The first mortgage that you take out to finance the purchase of your home is almost always going to be considered your senior mortgage and take the first position when it comes to repayment. But what about all subsequent mortgages that you take out? These mortgages are known as subordinate financing and are a little different than dealing with a senior mortgage.
In this article, we’ll cover the ins and outs of subordinate loans and answer questions like:
- What is subordinate financing?
- Can subordinate financing turn into senior financing?
- What are the different types of subordinate financing?
- What are the pros and cons of subordinate financing?
- When should you use subordinate financing?
What Is Subordinate Financing?
Any subsequent loan that is taken out after your initial purchase loan is considered to be a junior-lien or subordinate mortgage. Therefore, subordinate financing is the use of two or more mortgages to finance the purchase of real estate or using your home’s equity for liquid cash.
Subordinate financing debt has a few differences from a senior mortgage that stretch beyond the simple order by which the loans are taken out. Subordinate financing is also positioned behind the first secured lender’s debt when it comes to repayment.
This means if the borrower defaults on the loan payments, the first lien will be paid off first if the home is foreclosed upon or sold. Because of this, only mortgage lenders of senior loans are reasonably assured to earn their money back.
Can Subordinate Financing Turn Into a Senior Financing?
Yes. Subordinate financing turns into senior financing once the existing senior mortgage has been paid off. Conversely, a senior purchase mortgage can become subordinate if another lender or creditor creates a claim to the collateral.
This could happen, for example, if the Internal Revenue Service placed a lien against your home for unpaid taxes or a county files a claim for unpaid property taxes. These types of liens are senior and bump purchase mortgages down to the subordinate position.
What Are the Different Types of Subordinate Financing?
There are many examples of subordinate financing, but some of the most common include:
- Home Equity Loan. Home equity loans are a type of second mortgage and are taken out against the equity that you have built up in the home. The money can be used for anything from home improvements to consolidating credit card debt.
- Home Equity Line of Credit (HELOC). HELOCs are similar to a home equity loan but don’t come in the form of an upfront lump sum. Instead, money can be taken out as needed, similar to a credit card.
- Other Second Mortgages. Not all second mortgages are equity loans. Other second mortgage forms like piggyback loans are also considered subordinate financing.
What Are the Pros and Cons of Subordinate Financing?
Subordinate financing can come in handy in a variety of situations, from downpayment assistance to cash to complete home renovation projects. But like most things in the financing world, it is not without its fair share of drawbacks.
- Can Help You Avoid Jumbo Mortgages. Traditional conforming loans cap at $510,400 for all Texas counties. If you need a more substantial mortgage than that, you’ll likely have to take out a jumbo mortgage. Homeowners may choose to take out one conforming loan and one smaller subordinate loan to split the amount into two.
- Avoid Paying Private Mortgage Insurance (PMI). In most cases, lenders will require private mortgage insurance if less than 20% is placed down on a home purchase. Subordinate financing can be used to put down a larger down payment, therefore eliminating the need to pay for PMI.
- Receive Cash for Home Renovations and More. Loans borrowed against your home’s equity provide you with money that you can use at your discretion. While there is some risk of abuse with this product, it can be used to complete home renovations, which increases a home’s value. Another common use of these funds is debt consolidation and higher education expenses.
- Better Interest Rates Than Other Forms of Borrowing. Compared to different types of borrowing like credit cards, subordinate financing offers more affordable interest rates.
- Tax Deductions on Mortgage Interest. In some cases, you can take advantage of a tax deduction on mortgage interest, which helps your wallet during tax season. However, laws around this have recently changed, so be sure to consult a tax professional to ensure you’re eligible.
- Increasing Your Debt Burden. You always have to be careful when you grow your debt burden, especially when it is secured against your home. As with your mortgage, this puts you at risk of foreclosure should something prevent you from being able to make payments. An increased debt burden makes subordinate financing riskier than some of the other ways to borrow.
- Multiple Loan Payments. With subordinate financing, you pay both home loans off concurrently. Two payments mean you’ll have two bills every month, which can be costly as well as a hassle.
- Higher Interest Than the Senior Mortgage. Because of the greater risk that financial institutions carry with a subordinate loan, they typically have a slightly higher interest rate than primary home mortgages.
- Unwise Spending. While cash in hand can be used for worthwhile projects, it can also be spent unwisely and end up costing you. Remember that you are still paying interest on these funds and should not treat this as free money.
When Should I Utilize Subordinate Financing?
There are all sorts of situations where subordinate financing is appropriate. If you’re looking to take out a subordinate loan, there’s a number of channels you can go through. Credit unions, for example, offer competitive interest rates and can be a helpful resource in guiding you through the world of home financing.
But like any big choice, a finance decision needs to be thought through. Weigh the advantages and disadvantages of your particular financial situation. Ask yourself if the benefit is greater than the inherent risk that second mortgages carry. Do your research, and you may decide that subordinate financing is right for you.