How Subordination Agreements Work Between Creditors

How do subordination agreements determine creditor priority?

A subordination agreement changes the order in which creditors are paid from a borrower’s collateral or estate. It is a written contract that moves an existing creditor’s claim to a lower priority—senior becomes junior—so a new lender or creditor can take a superior position. These agreements are commonly used in mortgage finance, corporate lending, mezzanine financing, and in limited tax-lien situations to permit refinancing or new capital.

In practice, a subordination agreement affects four things: repayment order, the lender’s remedies in default, the borrower’s capacity to obtain new credit, and perceived risk (which may show up as interest-rate changes). The party agreeing to subordinate accepts greater recovery risk in exchange for retaining a lending relationship or receiving other concessions.

Sources and further reading on liens and subordination include official guidance from government agencies and detailed explainers. See the Consumer Financial Protection Bureau for general secured-lending guidance (https://www.consumerfinance.gov/) and IRS guidance on federal tax liens (https://www.irs.gov/businesses/small-businesses-self-employed/federal-tax-lien). For practical, step-by-step tax-lien subordination or withdrawal options, see our guide on resolving tax liens: “Resolving Tax Liens: Removal, Withdrawal, and Subordination” and “Steps to Qualify for Lien Withdrawal or Subordination.”

• Resolving tax liens: https://finhelp.io/glossary/resolving-tax-liens-removal-withdrawal-and-subordination/
• Steps to qualify: https://finhelp.io/glossary/steps-to-qualify-for-lien-withdrawal-or-subordination/

Voluntary vs. involuntary subordination

• Voluntary subordination: A creditor signs a subordination agreement by choice—often to let the borrower refinance or take on a loan that benefits both borrower and the subordinating creditor indirectly (for example, by preserving collateral value or keeping a business operating).
• Involuntary subordination: Occurs as a result of bankruptcy law or court determination. A court can reclassify claims, and statutory priorities (e.g., secured vs. unsecured, tax claims) can limit the effect of voluntary agreements.

Even when voluntary, subordination agreements must be drafted carefully. Courts scrutinize intercreditor arrangements during bankruptcy. A poorly drafted agreement may not protect a creditor’s practical rights in a restructuring.

Typical situations where subordination appears

• Mortgages and real estate: A homeowner or developer wants a second mortgage or a construction loan. The first-mortgage holder may sign a subordination agreement so the new loan becomes first lien on the property.
• Corporate lending and intercreditor agreements: Senior and mezzanine lenders set priority and document enforcement rights, payment blocking, or cure periods.
• Tax liens: Federal or state tax authorities sometimes subordinate or allow withdrawal of a lien to permit a sale or refinance, but tax agencies apply strict criteria (see IRS guidance and our internal resources on resolving tax liens).

What a subordination agreement usually includes

Good subordination agreements or intercreditor agreements will address:

• The effective date and scope (which debts are subordinated and whether future advances are covered).
• Priority ranking (explicitly describing senior and junior claims).
• Fixed remedies and enforcement rights for senior lenders (e.g., right to pursue collateral first; standstill periods for junior creditors).
• Payment waterfall and distribution terms in default.
• Acceleration, cross-default, and voting rights during workouts or bankruptcy.
• Release language for liens and conditions for modification or rescission.
• Representations, warranties, and covenants (e.g., borrower’s title, lien perfection).
• Recording and notice provisions—some subordination agreements must be recorded or filed with public registries to impact third parties.

Example: simple numeric scenario

Imagine a property with two loans:

• Loan A (existing) — $200,000, recorded first.
• Loan B (new) — $150,000, lender requires first priority to underwrite construction.

If Loan A’s lender voluntarily signs a subordination agreement placing its lien behind Loan B, then in a foreclosure sale the proceeds go first to Loan B until it is paid off, then to Loan A. If the property sells for $300,000, Loan B recovers $150,000 first, then Loan A collects the remaining $150,000 (recovering 75% of its balance). Without subordination, Loan A would be paid first.

This ordering changes lender risk and is why senior lenders usually demand higher protective covenants or reserve amounts when they subordinate.

