Subordinated financing is a secured loan that is only collected after the primary loan is repaid, making it riskier for the lender. It is often used in home equity loans, where the subordinated lender may suffer a loss if the sale proceeds are not enough to cover both loans.
Subordinated financing is a secured loan that can only be collected from the borrower’s assets after another secured loan has been repaid. The subordinated lender comes second to recover the assets if the borrower defaults. If there is nothing left after the primary lender has been paid, the subordinate lender suffers a loss. This additional risk of default means that the interest rate on subordinated financing is often higher than the interest rate on the principal loan.
When a person or business needs money to purchase an asset, a lender may not be willing to pay the full bill. In some cases, the borrower decides after the initial loan is made that he needs additional money. Other times, a borrower may simply want to take equity out of an asset that still has a principal attached to it.
In these financing scenarios, the first loan obtained is secured by the asset being purchased. This type of transaction is called a secured loan. A secured loan gives the lender the right to repossess the asset if the borrower defaults on the terms of the loan. The purchased asset secures the loan, so the lender knows they will get their money back or something of similar value.
A secured loan is the opposite of an unsecured loan. Lenders who make unsecured loans do not have a specific asset to attach if the borrower defaults. To try to collect on the loan, an unsecured lender has to sue the borrower, get a judgment, and hope that the borrower has enough unsecured assets for the lender to seize.
Subordinated financing relates only to secured transactions. The subordinated lender lends money to the borrower against an asset that has an outstanding principal loan. He is aware that if the borrower defaults, the principal loan will have to be paid off first, before he can get the money back from the asset.
One of the most common examples of subordinated financing is in the case of home mortgages. A person taking out a mortgage to buy a home is making a secured transaction with a primary lender. If the borrower defaults, the primary lender will foreclose on the home, sell it, and take the money still owed on the loan from the proceeds.
Occasionally, a homeowner will want to take out a home equity loan. This loan allows the homeowner to borrow against the home’s equity. It is also a secured loan, but it is subordinated to the main mortgage on the house. If the borrower defaults, the principal mortgage will be paid off with the sale of the home. The subordinated financing will be repaid only if any of the sale proceeds remain, and the junior lender may well have to take a loss if the sale proceeds are not significant enough to cover both loans.
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