Subordination in Construction Loans: What Borrowers Need to Know

What is subordination in construction loans and why does it matter?

Subordination is a legal and contractual tool that sets the order of claims by lenders against a construction project. When multiple creditors have an interest in the same property, the priority—who gets paid first—can decide whether a lender recovers money if the borrower defaults. For construction borrowers this affects access to additional funds, interest costs, underwriting requirements, and the feasibility of refinancing or converting to permanent financing.

Below I explain how subordination works in practice, common agreements you’ll encounter, negotiation strategies, and a practical checklist to protect your project. These points are drawn from my 15 years working with construction borrowers and lenders and from consumer and title best practices.

How subordination actually works

• Priority is usually set by the date a lien or mortgage is recorded, subject to agreements that alter priority (state recording laws apply). Recording statutes and local lien rules determine default priority absent an agreement (see Cornell Legal Information Institute on recording acts).
• A subordination agreement is a written contract in which one lienholder agrees to be ranked below another. For example, a junior lender (second mortgage or mezzanine lender) may sign a subordination agreement putting the bank’s construction loan ahead of theirs.
• Lenders commonly require a subordination agreement or an intercreditor agreement when different lenders provide primary construction financing, mezzanine financing, or investor equity. Intercreditor agreements outline specific rights—standstill periods, enforcement rights, and loss-sharing—beyond simple rank ordering.

Practical example

• You take a bank construction loan (first lien) for site prep and framing. Later you need extra capital and get a private lender to cover shortages. The private lender may accept a subordinate position—meaning it will only be repaid after the bank is satisfied if the property is sold or foreclosed.

Common documents and clauses to watch for

• Subordination agreement: a signed document that explicitly lowers one lender’s claim.
• Intercreditor agreement: used when two institutional creditors want detailed protections including remedies, payment waterfall, control rights, and enforcement sequencing.
• Standstill clause: delays enforcement by the subordinate lender for a set period if the senior lender is enforcing remedies.
• Payment waterfall: how proceeds from sale or foreclosure are split among creditors.
• Non-disturbance and recognition clauses: protect tenants or downstream parties by limiting enforcement actions that disrupt occupancy.

Each clause alters practical risk. For borrowers, the presence of strict standstill or control clauses can make a subordinate lender less flexible and may complicate workouts.

Why lenders ask for subordination (and why it affects borrowers)

• Risk allocation: Primary lenders want first claim so they have greatest recovery chance in default. That lowers their perceived risk and can produce better pricing or higher loan-to-cost (LTC) ratios.
• Exit strategy: Permanent lenders or purchasers may require first-priority lien before converting a construction loan to a takeout or permanent mortgage.
• Secondary lender pricing: Subordinate lenders expect higher interest rates and stricter covenants to compensate for their lower recovery priority.

For borrowers this means:

• You may secure a larger or cheaper primary loan if a subordinate party agrees to step back.
• Subordinate financing usually costs more and can include covenants that limit refinancing or additional borrowing.

Typical scenarios where subordination matters

• Adding a second construction loan or mezzanine loan mid-build.
• Taking short-term bridge or private funds to cover cost overruns.
• Converting a construction loan to permanent financing (lenders may demand a first lien before issuing takeout financing).
• Refinancing after construction—title order matters; a new lender often insists on elimination or subordination of junior liens.

When you’re planning a multi-source capital stack, consider the effect of subordination on future options.

Step-by-step: How borrowers should handle requests for subordination

1. Identify all existing liens and record dates. Request a title report early so you clearly see current priority (your title company can provide this).
2. Ask the prospective subordinate lender for draft subordination or intercreditor language. Review it with counsel—vague language can create unintended obligations.
3. Negotiate material terms: carve-outs for lender defaults, limits on standstill duration, approval thresholds for enforcement actions, and cure rights.
4. Coordinate with the title company to make sure the final, recorded documents reflect the agreed priority.
5. If a permanent or takeout lender is lined up, confirm their lien priority requirement before finalizing subordinate financing.

In my work I’ve seen projects stall when borrowers agreed to subordinate terms that blocked conversion to permanent loans. Early coordination with future lenders prevents this trap.

Negotiation tips and strategies (practical)

• Start early: present your full capital plan to all lenders before funds are committed. Lender buy-in is easier before construction begins.
• Limit subordinate lender enforcement rights: cap remedies, add short cure periods, and limit foreclosure triggers tied to construction draws rather than permanent loan covenants.
• Request a conditional subordination: some senior lenders will accept temporary subordination during the construction phase with automatic reconveyance at closeout.
• Offer additional security or personal guarantees to subordinate lenders to lower their rate and improve terms.
• Use an intercreditor agreement when institutional lenders are involved; it clarifies enforcement and avoids costly litigation.

Risks to borrowers

• Reduced ability to refinance: future lenders may require payoffs or re-subordination, increasing transaction costs.
• Higher overall financing cost: subordinate debt usually carries higher rates and fees.
• Complicated workouts: in troubled projects, intercreditor battles between senior and junior lenders can delay resolutions and increase legal costs.
• Title and closing delays: improperly recorded or ambiguous subordination documents can stall closings and disbursements.

How subordination affects construction draws and closeout

Subordination often ties into how draws are approved and released. Senior lenders typically control draw schedules and inspections. To understand draw timing and interest handling in construction loans, review our guide on construction draws, inspections and interest handling. When the project completes, a construction loan closeout will reconcile liens and may be the point where subordinate claims are resolved or re-ordered.

If you plan to use a one-time-close product or convert to permanent financing, confirm lien priority requirements early—see our article on one-time close construction loans.

Sample borrower checklist before signing a subordination agreement

• Obtain up-to-date title report and list all liens.
• Get draft agreements from each lender and compare language.
• Confirm whether the senior lender requires “first lien” at permanent conversion.
• Ask for specific limits on subordinate enforcement rights and standstill periods.
• Verify recording strategy with your title company and lender counsel.
• Run pro forma scenarios showing how sale or foreclosure proceeds would flow under different outcomes.
• Consult a real estate attorney experienced in intercreditor agreements.

Frequently asked questions (brief)

Q: Can I remove a subordination later?
A: Sometimes, but it requires lender consent or refinancing that pays junior debt. Expect negotiations, payoff demands or amendments.

Q: Does a subordinate lender always get nothing in a default?
A: Not always. If sale proceeds exceed the senior lender’s claim, subordinated lenders are next in line. Recovery depends on asset value and the payment waterfall.

Q: Who determines lien priority—the lender or the county recorder?
A: Recording establishes legal priority absent agreements, but valid subordination agreements (and intercreditor contracts) can override the default order in practice. State recording and lien laws govern details.

Sources and further reading

• Consumer Financial Protection Bureau – resources on mortgages and liens (CFPB: consumerfinance.gov).
• American Land Title Association – title practices and priority issues (ALTA).
• State recording statutes and the Cornell Legal Information Institute on recording acts.

I’ve used these resources in practice to explain lien mechanics to borrowers. For authoritative legal rules about lien priority in your state, consult your attorney and title officer.

Professional disclaimer

This entry is educational and does not constitute legal or financial advice. The mechanics of subordination and lien priority vary by state and by contract. For personalized guidance, consult a qualified real estate attorney, your lender, and your title company.

If you’d like help reviewing draft subordination or intercreditor language, share the key terms and I can point out common red flags based on decades of construction finance experience.