Published by Kartik Subramaniam
Buying a house and obtaining a real estate loan can be confusing, especially if you're doing it for the first time. One important real estate finance term you should know about is a "subordination clause." I wanted to write an article explaining this clause and why it matters. We'll also show you how attending a real estate school or taking a real estate crash course can help you learn more about this and other real estate topics.
How Are The Priority of Liens Generally Determined?
In real estate financing, lien priority refers to the order in which various lenders and creditors have a legal claim or right to the property as collateral in the event of a default by the borrower. The lien priority determines who gets paid first and how much they receive when the property is sold or foreclosed upon.
Generally, lien priority is determined by the date and time when the liens were recorded. Liens recorded earlier typically have higher priority than those recorded later.
Here's an example to illustrate how lien priority works:
Let's say John owns a property and takes out a mortgage loan with Bank A, which is recorded on January 1, 2021. Later that year, John took out a home equity line of credit (HELOC) with Bank B, which was recorded on October 1, 2021. Finally, in 2022, John defaults on both loans, and the property is sold at a foreclosure auction for $500,000.
In this case, Bank A's mortgage lien has priority over Bank B's HELOC lien because it was recorded earlier. Therefore, Bank A will receive its total outstanding balance of $400,000 from the foreclosure sale proceeds first, while Bank B will only receive the remaining $100,000 (if there is any left after paying off Bank A).
What is a Subordination Clause?
A subordination clause is part of a mortgage or loan agreement where what would otherwise be a senior lender agrees to stay in a subordinate position and allow a new loan to have priority over an existing one.
Why is a Subordination Clause Important?
If you have more than one loan on your house, like a first and a second mortgage, a subordination clause helps determine which loan gets paid back first if you can't pay. This is especially important if you want to refinance (get a new loan with better terms) or get a second mortgage.
How Does a Subordination Clause Affect Homeowners?
A subordination clause can make it harder to refinance your primary mortgage or get a second mortgage. If the lender for your second mortgage doesn't agree to a new subordination clause, you might not be able to refinance. Also, getting a second mortgage will have a higher interest rate and not as good loan terms since it will be in a lower priority position.
How to Learn More About Subordination Clauses and Real Estate
Subordination clauses in development deals - an example
Imagine a developer named Emily who sees an opportunity to build a new residential complex on vacant land. To acquire the land and finance the construction, she needed to secure two loans: one for the land purchase and another for the construction costs.
Emily approached Big Bank to obtain a loan for purchasing the land. Big Bank agreed to lend her the necessary funds and make a first mortgage on the property using the land as collateral. This meant that in case of a default, Big Bank would have the first claim on the property. Now, Emily also needed a construction loan to cover the costs of developing the residential complex. She went to another lender, Builder Finance, which agreed to lend her the construction funds. However, Builder Finance needed assurance that they would also have a claim on the property if Emily defaulted on her loan.
Emily, Big Bank, and Builder Finance agreed to a subordination clause in their contracts to resolve this issue. The subordination clause stated that although Builder Finance's lien on the property was recorded later, Builder’s Finance would have a first loan on the property, and Big Bank agreed to a subordination clause. This meant that if Emily defaulted on her loans, Builder’s Finance would have the first right to recover its funds from the property, and Big Bank would have the subsequent claim after Builder’s Finance was fully satisfied.
This arrangement allowed Emily to secure both the land and the construction loan she needed to complete her project.
Using a subordination clause, Emily and her lenders created a clear and fair hierarchy of claims on the property, facilitating the successful financing and development of her residential complex.
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