Negotiation checklist for borrowers and lenders

For borrowers:

• Obtain clear, written subordination terms and a copy of any executed agreement.
• Require precise definitions (which loans, which collateral, duration of subordination).
• Ask for caps or carve-outs for certain events (e.g., default by the senior lender).
• Use escrow or release mechanics so the subordinated loan isn’t left unsecured unnecessarily.

For lenders deciding whether to subordinate:

• Ask for credit enhancements from the new lender (e.g., completion reserve for construction loans, personal guarantees, or additional collateral).
• Insist on a limited standstill and cure period that protects your right to act if the senior lender fails to enforce obligations.
• Require documentation that the borrower remains solvent and that lien perfection is maintained.
• Consider taking an intercreditor agreement that clarifies voting and control in a restructuring.

In my practice, I advise subordinating lenders to negotiate (a) defined triggers for senior enforcement, (b) a clear payment waterfall, and (c) protective covenants that limit the borrower’s ability to dilute collateral without consent.

Intercreditor provisions commonly negotiated

• Payment-blocking: Junior lenders may be prevented from receiving payments until certain conditions are met.
• Standstill period: Junior creditor agrees not to foreclose or accelerate for a set time if the senior lender begins enforcement.
• Subordination carve-outs: Specific types of claims (e.g., mechanics’ liens, environmental cleanup costs) may be carved out from subordination.
• Subrogation and setoff rights: How rights transfer after payment events.

Special considerations for tax liens

Tax authorities (federal or state) operate under statutory rules and have special procedures for subordination, partial releases, or withdrawals. The IRS may agree to subordinate or withdraw a Notice of Federal Tax Lien in narrow circumstances, but it evaluates requests against public interest and collection potential (see IRS guidance). For practical steps on qualifying and requesting lien actions, consult our guides on resolving tax liens and steps to qualify for lien withdrawal or subordination:

• Resolving tax liens: https://finhelp.io/glossary/resolving-tax-liens-removal-withdrawal-and-subordination/
• Steps to qualify: https://finhelp.io/glossary/steps-to-qualify-for-lien-withdrawal-or-subordination/

Always obtain counsel experienced in tax lien practice when negotiating with the IRS or a state tax authority.

Common mistakes and red flags

• Signing vague or open-ended subordination language that covers future debt without caps.
• Failing to record required documents, leaving priority unclear to third parties.
• Not securing additional protections (reserves, escrows, guarantees) when taking a junior position.
• Overlooking bankruptcy consequences: some clauses may be recharacterized by a bankruptcy court.

Practical steps to implement a subordination agreement

1. Identify all secured creditors and their recorded liens.
2. Negotiate clear scope and duration of subordination with written terms.
3. Require counsel for all parties to draft an intercreditor or subordination agreement.
4. Resolve recording/filing requirements with county or national recording offices.
5. Add credit enhancements as needed and obtain evidence of lien perfection and priority changes.

When to involve advisors

• Always involve an attorney experienced in secured transactions and bankruptcy. Lender rights in intercreditor disputes are heavily fact- and document-driven.
• Consult tax counsel when federal or state tax liens are involved.
• Use financial advisors to model recovery outcomes under different priority scenarios so all parties understand expected recoveries and risks.

Bottom line

Subordination agreements are powerful tools that reallocate repayment priority to permit refinances, new loans, or other capital structures. They create trade-offs: subordinating lenders accept higher risk in exchange for negotiated protections or business considerations. Proper drafting, clear scope, and appropriate legal and financial advice are essential to avoid unintended consequences—especially where tax liens or bankruptcy exposure exist.

This article is educational and does not constitute legal or financial advice. Consult an attorney or financial professional for guidance tailored to your situation.

Authoritative resources and further reading

• Consumer Financial Protection Bureau — consumerfinance.gov (secured lending guidance)
• IRS — Federal Tax Lien information: https://www.irs.gov/businesses/small-businesses-self-employed/federal-tax-lien
• Internal guides at FinHelp: “Resolving Tax Liens: Removal, Withdrawal, and Subordination” and “Steps to Qualify for Lien Withdrawal or Subordination.”