Subordination and intercreditor agreements both describe the position of importance of a lien. A lien is a claim that's made by a lender on an asset, such as a home. If the loan conditions aren't met by the borrower, the asset may be seized by the lender. A priority lien is usually the first recorded lien, although some types of liens may take first position regardless of when they're filed.
If a lender agrees to a subordinate lien position, it means that it agrees to be paid second or later from the proceeds of the asset's sale. For example, in a mortgage, a home equity loan is subordinate to the first mortgage; this means that the first mortgage gets paid first. While subordination may be risky, it can be lucrative for the right parties. For example, if a seller agrees to subordinate but requires in writing that the buyer use the proceeds to improve the property -- with the seller reaping a percentage of future gains based on the improvement -- then both the seller and the buyer stand to earn a tidy profit. As a result, subordination should only be used when both parties stand to gain from the deal and the use of the first loan's proceeds are guaranteed in writing.
The biggest risk of subordinating a loan is that the buyer will default on the payments. If this occurs and isn't remedied, the property may go to foreclosure. After foreclosure, the lien with first priority is paid first. This often results in subordinate liens being wiped out. While some agreements allow a subordinate lienholder to sue the borrower for the deficient loan balance, many states don't permit it. In addition, if the borrower is bankrupt, there won't be anything to collect, anyway.
Intercreditor Agreement Pros
An intercreditor agreement anticipates and attempts to remedy the problems that are presented when a borrower defaults. Simply put, the agreement states what the lien positions are and what remedies are available to subordinate lienholders in the event the borrower defaults. A major pro is that the second lienholder is offered the right to purchase at par the first lienholder's claim, in order to secure payment on its claim. As opposed to fair market value, "at par" means face value.
Intercreditor Agreement Cons
The likelihood of a lender exercising its intercreditor agreement rights are slim if the proceeds from the sale of the property don't exceed the amount of the first lien, because purchasing the claim increases the subordinate lienholder's losses. Secondly, getting multiple lenders to agree to an intercreditor agreement's terms may be time consuming and difficult. Thirdly, if the borrower is delinquent on property or income taxes, the rights in the intercreditor agreement may be irrelevant, because these liens have priority over any other lien -- even first liens.
Lisa Bigelow is an independent writer with prior professional experience in the finance and fitness industries. She also writes a well-regarded political commentary column published in Fairfield, New Haven and Westchester counties in the New York City metro area.