What Is a Subordinated Loan?

A subordinated loan, also referred to as a junior debt, is a loan that is secondary to a primary loan. Often, this term is used in describing property loans, though it may be used in other lending situations as well. The primary, or first, loan on a property also has the first lien, or legal claim, on it. If a foreclosure or bankruptcy occurs, the subordinated debt is less of a priority and is only paid once the primary liens are satisfied. Since the repayment of this type of loan is subject to its priority in relation to other debts, a subordinated loan is considered high risk for the lender.

To understand how a subordinated loan works, it may be helpful to consider loans in terms of ranking. The highest ranking loan, or primary loan, is the highest priority for payment. A subordinated loan ranks after primary debts when it comes to repayment. This means the lender who makes a subordinated debt has a secondary claim on the assets that can be seized or sold for repayment.

The position of a subordinated loan may be most evident when it comes to a default situation. If, for example, a borrower defaults on a loan that is secured by real estate, a lender may choose to foreclose. In such a case, the lender of the primary loan has the right to collect the money due first. Then, the holder of the subordinated loan collects from the money left after the primary lender is repaid. In the event that there is no money left to repay the secondary lender, the subordinated loan might result in a loss for the secondary lender.

Usually, subordinated loans are granted at a higher interest rate than primary loans. This is due to the fact that the lender takes on more risk when providing this type of loan. In fact, these loans are often more difficult to secure than primary loans because of the higher risk a lender faces when providing subordinated loans.

The payment order for priority debts and subordinated loans remains the same, even if a bankruptcy occurs instead of a foreclosure. If a borrower's assets are liquidated as part of bankruptcy proceedings, the priority debts are paid off first. The subordinated loan holder then receives payment after the priority debts are paid in full. This means the subordinated debt holder may not receive all, or any, of the money he is owed.