During your first-ever mortgage process, you learn all the ins and outs of terms like escrow and homeowners insurance. You also sign lots of closing documents, including a promissory note and mortgage (which may also be known as a deed of trust in some states). Your note is your contractual promise to repay the loan based on the terms and conditions agreed to with your bank, credit union or other type of lending institution. The mortgage/deed of trust is a legal document that is the security for the mortgage loan. This document is recorded with county recorder or register of titles in the county where the real estate is recorded.
There’s another important property-related term not typically mentioned when you take out a mortgage. Even so, every homeowner should know what it is and how it might eventually apply to them. It’s called a loan subordination agreement. Here’s the 411 on this key document.
First, what is a lien position?
You can’t understand loan subordination agreements until you know about lien positions because the two concepts are inherently connected. Let’s go back to the mortgage/deed of trust document. Part of that contract indicates that your new home is the collateral that backs up your mortgage. After a real estate closing, your lender records this document with your county’s register of deeds or its equivalent, depending on where you live. This creates a first lien position, or first mortgage, on your home.
As a homeowner, you might eventually decide you want to use your home’s equity—the difference between its current market value and your mortgage balance—for things like renovating your kitchen, preparing for a new baby or even investing in real estate. In that case, you’d likely either apply for a home equity line of credit (HELOC) or a home equity loan.
Once approved and at closing, you’ll sign another promissory note and mortgage/deed of trust, this time contracting you to the repayment terms of this new debt. The lending institution will record the mortgage/deed of trust with your county, granting it the second lien on your home, also called a second mortgage. So, your original mortgage remains in the first lien position and your HELOC or home equity loan goes in the second lien position. If you later take out another debt with your home as collateral, it would be in the third lien position.
Now, what’s a loan subordination agreement?
Loan subordination is simply the placement of the lien in a lower rank or position, like in the example above that outlines how each new lien is ranked. Property law follows the “first in time, first in right” rule. This just means that in the event you fail to make your payments and the loan is foreclosed, the lender in first lien position has the first claim to the collateral value of your home.
The second lien holder has the next claim, and so forth. A subordination would re-order those claims to the value of your property.
As for a loan subordination agreement, it’s a contract between lenders to accept a new rank in their lien position, allowing a new loan to “step ahead” of their existing lien.
And when are loan subordination agreements typically needed?
Many homeowners choose to refinance their original mortgage at some point for one or more of the following reasons:
- Take advantage of a lower interest rate
- Convert from an adjustable-rate mortgage (ARM) to a fixed-rate loan
- Lower their monthly payment by stretching out their mortgage over another full term
- Switch from a 30-year to a 15-year mortgage to save on interest over the life of their loan
- Get cash out to put toward home improvements, debt or even an emergency fund
When you refinance, you sign a new set of documents and the new mortgage/deed of trust gets recorded in your county—and your original mortgage is paid off, which cancels its first lien position (the servicer will prepare the satisfaction or lien release on the existing loan and send it for recording to release the prior lien and record). If you have a HELOC or other type of second mortgage on your home, it automatically moves into the first lien position in accordance with the “first in time, first in right” rule.
Refinancing lenders typically require that the lien positions be re-ranked so that your new mortgage is first and any pre-existing debt like a HELOC moves back into second. A loan subordination agreement accomplishes that.
Who handles getting the loan subordination agreement?
As part of their underwriting process, refinancing lenders usually request a loan subordination agreement from the lender holding your HELOC or home equity loan. As long as the property has adequate equity beyond the combined amount of the refinanced mortgage and the pre-existing line or loan, lenders typically agree to this request and sign the loan subordination agreement.
However, some refinancing lenders may require you as the borrower to request the loan subordination agreement. Again, this shouldn’t be a problem unless the property isn’t valuable enough to protect the other lender’s interest in it. If problems arise when you’re required to request the loan subordination agreement, you may need to enlist the help of an attorney. If you have legal insurance, this is as easy as contacting your provider to connect you with an attorney in its approved network who can assist you.
Now, you know what to expect during a refinance when it comes to a pre-existing HELOC or home equity loan that needs to be subordinated back to the second lien position.