Your home is typically one of your largest investments, and there are numerous ways that you can leverage this valuable asset in order to meet your goals. Subordinate mortgages, which can come in the form of a second mortgage, equity loan, or home equity line of credit (HELOC), can allow you to fund all types of projects.
Before you enter into one of these complex transactions, it’s important to have all the information you need. Here is an overview of subordinate mortgages that will help you understand the liabilities, rewards, and rules around this financial process.
What is a Subordinate Mortgage?
Subordinate mortgages are loans that have a lower priority status than any other recorded liens (or debts) against a property. When you get the loan you need to purchase your home, this loan is typically recorded as the first repayment priority on your deed after closing. This means that if you default on your loan, it will be the first debt repaid with any proceeds from the sale of your home.
Behind this primary loan, you may have secondary, or subordinate, mortgages. Examples of these can include separate mortgages used to help buy your home, HELOCs, or equity loans taken out after you purchased your home. Since these loans are subordinate to your first mortgage, if you default on your loans, they would be paid off by any proceeds left over after the first mortgage is paid off from the sale of your house.
What is a Subordination Clause in a Mortgage?
The part of your mortgage agreement that documents this process is the subordination clause. In this portion of your agreement, the mortgage company for your first loan states that your debt on their loan takes precedence over any other debts or liens you may have on your property, now or in the future.
What is a Lien?
A mortgage is not the only type of debt that can be recorded against your home. Another common type is a lien. A lien states that someone else has the right to repossess your home if you fail to make payments on a debt that you owe. Examples of liens include costs owed to contractors for large remodeling projects, unpaid child support, and Federal or State tax debt.
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How Does a Mortgage Become Subordinate?
If all of this seems quite straightforward and sensible to you so far, you may be wondering how or why your first mortgage could ever become subordinate to another debt. Still, there are situations in which your first mortgage may be placed in a subordinate position, whether by your request (and your lender’s agreement) or by law.
Any mortgages that are recorded after your first purchase loan are usually subordinate loans. However, lenders may occasionally agree to “change position,” and make their loans subordinate to other debts. These situations require you, the borrower, to ask your lender to subordinate to another loan, however, doing so is not usually in the lender’s best interest.
There are also situations where your first purchase loan can become subordinate by law or regulation, without your lender’s agreement. Here are two examples:
- If you have a Federal tax lien for unpaid income taxes, this debt automatically becomes a primary lien ahead of your first mortgage. Your Federal tax debt will be repaid first if you sell your home or go into foreclosure.
- A mechanic’s lien is used by an unpaid contractor, subcontractor, laborer, or material supplier to place a legal claim on your property for monies owed. In some states, your first mortgage debt can be relegated to a subordinate position to their unpaid bills. Keep in mind, the laws around mechanic’s liens vary widely from state to state.
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How Will Subordination Affect my Financing?
Having subordinate liens on your home might not have much of a noticeable impact on your daily life, but these debts can have a big impact on your ability to qualify for mortgage financing. Depending on your lender and the details of the lien(s), you may or may not be able to qualify to buy a new home or get another mortgage in the future.
Many lenders will only offer you mortgages if their loan will be in the primary position. If you have unpaid subordinate liens, you would have to ask those lien holders if they would be willing to be subordinate to your prospective new mortgage — something they may or may not be willing to do.
In addition, your lender will need to review these subordinate liens to make sure the payments remain constant, are something you can afford, and don’t include negative amortization, or other potential financial pitfalls that could make you more likely to default on your loan.
Subordination and Second Mortgages
If you loaned money to a friend, how would you feel if they told you that you were their last priority when it came to repayment? Would you still freely make the loan, or would you take extra steps to protect yourself?
Lenders view things in a similar way. If they are giving you a loan (like a second mortgage) that is subordinate to other debts, they consider the loan to be riskier. This is because they are taking a chance: They might not get paid back if your assets are gone by the time their loan is due to be paid on the priority list.
The result of this is that you will most likely be charged higher rates on subordinate mortgages than you would be on a primary mortgage. This higher rate is a way for lenders to protect their investment.
Subordinate Mortgages and Refinancing
During the time that you own your home, you may refinance your mortgage. The refinancing process is usually quite simple, but one thing that can add extra steps is the existence of subordinate mortgages, such as a HELOC.
When you refinance, your new lender will want their mortgage to hold primary status, and for the HELOC to remain subordinate. In order for this to happen, the HELOC lender will need to agree and the HELOC will need to be re-subordinated. This process allows the refinancing mortgage to have first claim on the property, even though it is a more recent loan than the HELOC.
Don’t be Scared of Subordination
“Mortgage Subordination” may sound intimidating, but it’s actually a straightforward process that allows lenders to give homeowners greater flexibility when it comes to leveraging the equity in their home. If you want to explore your mortgage options, take the first step and contact a Pennymac Loan Officer or apply online today.