A subordinated loan is debt that’s only paid off after all primary loans are paid off, if there’s any money left. It’s also known as subordinated debt, junior debt or a junior security, while primary loans are also known as senior or unsubordinated debt. Primary loans are the first loans to get paid back if a company faces bankruptcy. They’re more likely to be paid back because they’re often secured. On the other hand, subordinated loans are not secured and more of a risk. A subordinated loan can also refer to a second mortgage.
Here’s everything you need to know about subordinated loans and what they mean for lenders, businesses and homeowners.
Who Borrows Subordinated Loans?
Borrowers of subordinated debt tend to be large corporations or other types of business entities. When taking out debt, a corporation normally issues two or more types of bonds that are either subordinated or unsubordinated debt.
However, homeowners can also take on subordinated debt in the form of a second mortgage. A second mortgage is considered a subordinated loan because it is second to the first mortgage, which is the primary or senior loan.
If a company goes into bankruptcy, it effectively defaults on all of its loans. A bankruptcy court will prioritize loan repayments and require the company to repay its outstanding debt using any assets it has left. The debts have an order of priority that determines if or when they will receive payment. The first people who get paid are holders of preferred stock. Unsubordinated or senior debt holders, tax liabilities and the liquidator all get paid next, and then subordinated loans are paid – if there’s any money left. Common stockholders get paid only after subordinated loans.
A similar repayment structure happens with homeowners who have more than one mortgage. If a person’s property is foreclosed on, the bank or financial institution that holds the first mortgage is paid first and the financial institution that holds the second mortgage is paid second, if there is any money left to pay them.
Since subordinated loans are the lowest-seniority loans and don’t get paid back until after all of the primary loans and senior debt are paid off, they’re considered riskier loans. If there’s no cash left to pay back a subordinated loan, the lender of that loan loses money. If there’s only enough cash left to partially pay the subordinated loans, the subordinated loans will be partially paid off. Subordinated lenders generally charge borrowers a higher interest rate in exchange for this extra risk.
How Corporations Report Subordinated Debt
All debt obligations, including subordinated loans, are considered liabilities on a company’s balance sheet. Current liabilities are listed first on the balance sheet and then come long-term liabilities. Senior debt and subordinated debt are both listed as long-term liabilities. These long-term liabilities are listed in order of payment priority, so obviously senior debt comes first. When a company receives cash from a lender, the liability is recorded for the same amount the company received. The cash is either added to the company’s cash account or to its property, plant and equipment (PPE) account.
Subordinated Loans as Mortgages
Although subordinated loans are usually for businesses, sometimes people can take out subordinated loans in the form of a second mortgage. Second mortgages are usually subordinated to first mortgages. The first mortgage is the mortgage that was initially taken out and used to buy the property. If a homeowner has two mortgages and pays the first off, the second mortgage then becomes the first mortgage.
A piece of property can have just one mortgage, and then later have a home equity loan or a home equity line of credit (HELOC) placed on it. The home equity loan or HELOC would be considered junior debt and will almost always have a higher interest rate than the first mortgage because it is considered subordinated to the original mortgage. This means that if the house was foreclosed on, the HELOC or home equity loan would only be paid off after the first mortgage was paid off, if there was money left. The higher interest rate on the HELOC or home equity loan compensates for this extra risk.
If you want to refinance your home, and you have a home equity loan or HELOC in addition to your first mortgage, you have to go through the resubordination process. When you refinance your home, you pay off your first mortgage and put a different mortgage in its place. That means the home equity loan or HELOC moves into the senior debt or primary position, unless there is a subordination agreement, which prioritizes the new first mortgage and ranks it above the home equity loan or HELOC. Your new lender will insist that the HELOC or home equity loan be moved into the primary spot. However, if that’s not possible, you may have to wait and build up more equity before you can refinance your home.
The financial institution that holds the home equity loan or HELOC has to agree that their loan will be subordinated to the new first mortgage loan through a subordination agreement. Most financial institutions will agree to this, but there are usually some requirements. You generally have to be in good standing with your lenders on your payments. There are usually limits on your usual mortgage payments and it’s possible the institution may not allow you to consolidate debt or take cash out with the new first mortgage. You might also have to pay administrative charges.
There are two reasons financial institutions may not agree to the resubordination process. The first is if you have a large amount of equity in your home and want to do a cash-out refinance. Cash-out refinancing involves borrowing a larger amount of money for the first mortgage and taking a large amount of cash out of the equity of the house. Another reason is if you have little to no equity in your home when you refinance the mortgage. In this case, the lender worries that you will not be able to pay off your loan.
If you have problems resubordinating your HELOC or home equity loan, you could try refinancing that loan, too. Refinancing a second mortgage is much easier than refinancing a first mortgage.
Why Would Anyone Lend Subordinated Debt?
Lenders of subordinated debt are able to charge a higher interest rate to compensate for their potential loss. Subordinated debt is issued by many different organizations, but it may be most attractive to banks because subordinated debt interest payments are tax-deductible. In addition, subordinated debt is used by some mutual savings banks to meet regulatory requirements for Tier 2 capital, or the other half of the bank’s required reserves.
In a 1999 study by the Federal Reserve, authors wrote that banks should issue subordinated debt in order to self-discipline their levels of risk. The authors of this study argued that issuing subordinated debt would require banks to profile risk levels, which would provide a look into the bank’s finances and operations. This study was authored shortly after the repeal of the Banking Act of 1933, also known as the Glass Steagall Act, when there was significantly less bank regulation.
The Bottom Line
Subordinated debt is risky because there’s less of a guarantee that it will be paid back in full. Potential lenders should keep in mind the company’s or homeowner’s other debt obligations, total assets and ability to meet long-term debt and financial obligations when making their decision. Be mindful of the high interest rates that you may pay when considering a subordinated loan.
Tips for Managing Debt
- If you’re interested in taking out subordinated debt, whether as part of a business or as a second mortgage, consider asking a professional for advice before making any decisions. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Paying down debt can take time, but the right strategy can help you lower what you owe fast. Consider different methods that may work for your financial situation. The avalanche method suggests paying down your high-interest debt first, while the snowball method suggests paying down the debt with the largest balance first. With the right process in place, you’ll be debt free before you know it.
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