A subordination agreement assists in the payment hierarchy when a debtor defaults, by assigning higher priority to certain debts for repayment. These could become crucial when a debtor fails to meet mortgage payments, refinances their loan, or files for bankruptcy. Key players in such situations would include the debtors, who carry the risk of not being fully paid, and lenders, who may gain higher interest rates for taking on greater risks.
Often, when individuals or businesses seek loans from financial institutions, they accrue multiple debts for different requirements. If bankruptcy is declared, the available funds may not be sufficient to repay all the creditors. When such a situation arises, a court-appointed trustee will start the repayment process in line with the prioritized debts assigned by the subordination agreement, commonly known as senior debt.
Further down in the priority queue are obligations classified as junior debt or subordinated debt. Lenders of senior debt legally have the first right to full repayment when a borrower goes bankrupt. As a result, subordinated debt lenders may only receive partial payment or, worst case, nothing.
Lenders agree to a subordination agreement knowing that senior creditors supersede them in the event of the debtor's assets being liquidated. Although this appears risky, the lenders might agree for several reasons; they could be offered a higher interest rate for taking on the greater risk, or they might be given fees. Notably, for a subordination agreement to hold ground legally, it needs to be notarized and recorded in the county's official records.
This system, more common in mortgages, ensures the lender who grants the initial mortgage will have the first claim on the property in case of foreclosure. If the homeowner wishes to refinance the original mortgage, the lender of the new mortgage could insist on the subordination of the home equity line of credit (HELOC), which usually involves a fee.
Both businesses and individuals can file for Chapter 7 bankruptcy, resulting in selling off of the debtor's assets to pay back the creditors. Businesses often employ Chapter 11 bankruptcy for restructuring under a court-appointed trustee's supervision without going out of business. Chapter 13 bankruptcy, often chosen by individuals, allows keeping more assets provided they adhere to a court-approved repayment plan.
Overall, subordination agreements help prioritize debt repayments during foreclosures or bankruptcy, protecting senior creditors. The subordinated lenders may receive higher interest rates or fees to compensate for the increased risk. Before entering into a subordination agreement, it is crucial to seek assistance from a legal expert or financial advisor.