If you want to refinance your first mortgage and you have other liens or mortgages on your home, you might need a subordination agreement to adjust the priority of the lien. Read on to learn why you might need a subordination agreement when you refinance your first-mortgage loan, and what it does.
Generally, the priority of a lien is determined by its recording date. Though some liens, like property tax liens, have automatic superiority over essentially all prior liens. When there's more than one lien on a property, the priority of liens determines the order in which the liens will be paid if the property is sold in a foreclosure sale. (To learn more about liens, see Types of Property Liens.)
Like most other liens, mortgage liens have different priorities based on the date of recording. A first mortgage lien—one that you take out first and therefore is recorded first with the county land records office—is given higher priority than a second mortgage lien and will be paid first. A lien that is recorded second has second priority and will be paid second, and so forth.
Because there is a limited amount of money from a foreclosure sale, the lower a lien is in priority, the less likely it is that that lien will be paid if there is a foreclosure.
Sometimes the priority of liens is controlled by a special agreement called a "subordination agreement." In a subordination agreement, a prior lienholder agrees that its lien will be subordinate (junior) to a subsequently recorded lien.
Example. Let’s say you want to refinance your primary mortgage, which is in the amount of $300,000 with 7.5% interest, to get a lower interest rate. You also have a Home Equity Line of Credit second mortgage (a HELOC) on the property for $50,000. When you refinance the first mortgage, you are essentially paying it off and receiving a new loan. The second mortgage (the HELOC) would then move into first position because it would be the oldest mortgage still recorded on the property. The refinancing lender, who is providing $300,000, will require that its loan be in first position so it will ask the HELOC lender to subordinate. By signing the subordination agreement, the HELOC lender agrees to give up its lien priority in favor of the new lender even though the HELOC lien was recorded prior to the refinancing.
Because conventional first mortgage lenders will not agree to refinance a loan unless they're guaranteed first position, the only way refinancing transactions work is when the second mortgage holder agrees to subordinate and allow the new lender into first position. Junior lienholders will not automatically agree to be subordinate to a new first mortgage, but will generally agree to do so if there is sufficient value in the property to cover both loans. Consequently, subordination agreements are a relatively common practice in the lending industry.
To learn more about mortgages, see Mortgages: What You Need to Know.