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Refinancing information: what you need to know about loan subordination

What is mortgage subordination and why should you care?

Mortgage subordination becomes an issue when you replace a first mortgage with a refinance mortgage but leave your second mortgage alone. Here's how it works.

Home equity loans are often called second mortgages because they are positioned behind your first mortgage. This means that if you default on your mortgage and go into foreclosure, the property is sold and the first mortgage lender is paid first. The second mortgage lender, also called the junior lien holder, is only paid after the first mortgage lender's claim is satisfied, and only if there is any money left. So home equity lenders are in a riskier position; that's why interest rates on second mortgages are higher.

However, if you were to refinance your first mortgage and not your second mortgage, the existing second mortgage automatically moves into first position, and the new refinance mortgage takes second position. The refinance lender will not allow that; it's not getting a higher rate to compensate for that level of risk. So it will not fund your refinance unless the junior lien holder agrees to move itself once again into the second or junior position. That process is called subordination.

When would you need to subordinate a second mortgage?

There are several circumstances that would require a borrower to subordinate a second mortgage rather than just wrap it into a new first mortgage.

  • Your current second mortgage may have a nasty prepayment penalty.
  • You may want to keep a home equity line open for business or other reasons.
  • You don't have sufficient home equity to replace your first and second mortgages with a new refinance mortgage.

If you think you may need to subordinate a second mortgage, understand that there are conditions you may have to meet.

What is required for a second mortgage subordination?

Mortgage lenders don't just blindly agree to position their loan behind a new first mortgage. Here are some common requirements:

  • You need to be in good standing with your lender -- current on your loan payments.
  • Your new loan cannot increase your mortgage payments beyond specified limits.
  • You can't usually consolidate debt or take cash out with your new first mortgage.
  • You may be required to pay nominal administrative charges.

On occasion, you may be able to get an exception to the lender's policy if you can show that the new loan strengthens your financial position (for example, debt consolidation drops your debt-to-income ratio from 50 percent to 38 percent), or if you can show that your application is very strong (perfect credit, low debt-to-income ratios, plenty of reserves). Expect this to take some time; you probably want to resolve the subordination issues before entering into a mortgage refinancing process.

What if your second mortgage lender refuses to subordinate your loan?

It happens. Some lenders are just jerks to work with. Ideally, when getting a second mortgage, you'd get the lender's subordination policy in writing so you'd know what you're dealing with (but almost no one does this in real life). There is no good reason that a second mortgage holder would refuse to subordinate a home equity loan if you are in good standing and your new refinance mortgage gets you into a stronger financial position.

If your total mortgage balance hasn't increased (that is, you have not included debt consolidation or taken cash out), and your interest rate and monthly payment are lower (if your financial position improves with a mortgage refinance, it actually makes the second mortgage less risky for the junior lien holder), there is absolutely no reason that a home equity mortgage lender shouldn't be willing to subordinate its loan.

But stupidly, it happens. If it does, let the lender know that it will lose your business if it doesn't comply with your reasonable request. If that doesn't work, get some mortgage quotes and refinance your second mortgage with a more cooperative lender. Refinancing a second mortgage costs little or nothing and can be done fairly quickly. Get the new lender's subordination policy in writing so that you can be sure it will subordinate its lien to that of a new first mortgage lender.

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