Subordination Clause in Real Estate: Key Facts to Know

If you’re preparing for your real estate licensing exam, understanding the subordination clause in real estate is important. This clause appears in many real estate transactions, especially when multiple loans or liens are involved.

In this blog post, we’ll break down what a subordination clause in real estate is, how it works, and why it matters. By the end, you’ll know how to define it and be ready to answer questions about it on exam day.

What is a subordination clause in real estate?

A subordination clause in real estate is a contract term stating that the current claim on any debts will take priority over other claims made in the future.

It changes the order in which debts are paid if the borrower defaults (doesn’t pay). When a property has more than one loan, the subordination clause decides which lender gets paid first in case of foreclosure or a sale.

For example, if you have a primary mortgage on a house and then take out a second mortgage, the primary mortgage usually gets paid first if you can’t repay your loans. However, a subordination clause can change this order. Depending on the agreement, the second mortgage lender might be given priority over the first lender.

In short, this clause helps lenders know their place for repayment when a real estate transaction goes wrong, such as when the borrower defaults on their mortgage.

Subordination clause in different real estate agreements

You’ll come across subordination clauses in a variety of real estate contracts. Here are some common scenarios:

• Refinancing Agreements: When a borrower refinances their primary mortgage, the new mortgage may become subordinate to the second mortgage unless a subordination clause is signed. This clause ensures the first lender maintains priority.

• Second Mortgage Agreements: A subordination clause is often used when a property owner takes out a second mortgage. Usually, the first lender wants to ensure their loan is prioritized over the second mortgage in case of default.

• Lease Agreements: In commercial lease agreements, subordination clauses ensure that a mortgage lender has priority over a tenant’s lease. If the property is foreclosed, the tenant’s lease could be terminated, depending on the agreement.

• Equity Agreements: When a property owner uses home equity to take out another loan, the new lender often requires a subordination clause to ensure their loan is paid second after the primary mortgage.

Now, let’s explain further how a subordination clause works. Here are two common cases when this type of real estate contract clause is used.

How does a subordination clause in real estate work?

Subordination clause in case of foreclosure

When a borrower fails to make mortgage payments, the lender will take action to recover the loan balance. This usually happens by starting a foreclosure, a process to take ownership of the property and sell it in an auction to recover their money.

Of course, there are ways to stop foreclosure depending on each state’s laws, but if the case has no other solution and the property is finally sold, the borrower loses the property, and the sale money goes to the lender.

But what happens if there is more than one lender if the borrower has a second mortgage? How do they recover their loans? That’s when the subordination clause comes in handy.

Usually, if the borrower defaults, the lenders get paid according to their lien priority. The primary mortgage lender gets paid first, and the second mortgage lender only gets paid if there are remaining funds. If there’s a third lender, they’ll even have fewer chances to get paid. The further the chronological precedence of the loan, the lesser their opportunities to get their money back in case the mortgage goes wrong.

However, with a subordination clause in place, the priority of payment can be adjusted. If the first lender agrees to prioritize the second lender, the second will be paid first.

Subordination clause in case of refinancing agreements

To understand how a subordination clause in real estate works in case of refinance, picture this: you’re a homeowner with two loans—a first mortgage and a second mortgage. Normally, if you default on the loan and the property gets foreclosed, the first mortgage lender would get paid first, and the second mortgage lender would get paid with whatever is left.

But what happens if you refinance your first mortgage? Refinancing essentially cancels your old loan and replaces it with a new one. Without a subordination clause, the second mortgage would automatically move up in priority, which the lender of the refinanced mortgage won’t agree to. To avoid this, the second mortgage lender must agree to remain in second place, done with a subordination agreement.

This is a usual process in a refinance agreement. In this way, the subordination clause effectively gives the refinance lender peace of mind, ensuring they still get first priority in case of foreclosure. It’s all about protecting the lender’s investment.

What happens when a borrower defaults without a subordination clause?

The lenders get paid according to their lien priority if the borrower defaults. For example, the primary mortgage lender gets paid first, and the second mortgage lender only gets paid if there are remaining funds.

What happens if a borrower defaults when there is a subordination clause?

If a borrower defaults, the subordination clause determines the repayment order to creditors. The primary mortgage lender always gets first dibs on any sale proceeds. Any remaining funds go to the second mortgage lender and other lien holders in order of their priority.

If the property’s value is not enough to cover all loans, the secondary lender may not receive full repayment. This is why secondary loans tend to come with higher interest rates—they carry more risk.

Examples of subordination clauses

Let’s break down a few examples to make this easier to understand:

Example 1: Refinancing a home

Sarah has a primary mortgage and a second mortgage on her house. The second mortgage could take priority when she decides to refinance the primary mortgage. The lender of the new mortgage will require a subordination agreement to ensure their loan remains in the first place.

Example 2: Taking out a second mortgage

John buys a home with a primary mortgage and later takes out a home equity loan (a second mortgage). A subordination clause in the home equity loan ensures that the primary mortgage has priority in case of default.

Example 3: Leasing commercial property

ABC Company leases a building from a property owner who defaults on their mortgage. Because the lease has a subordination clause, the mortgage lender can cancel the lease if necessary, affecting ABC Company’s business.

Types of subordination clauses in real estate

You may encounter different types of subordination clauses in your real estate studies. Here are two common types:

• Executory Subordination Clause: This clause doesn’t kick in until certain conditions are met, like a borrower defaulting on the loan or selling the property. It’s more complex and requires specific actions to trigger the subordination.

• Automatic Subordination Clause: This clause takes effect as soon as the agreement is signed. There are no additional conditions to meet, and the priority order is immediately established.

Summing-up

As a real estate student preparing for the licensing exam, you must master subordination clauses. Understanding how they work is crucial when dealing with real estate transactions, especially when properties have multiple loans or liens. The subordination clause affects the repayment order if the borrower defaults or refinances, protecting the lender’s interest.

Take the time to study examples of subordination clauses in different situations, like mortgage refinancing and second mortgages, so you can easily answer exam questions. Remember, this knowledge is not just for the test— it will also serve you in real-world real estate transactions when you need to explain loan structures to clients.

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