What Is a Subordination Agreement and How Does It Work?

A subordination agreement is a legal document that establishes one debt or claim as ranking behind another in priority for repayment. It formally adjusts the typical order in which creditors are paid, making one party’s claim inferior to another’s. This agreement is used to reorder financial interests, particularly if a borrower faces default or bankruptcy, ensuring specific obligations are settled in a predetermined sequence.

Understanding Debt Priority

Priority in financial claims refers to the established order in which debts are repaid, especially when a borrower cannot meet all obligations. When multiple parties have a claim against a borrower’s assets, a hierarchy determines who gets paid first. Generally, secured debts, those backed by collateral like a house or car, hold a higher position than unsecured debts.

This order of repayment becomes highly significant in situations of default, foreclosure, or bankruptcy. In such cases, a court-appointed trustee or liquidator distributes available funds according to this predefined priority. Lenders with senior claims have the legal right to receive full repayment before those with junior claims receive anything.

Subordination directly impacts this established priority by allowing a creditor to voluntarily agree that their claim will be paid after another, lower-ranked, debt. This contractual reordering moves a debt that might otherwise be first in line further back. Without such an agreement, debts follow a “first in time, first in right” rule, where the earliest recorded lien takes precedence.

Common Applications of Subordination

Subordination agreements often arise in real estate transactions, particularly during mortgage refinancing. When a homeowner with an existing first mortgage and a second mortgage refinances their primary loan, the new first mortgage would ordinarily fall behind the existing second mortgage in priority. Lenders for the new primary mortgage require a subordination agreement from the second mortgage lender to ensure the new loan maintains the first lien position.

The original first mortgage is paid off and replaced by a new one during refinancing, which could cause the second mortgage to automatically move into the primary position. To avoid this, the second mortgage lender agrees to remain in its secondary position, ensuring the new primary mortgage lender has the top claim on the property. This agreement ensures that in the event of a foreclosure, the first lien is always paid off before any subsequent liens.

Subordination also plays a role in business financing, especially with intercompany loans or loans from principals to a business. External lenders, such as banks, often require that any loans made by the company’s owners, affiliates, or other related parties be subordinated to the bank’s financing. This means that if the business faces financial distress, the external bank loan will be repaid before any internal or related-party loans. This arrangement provides external lenders with greater security and makes the business more attractive for securing necessary financing.

Key Aspects of a Subordination Agreement

A subordination agreement is a legally binding contract that outlines the altered priority of debts. It is a formal document that must be agreed upon and signed by all relevant parties. These parties include the borrower, the original creditor whose debt is being subordinated, and the new or existing creditor who will now hold the senior position.

The agreement identifies the specific debts involved, detailing the principal amounts, interest rates, repayment schedules, and maturity dates for each. It contains a statement confirming which debt is being subordinated and to which other debt. The document may also include conditions or terms under which the subordination becomes effective, such as the borrower’s financial standing or the fulfillment of other loan covenants.

It also defines the rights and restrictions of each party, particularly concerning the order of repayment in the event of default or bankruptcy. The agreement ensures that all parties understand their respective roles and the implications of the reordered priority. The senior lender receives greater assurance of repayment, while the subordinated lender acknowledges their lower position in the claim hierarchy.