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, the terms "mortgage" and "deed of trust" mean the same thing.) The lender will then record the mortgage, called a "first mortgage," in the county records or other public land records to create a lien on your property. If you then take out another loan, like a home equity loan, the second lender will record it and also get a lien on the property.
If you have two mortgages on your home and refinance the first loan, the refinancing lender might require a "subordination agreement." The purpose of a subordination agreement is to adjust the priority of the new loan.
Legal Concept of "First in Time, First in Right"
Mortgage liens generally follow the "first in time, first in right" rule. This general rule says that whichever lien is recorded first in the land records has higher priority than later-recorded liens.
However, some liens, like property tax liens, automatically get priority over most earlier ones. But judgment creditors, for example, don’t get priority over previously recorded liens.
Priority and Foreclosures
When a property has multiple liens, priority determines the lienholders’ rights after a foreclosure sale. The first mortgage lender has priority over the second mortgage lender and, therefore, gets paid from the foreclosure sale proceeds before the second lender. In other words, only once the first lender receives all of the money it is owed does the second lender get any money.
If there’s a third mortgage lender, the second mortgage lender gets paid before that lender. And so on. But because a foreclosure sale brings in a limited amount of money—perhaps even less than the borrower owes on the first mortgage—a second mortgage lender and other low-priority lien holders sometimes get nothing out of a foreclosure sale.
Refinancing Alters Priority
If a home has two mortgage liens, and the homeowner refinances the first mortgage, the new loan pays off the existing first mortgage. Then, what was previously a second mortgage moves up in priority to become a first mortgage. The refinancing loan then becomes second in priority.
What Is a Subordination Agreement?
In a subordination agreement, the lienholders agree to change the priority of their liens.
Who Is Involved in a Subordination Agreement?
Generally, in a refinance situation, the parties to a subordination agreement are an existing second mortgage holder and a lender refinancing the first mortgage.
Why Is a Subordination Agreement Important?
Most lenders won’t agree to refinance a first mortgage unless the second mortgage lender signs a subordination agreement. In a subordination agreement, the second mortgage lender agrees to stay in second position after a refinance of the first mortgage.
How Does a Subordination Agreement Work?
Here's how a subordination agreement works. Say Mrs. Brown wants to refinance a $200,000 mortgage she initially got from Bank One to buy her home. She also has a second lien on the property—a $50,000 home equity loan that she got from Bank Two.
When Mrs. Brown refinances her first mortgage, she gets a new $200,000 loan from Bank Three. The new loan pays off Bank One’s mortgage. Bank Two’s second mortgage then moves into the first position because it is the oldest lien recorded on the property. Bank Three, which is providing a $200,000 loan, insists that Bank Two sign a subordination agreement to adjust the priority.
Once Bank Two signs the subordination agreement, Bank Three’s loan becomes the first mortgage and gets priority over Bank Two’s mortgage, even though Bank Two recorded its mortgage before the refinance.
What Are the Benefits of a Subordination Agreement?
A subordination agreement encourages a lender to provide a refinance loan for a first mortgage, even if the property already has a second mortgage. The refinancing lender gains top-tier status, so it will go ahead and make the loan.
Assuming the property has plenty of equity, the second mortgage lender also benefits from the transaction. A homeowner that's able to refinance a first mortgage might be in a better financial position afterward, thus ensuring that payments on the second mortgage get made. By collaborating and agreeing to a subordination agreement, financial institutions work together to provide loans that benefit both property owners and lenders.
What Are the Risks of a Subordination Agreement?
The risk of a subordination agreement falls mainly on the subordinating lender. After agreeing to make its lien junior to a refinancing lender, the subordinating lender risks losing its security interest in a foreclosure. Then, the subordinated lender might face challenges in recouping their investment if the foreclosure sale proceeds aren't sufficient to cover all liens.
However, theoretically, a lender wouldn't agree to a subordination agreement unless the home was worth enough to satisfy both loans.
How Is a Subordination Agreement Enforced?
Enforcement of a subordination agreement is usually through the foreclosure process. After a borrower defaults on the first (refinance) mortgage, that lender will seek to enforce its priority status and recoup its investment by foreclosing. Because of the subordination agreement, that lender's claim takes precedence over the junior lender's.
So long as the terms of the subordination agreement are clear, enforcing a subordination agreement is a straightforward process.
How Do I Get a Subordination Agreement?
Second mortgage lenders don’t always readily agree to lower their priority with a subordination agreement. But most second mortgage lenders will sign the agreement if the property has enough value to cover both loans.
In some cases, a refinancing lender will take on the task of getting any needed subordination agreements. However, this burden sometimes falls on the borrower. To get a subordination agreement from a second mortgage lender, contact that lender. Explain that you're refinancing your first mortgage and that the new lender wants a subordination agreement.
Read More Articles About Second Mortgages
Find out what happens if you default on a second mortgage.
Learn what happens to a second mortgage in a foreclosure.
When to Talk to a Lawyer About a Subordination Agreement
If you have difficulty getting the second mortgage lender to sign the agreement, consider hiring a real estate lawyer to help you through the process. For answers to questions about lien priority in a foreclosure, contact a foreclosure attorney.