A subordination clause is a provision that states that a current debt has priority over other future debts. Such a clause is most often used for loans and mortgages.
If a home or property is foreclosed on and then is subsequently liquidated in order to obtain cash, the mortgage lender who was the first lender is the primary beneficiary of the sale proceeds. Funds that left over after this takes place is then used to pay the second mortgage. The more lenders that lay ahead of another lender, the lower their chance of reclaiming the original loan amount becomes.
In order to combat this, a subordination clause will render a claim as the primary senior, any other agreements or mortgages that are attached will take a back seat to the senior. Subordination clauses are generally used in deals such as bond issues as well as mortgage contracts.
A good example would be if a home is being foreclosed on due to the owner defaulting on their mortgage payments. The property will then be sold, with the earnings from the sale being allocated to the lenders. The lender who would otherwise be waiting behind other lenders who have primary position on the returns are able to leapfrog and become first in line with the subordination clause.
Subordination Clause In Relation To Bond Issues
A company can issue out a bond that has a subordination clause attached to it. The clause makes sure that if any additional bonds are given out, the original bondholder will be paid first. The clause acts as a safeguard for the original bondholders as the clause significantly increases the chances that they will be paid back.
Subordination Clause & Mortgage Refinancing
Although a subordination clause can be used for bond issues or home foreclosures, they are typically used in refinancing mortgages. A homeowner can hold both a primary and a secondary mortgage simultaneously. The individual can then refinance which will cancel the mortgage that they initially had and they will receive a new mortgage. When this is done, the second mortgage that the individual had on their home will be bumped up to the primary position which while the new mortgage is now second in line.
First lenders often demand that the lender second in line sign a subordination agreement which cements their status as the primary lender and keeps the other lender behind them in regards to being paid back.