A subordinate (or subordination) clause notes that a mortgage will remain subordinate to an existing lien on the property in question. It is typically written into home equity loans or lines of credit. This is why the main mortgage is referred to as a “first mortgage,” and a home equity loan or line of credit is called a “second mortgage.” In the case of a sale or foreclosure, the first mortgage loan would be paid off in full before funds are applied to the second, subordinate mortgage.
Lien Position Is Based on the Age of the Loan
Without a subordinate clause, loans would be automatically be given priority based on when they were originated. This priority is called the loan's "lien position." The oldest loan would default to first lien position. When additional mortgage loans are written against a property, they automatically fall into second or third lien position without any affect to the primary mortgage loan, whether or not a subordinate clause is included.
Refinancing with a Subordination
If a borrower who has a home equity loan or line of credit wants to refinance her primary mortgage, the first lender has to apply for a subordination agreement with the second lender. This allows the first mortgage lender to retain priority. An agreement is executed in which the second lien holder agrees to remain in subordinate position. Normally this process is a standard procedure of a refinance, but if the borrower’s financial situation has worsened, or if the value of the house has significantly declined, the second lien holder may be unwilling to execute the subordination agreement. If the second mortgage is a line of credit, they might freeze the line of credit so that no further money can be borrowed against it.
Lien Position Affects Lender Risk
First and second mortgage loans are underwritten based on different risk factors. Typically a second mortgage loan will have a higher interest rate than a first mortgage loan, or else have a variable rate. This reflects the greater risk of the lender to write a mortgage in a second lien position. They will assess how much they are willing to lend based on the combined ratio of the first and second mortgage loans to the current value of the property.
Review Your Loan Note
If you are obtaining a home equity loan or line of credit, consider whether you may want to refinance your first mortgage at a future date. Taking out a second mortgage may affect your ability to do so. One of the ways it might restrict you is through the ratio of your total loans to the value of the house. Second mortgages will commonly allow you to borrow up to 90 percent of the value, but in a refinance, the first mortgage lender may not want your combined loan to value ratio to be over 80 percent. Review the subordinate clause in the loan note to see what future restrictions may apply.
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