage refinancing will now require that a subordination
agreement be signed by the second mortgage lender to reposition it in top
priority for debt repayment. The priority interests of each creditor are changed
by agreement from what they would otherwise have become.