Summary:

Consider a real-life scenario: A borrower requested a subordination of an existing lien in a seller carry-back transaction.

The borrower and the first lien holder were advised that creating an inter-creditor agreement was the best option.

A seller’s carry-back first lien would be paid off on a refinance, but there was insufficient equity to pay off all the first liens.  The seller agreed to accept a paydown of the net proceeds of the new first and carry a small second for the remainder.

The pivotal moment in this scenario was the signing and recording of the subordination agreement by the first and subordinate lien holders.  This agreement and the inter-creditor agreement clearly outlined their rights and responsibilities in case of a borrower default, playing a crucial role in the successful transaction.

Article:

Understanding the Basics: What is the Subordination of a Lien?

Subordinate liens mean a lien is, or will be placed, in a lower position, rank, or junior to the senior lienholder(s). The junior lender is subordinate to the senior lender unless a written agreement states otherwise.

Loan documents are recorded at the municipal recorder’s office using a sequential date and time stamp method.  Any lien with an earlier recording date and time stamp is a senior priority unless the parties agree otherwise. Sometimes, it is desirable or necessary to retain the lender’s lien on the property while agreeing to modify or lower its priority.  A subordination agreement is a method.

When a lender prepares the subordination agreement for the borrower and possibly senior and subordinate lenders to sign, it’s a moment of reassurance.  All parties agree that the lien priority will change or be transferred to a subordinate (lesser) or junior position, ensuring a smooth and secure transaction.

Understanding the reasons for the subordination of liens is crucial, but it’s also empowering.  It equips you with the knowledge to make informed decisions in real estate transactions, ensuring you’re always in control.

Reasons include:

• The transaction is an installment sale in real estate and tax planning.  A seller’s carry-back financing lender (beneficiary) may choose to defer receiving the principal from the property sale for tax deferral purposes.  The reasoning is to extend the payment schedule, including principal reductions and interest, for a specified period.  Since a seller pays capital gains on the principal received and ordinary income on the interest earned, a subordinated lien is a vehicle for deferring tax payments, provided it is drawn correctly, offering significant benefits in tax planning.
• During a refinance process, a lender may determine that the property equity is insufficient to refinance and pay off all the underlying liens and encumbrances.  The transaction will only be successful if one or more existing lien holders (lenders) agree to accept a partial principal paydown and subordinate a portion of their loan.

What is an Inter-creditor agreement (ICA)?

An Inter-creditor agreement is a written legal contract that is a signed and acknowledged document of mutual understanding between two or more lenders (usually two lenders/creditors, a first and second lien holder).  The agreement provides a secure framework for resolving disputes fairly between creditors and ensuring their respective rights are protected. The contract clearly outlines the priority of the liens and how the responsibilities of parties with competing security interests are addressed when they hold separate and unequal lien positions in the event of a borrower’s default, ensuring that everyone’s rights and obligations are clear and protected.

If a borrower defaults on a first trust deed, the second or junior lien could be foreclosed on and lose all its principal.  If the second lien holder is unaware of the first lien borrower’s default, a foreclosure procedure may wipe out the second lien holder’s loan.  The entire junior lien could be lost, highlighting the potential risks of not having an explicit inter-creditor agreement.  This highlights the importance of caution and awareness in lending situations, promoting informed decision-making.

An inter-creditor agreement defines in writing who is responsible for loan payments, property insurance, property taxes, and association dues in the event of borrower default. The subordinate lender (junior) must write checks for all these expenses to protect its interest.  At the same time, the subordinate lender can begin the foreclosure procedure while keeping the first current for a specified period.

Intercreditor and Subordination Agreement: The document is combined.

THIS INTERCREDITOR AND SUBORDINATION AGREEMENT (this “Agreement”) is made as of __________, by and among __________________, having an address at ____________________________ (such entity, together with any subsequent holder of the First Mortgage Loan Documents (hereinafter defined), the “First Mortgagee”), ________________________________, having an address at _______________ (such entity, together with any subsequent holder of the Subordinate Mortgage Loan Documents (hereinafter defined), the “Subordinate Mortgagee”) and _____________________, having an address at _________________(“Borrower”).

Then, the definitions, explanation of lien priorities, standstill agreement, turnover of improper payments, cure rights, representations, and miscellaneous items are included in the agreement.  The first lien holder, the subordinate lien holder, and the borrower will sign the document.

If you need a blank copy of this agreement, please email me at dan@danharkey.com with this request.

The Loan Broker stated :

My client is in the process of refinancing their seller carry-back first lien financing. The property has increased only marginally, so the protective equity is insufficient to take the first lien. The property was appraised at $970,000 with a first lien of $ 750,000. The new lender will only loan 70% of the value, or $679 00. That leaves a shortfall of $71,000, or approximately $100,  after accounting for costs and fees.  The seller’s carry-back principal was reluctant to allow a portion of their lien to be subordinated to a second lien position.  However, the advantages were explained by providing additional protections for an inter-creditor agreement.

The agreement provided that in the event of borrower default, the junior $100,000 lien holder could bring the property to court and begin their foreclosure proceedings. The second was to receive a notice and 30 days to get the first current.

This well-structured arrangement benefited all parties, providing reassurance and instilling confidence in the transaction’s fairness and security.

Please share this valuable information with friends and associates.  By doing so, you’ll help them make informed lending and real estate decisions and contribute to a more knowledgeable and responsible lending community.