Understanding Debt Repayment Priority
If you owe money to more than one person or entity, you need to establish a pecking order for repayment. That's where a subordination agreement comes in—it outlines which debts get paid first if bankruptcy happens.
What Is a Subordination Agreement?
Let me explain it directly: a subordination agreement is a legal document that sets one debt as lower in priority than another when it comes to collecting repayment from you, the debtor. This priority matters a lot if you default on payments or file for bankruptcy. The debt with higher priority has a better chance of getting repaid, at least partially.
Key Takeaways
Here's what you need to know: these agreements rank debts so one is behind another for repayment in foreclosure or bankruptcy. A second-in-line creditor only gets paid after the priority one is fully satisfied. Subordinated debts are riskier, so lenders usually demand higher interest or other compensation. You'll often see them with multiple mortgages on a single property.
How a Subordination Agreement Works
When you or your business needs funds, you might borrow from multiple sources for different reasons. If bankruptcy hits and there's not enough money to go around, a court-appointed trustee steps in to repay as much as possible, starting with the highest-priority debts, which we call senior debt.
Lower down are the junior or subordinated debts. Lenders of senior debts have the legal right to full repayment before subordinated lenders get anything. That means those lower-priority lenders might get partial payment or nothing.
By signing a subordination agreement, a lender agrees that another party's claim comes first if your assets are liquidated to pay debts. Why agree? Often, they get a higher interest rate or fees for the extra risk.
Important Requirement
Remember, for it to be enforceable, the agreement must be signed, notarized, and recorded in the county's official records.
Examples of Subordination
Subordination plays out in bankruptcies for businesses or individuals. Take a business example: imagine a company with $670,000 in senior debt, $460,000 in subordinated debt, and $900,000 in assets. It files Chapter 7, assets are liquidated for $900,000. Senior holders get paid fully, leaving $230,000 for subordinated holders—pennies on the dollar. Stockholders get nothing, as they're last in line.
For individuals, obligations like alimony and child support top the list, followed by senior debts over junior ones.
You’ll most likely deal with this in mortgages. Say you have an original mortgage and a HELOC on your home. The mortgage has the first lien. If you refinance, the HELOC might move up, but the new lender could require a subordination agreement from the HELOC lender, who might agree for a fee or refuse, killing the deal.
What Is Chapter 7 Bankruptcy?
In Chapter 7, your non-exempt assets are sold off to pay creditors as much as possible. It's for individuals or businesses and known as liquidation bankruptcy.
What Is a Chapter 11 Bankruptcy?
Chapter 11 is mainly for businesses. Instead of liquidation, they reorganize under a trustee and keep operating while following a repayment plan over years.
What Is a Chapter 13 Bankruptcy?
For individuals, Chapter 13 lets you keep more assets than Chapter 7 if you stick to a court-approved repayment plan.
The Bottom Line
Subordination agreements legally set the repayment order in foreclosure or bankruptcy. The subordinated lender gets compensated for the risk, often through higher rates. If you have multiple home mortgages and refinance, expect to encounter one.
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