'Subordinate Financing' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Subordinate financing refers to that type of debt finance which ranks behind the primary finance. It is second in importance and position to debt that senior or secured lenders hold. This is important when a default occurs, as it determines who gets repaid first from any bankruptcy proceedings or foreclosure. The term signifies that senior lenders who are secured will be repaid before the debt holders that are subordinate.
Lenders who participate in this subordinate financing take on greater risk than the lenders considered to be senior. This is because they have a lower claim on the business or property assets. Sometimes this type of corporate finance is comprised of both equity and debt financing. A lender would be interested in this because it would offer them potential stock options or warrants that would reward them with extra yield as a means of compensating for the greater risk they take.
Where consumer borrowers and loans are concerned, subordinate financing would be a second mortgage. It takes second priority below the original first mortgage. First mortgages have the property to secure their loan and the debt. While nearly every mortgage is backed by the underlying property, first mortgages receive special seniority ahead of subordinated mortgages. This means the senior mortgage lender is repaid first in a foreclosure. With mortgages, subordinate financing could be a mortgage that is 80/20. In this case, the first mortgage would be 80 percent while the second mortgage that was subordinated represents 20 percent.
This means that only the lenders which are first mortgage holders are likely to get at least a portion of their money back if a borrower defaults in general. Should a borrower only default on the subordinate mortgage, this lender is able to foreclose on the property to regain its principal. Subordinated lenders could work to make their mortgage the senior one and then foreclose. They could do this by buying out their borrower’s first mortgage. Afterwards, they could choose to subordinate the original first mortgage so that their once second mortgage became senior in the foreclosure.
Consumers should think carefully before participating in subordinate financing to obtain their houses. There are several disadvantages involved. Home owners will usually have to write two different mortgage payments each month if they do. They will also typically pay a higher interest rate on the second mortgage since these rates are usually greater than the first mortgage rates. There are also often two different loan fees, costs, and even discount points when first and second mortgages are used. Finally, this type of finance will often lead to a greater monthly payment when the two are combined than only one mortgage payment would.
The main reason that a home buyer would be interested in employing subordinated financing to purchase a home is because an 80/20 mortgage would not require them to come up with any down payment. It might also eliminate the need to pay for PMI private mortgage insurance which can be a substantial component of the monthly mortgage payment. This would depend on how the mortgage financing was originally structured.
Consumers will generally require a high credit score of minimally 700 in order to qualify for this subordinated financing. When borrowers have two mortgages, it will likely be impossible to obtain a home equity loan or line of credit at a later time.