What is a Subordination Clause?

A property can have more than one loan attached to it. In these situations, the loans will have a structure of hierarchy where one debt will have the repayment priority over others. This is important when the borrower defaults and the property is foreclosed on. These hierarchy levels are commonly referred to as first position, second position, third position, etc.

A subordination clause is a section of a contract that states that repayment of the debt in the subject contract will take priority over any future debts that get taken out against a property.

Let’s take a look at an example.

George purchases his home and has takes out a first mortgage to do so. There is a subordination clause in the loan contract stating that this mortgage must be repaid before any subsequent debts get repaid in the instance of a foreclose. Five years later, George's property has gone up in value, so he decides to take out a second mortgage to cover the costs of the kitchen renovation.

Unfortunately, a couple of years later, George enters a period of financial hardship and cannot make his mortgage payments. Ultimately, the bank chooses to foreclose on the property. But unfortunately, the real estate market has declined considerably, and now George's mortgages are more than the market value of his property.

In this case, the property will be foreclosed and sold. However, under the subordination clause, the first mortgage will be repaid in full, and any remaining funds will go towards paying off the second mortgage.

Because of the subordination clause, loans in second position are a higher risk loan for lenders than first position. Therefore, borrowers can expect to have a higher interest rate for a second mortgage than their first to compensate the lender for their higher risk position.

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