Subordinate financing is a secured loan that can only be collected from a borrower's assets after another secured loan has been paid off. The subordinate lender stands second in line to recover against assets if the borrower defaults. If there is nothing left over after the principal lender has been paid, the subordinate lender takes a loss. This additional risk of nonpayment means that the interest rate on subordinate financing is often higher than the interest rate on the principal loan.
When an individual or business needs money to purchase an asset, one lender may not be willing to foot the entire bill. In some instances, the borrower decides after the initial loan has been made that he needs additional money. Other times, a borrower may simply want to pull the accrued equity out of an asset that still has a principal loan attached.
In these financing scenarios, the first loan taken out 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 under the loan terms. The purchased asset secures the loan, so the lender knows he will either recover his money or something of similar value.
A secured loan is the opposite of an unsecured loan. Lenders who provide unsecured loans have no specific asset to attach if the borrower defaults. To try to collect on the loan, an unsecured lender has to sue the borrower, obtain a judgment and hope the borrower has enough unsecured assets for the lender to seize.
Subordinate financing relates only to secured transactions. The subordinate lender loans the borrower money against an asset that has a principal loan outstanding. He is aware that if the borrower defaults, the principal loan would have to be paid off first, before he can recover any money from the asset.
One of the most common examples of subordinate financing is in the case of home mortgages. A person who takes out a mortgage to purchase a house is entering into a secured transaction with a principal lender. If the borrower defaults, the principal lender will foreclose on the house, sell it and take the money that is still owed under the loan from the proceeds.
Occasionally, a home owner will want to take a home equity loan out on his house. This loan allows the owner to borrow against the equity in the property. It is also a secured loan, but it is subordinate to the main home mortgage. If the borrower defaults, the principal mortgage will be paid off from the sale of the house. The subordinate financing will be paid off only if there is anything left over from the sale proceeds, and it is very possible that the junior lender will have to take a loss if the sale proceeds are not significant enough to cover both loans.