Debt and credit are complex topics, made all the more opaque by the jargon used to discuss the details of the industry. Mezzanine debt and subordinate debt are just two examples of this obscure lingo. The good news is that most consumers don't have to worry about these terms -- but if you do, here are the basics. Mezzanine debt is technically a form of subordinated debt in which the borrowed funds can be converted to equity in the event of a default by the borrower. Subordinated debt is itself money owed to an unsecured creditor that is only eligible for repayment during liquidation if all other claims by secured creditors have been fully met.
Mezzanine debt is a type of subordinated debt which can be seamlessly converted into equity if the borrower chooses to default.
Understanding Subordinate Debt
There's a pecking order to debt that only becomes relevant if you default on all of your debt at once -- such as if you file for personal bankruptcy or decide to dissolve your company. Subordinate debt is in second place when it comes to collecting in such a circumstance: your creditor collects its money only after debt with higher-priority debts get settled.
Example of Subordinate Debt
The most common example of subordinate debt is a first and second mortgage. In most cases, the bank holding the first mortgage has first claim to any money realized after a foreclosure and sale of the property. The bank holding the second mortgage -- the subordinate debt -- gets whatever's left, which might be nothing at all. This extra risk is the main reason second mortgages tend to have higher interest rates than primary mortgages.
Exploring Mezzanine Debt
A mezzanine is an extra or interim floor between two main floors -- for example, a balcony overlooking an entryway. Just as this name implies, mezzanine debt is interim debt, in which a borrower gets money for a project while looking for a better deal. Mezzanine debt is typically very expensive, which is why professionals consider it an interim measure -- for use when they need money quickly -- rather than a long-term financing option.
Example of Mezzanine Debt
Businesses can get easy access to high-interest credit attached to certain valuable equipment or to credit card proceeds. For example, if your company needs money to finish fulfilling an order, you might take on such a loan to be able to complete the company's obligations while looking for a business line of credit with lower interest and better payment options. Credit cards are another form of mezzanine debt, offering convenience in exchange for high rates.
Alternative Definitions to Consider
Some professionals also use the term "mezzanine debt" more loosely, to describe any temporary borrowing measure. This could include a high-risk loan using vital equipment as collateral while looking for an unsecured loan for long-term financing. It can also mean simply borrowing money on margin, such as when you obtain a loan to buy goods that you plan to sell quickly -- and you plan to use the money from that sale to pay off the loan quickly.