What is a Subordination Clause? Everything You Need to Know
When lenders issue loans for the purchase or maintenance of real estate property, they inevitably take on several liabilities.
These liabilities more often than not come in the form of credit risks where the lender may incur losses due to a borrower’s inability to pay back a loan.
To minimize the possibility of losses happening, lenders make use of subordination clauses to ensure their lien on a property takes priority over other liens.
The real estate industry so happens to be one where financial issues can arise at any time. Therefore, you should acquire an in-depth understanding of what subordinate clauses entail before venturing into the realm of real estate deals.
Doing this will assist you in taking adequate control of your interests and prepare you for everything possible.
In this article, we will be taking you through what a subordination clause is, how it works and how it affects homeowners.
What is a Clause in a Real Estate Contract?
Before we dive into subordination clauses, let’s, first of all, discuss what a clause in a real estate contract is.
According to legal terms, a real estate contract clause is a provision in a legal document that dictates specific conditions under which all parties agree to abide by during the purchase and sale, exchange, or transfer of a real estate property.
These statements point out the rules and obligations to which a buyer, seller, and other entities involved agree.
A real estate transaction requires a contract to make it legally binding, and the use of clauses protects and prioritizes the needs of all parties involved.
In the competitive real estate market, buyers, sellers, and even lenders continually seek more flexibility in their transactions. To achieve this, any of the seven essential types of contract clauses can be utilized when preparing purchase offers or counteroffers.
Here are the seven essential types of clauses in a real estate contract:
- Subordination clause
- Prepayment penalty clause
- Release clause
- Due-on-sale clause
- Acceleration clause
- Defeasance clause
- Subrogation clause
What is a Subordination Clause?
A subordination clause, also known as a dependent clause is a provision in a contractual agreement that allows the present claim on a mortgage to take precedence over subsequent claims that may be made in the future.
In real estate, a subordination clause becomes effective once a mortgage loan has defaulted and there is more than one lien on a property.
When a borrower defaults on a mortgage, there is the possibility of the property being foreclosed and liquidated for cash.
Typically, the first mortgage lender gets the legal rights to repossess the property and recover the loan’s balance before any other lender. In many cases, the value of the property may not be sufficient to cover all the liens.
Therefore, the further down a lender is on the mortgage tier, the less likely they are to recover their loans.
To improve the priority of a lien, most lenders will include a subordinate clause in the real estate contract to protect them in case of a default. The subordination clause can be found primarily in mortgage notes and commercial real estate lease agreements.
How Does a Subordination Clause Work?
A subordination clause works by establishing that one party's interest is superior to another if the borrower’s property needs to be sold to pay off outstanding debts.
The most important thing to remember about how a subordination clause works is that if the borrower defaults on the mortgage, the first lienholder which is usually the primary lender is taken care of before subordinate liens can recoup their costs.
For example, a lender agrees to lend Mr. A the money to purchase a house after a subordination clause, stating that they are to take repayment priority, has been signed.
If after two years Mr. A has incurred a huge amount of credit card debts and a lien has been issued on his house by the court. Mr. A is obliged to, first of all, pay the lien to the lenders before repaying the credit card company.
Subordinate clauses are also common in situations when there are two mortgages on a property but the property owner needs to refinance their primary mortgage.
The refinancing lender will require that a subordination clause be signed by the second mortgage lender to ensure that they are paid first if there is a default.
How Does a Subordination Clause Affect a Homeowner?
Although it may seem like the subordination clause is only important to lenders, this is not true. Subordinate clauses can significantly affect a homeowner's finances when refinancing a house.
This is because they can create huge stumbling blocks when trying to take advantage of the low-interest rates that come with refinancing a mortgage.
Refinancing happens when the initial loan has been fully paid and a new lender offers a loan under a new interest rate. A subordination clause will then be used to give priority to this new lender and ensure they are the top priority for repayment.
However, this may not always work out as many claim holders will not authorize this refinance because they would then become subordinate lenders.
What is a Lien?
A lien is a legal right or claim which has been issued against a property to assist the creditor -banks or mortgage agencies- to collect what is owed to them. Liens are real estate encumbrances that set a limit to what the property owner can do with the asset.
This encumbrance is placed on a property when a debtor fails to fulfill their financial obligations. As stakeholders in the property, creditors are given certain legal rights and may choose to get rid of the property by selling it to get their money back.
How Do You Remove Liens From Titles?
The most straightforward way to remove a lien from a property is to either satisfy the debt or negotiate a payment plan with your creditor. Once your debts have been fully paid, you can then file for a Release of Lien form which will act as evidence that you no longer owe your creditor.
Before purchasing a property, it is important to find out if there is a lien attached to the property. If yes, find out what type of lien it is. Liens are a matter of public record, therefore, by running a title report you can discover any liens that may be on the property.
Final Thoughts on Subordination Clauses
Subordination clauses are a complex and delicate aspect of real estate transactions that should be handled with the utmost level of understanding. Failure to do this can result in severe financial and legal consequences that could easily have been avoided. Also, it would be wise to always seek legal help when preparing and before signing a real estate contract.
TL;DR: A subordination clause is a provision in a contract that prioritizes the repayment of liens on a title. Some lenders will use the subordination clause to ensure that they will have top priority when the borrower is making payments.