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What is Subordinated Debt?

Patrick Austin, J.D. | September 27, 2024

Patrick Austin
Attorney from George Mason
Patrick Austin, JD

Patrick Austin is a licensed attorney with a background in data privacy and information security law. Patrick received his law degree at George Mason University's Antonin Scalia Law School, where he served as the Editor-in-Chief for the National Security Law Journal.

Edited by Hannah Locklear

Hannah Locklear
Editor at SoloSuit
Hannah Locklear, BA

Hannah Locklear is SoloSuit’s Marketing and Impact Manager. With an educational background in Linguistics, Spanish, and International Development from Brigham Young University, Hannah has also worked as a legal support specialist for several years.

Summary: Subordinated debt is effectively unsecured debt that is ranked lower in the priority hierarchy to other, more senior, loans or securities. This is why subordinated debt is oftentimes referred to as “junior” debt. In the event you default on your loans or file for bankruptcy, creditors holding subordinated debt will not be paid until senior debt holders are paid in full.

If you are struggling to repay multiple loans (e.g., mortgage, student loans, personal loans, etc.) and have fallen behind on payments, or you are considering bankruptcy, you may have encountered the term “subordinated debt.” This may lead you to ask, “what is subordinated debt?” Well, subordinated debt is basically “back of the line” debt.

For example, let’s say you default on your loans. Debt X is your home mortgage loan for $500,000. Debt Y is an unsecured personal loan for $25,000. In this scenario, Debt X is the senior debt while debt Y would be considered the subordinated debt. If you ultimately decide to file for Chapter 7 bankruptcy, the holder of debt X would be repaid in full first. Only if there are sufficient funds remaining would the holder of debt Y get repaid.

Common examples of subordinated debt, also known as junior debt, include unsecured loans, mezzanine debt, convertible loans, and working capital credit lines.

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What is the difference between subordinated debt and senior debt?

There are important differences between subordinated debt and senior debt. Simply put, senior debt is paid back before subordinated loans. Only once the senior debt is paid back in full can repayment commence on the subordinated debt.

Since senior debt holds the highest priority for repayment in the event of bankruptcy or liquidation, this type of debt typically carries a low amount of risk. As a result, this type of debt typically offers lower interest rates relative to other types of debt. This is why the average interest rate for a home mortgage is single digits (e.g., between 5 and 7 percent) while the interest rate for a personal loan can be anywhere between 12 and 25 percent. Credit card debt often has higher interest rates since credit cards are considered to be unsecured debt instruments held by subordinated debt holders.

The order of priority can change for subordinated debt

It is possible for the priority on certain types of debt, including secured debt, to change. For example, let’s say you already have a mortgage on your home and you decide to apply for a second mortgage. The secured debt for the second mortgage loan will have a lower priority than the original mortgage. However, the order of priority for debt obligations can be changed if you opt to also refinance the first mortgage loan. Since the refinanced mortgage is actually a new mortgage (i.e., the first mortgage is paid off and a new loan is taken out), the refinanced mortgage is now behind the second mortgage in terms of priority.

What is a subordination agreement?

If you apply for a secured loan, you may encounter a specific subordination agreement. This agreement comes into play in the event you were to default on the secured loan. A common example of a secured loan is a home mortgage. The subordination agreement would help shed light on who gets paid from the sale of the asset that secured the mortgage loan.

In the mortgage example, a subordination agreement could help determine who gets paid first from the sale of the home, in the event of default or filing for bankruptcy. This is possible because the mortgage lender would have a lien on the asset. In effect, the position of the lien will determine which lien holder gets paid first.

Similarly, if you were to declare bankruptcy, certain assets would be liquidated and the proceeds repaid to your creditors. A subordination agreement could determine who gets paid first from the liquidation of your assets.

The mortgage example is most relevant since you have the highest chance of encountering a subordination agreement when engaging in a real estate transaction. For example, some states use a loan agreement known as a deed of trust for loans involving real property. Home mortgages and deeds of trust function in a similar manner.

How do subordination agreements work?

As mentioned, lenders often use subordination agreements to protect their interests by preventing their debt from becoming subordinated debt in case of default. This way, if a borrower stops making the required payments on the loan, the lender can point to the subordination agreement to get priority placement in the repayment hierarchy.

For example, let’s say a borrower takes out a $500,000 mortgage to purchase a home. The lender asks the borrower to sign a subordination agreement to guarantee that the loan will be categorized as senior debt in the event of default or liquidation. Subsequently, the borrower takes out a second mortgage of $200,000 from a new lender and uses the same house as collateral. This second mortgage will generally be considered subordinated debt because it is second in line to the first mortgage.

Subordination agreements are important to you because they can impact whether you can refinance a loan. For example, if you take out a second mortgage on your house, you may not be able to refinance your first mortgage because the lender of the second loan may not agree to the subordination agreement.

Key Takeaways

In summation, subordinated debt is basically any debt that is deemed junior to other types of debt. Examples of subordinated debt, also known as junior debt include:

  • Unsecured loans
  • Mezzanine debt
  • Convertible loans
  • Working capital credit lines

In the event you default on a loan or you opt to file for bankruptcy, your subordinated debenture will only be paid out until after senior debt holders are paid in full. The repayment priority is one of the reasons why the interest rate on secured loans is lower relative to unsecured loans (e.g., personal loans, revolving credit lines). If you apply for a home mortgage, or second mortgage, you may also be asked to sign a subordination agreement that stipulates the loans priority in the event of default or liquidation.

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