Definition: what is a subordinated loan?
A subordinated loan is a loan that, in the event of the borrower’s insolvency, is only serviced after the senior loans. The creditor of a subordinated loan therefore takes a higher risk, which is usually reflected in higher interest rates. An exception is Across Lender funding, the majority of whose loans fall into the subordinated loan category because they are not entered in the land register.
Subordinated loans are interesting for investors in the area of investment. They promise high interest rates – especially when it comes to crowd investing. However, they often involve a high risk of default for investors.
Difference between senior and subordinated loans
In the case of construction financing, banks provide the borrower with a large amount – in return, they require interest and security. As a rule, a land charge is entered in the land register for real estate financing. If the borrower can no longer pay the debt and the interest, then the lenders have access to the real security, i.e. the property, and can sell it. As a rule, this happens through a forced auction.
When the collateral is realized, the loans that are entered in the land register with a higher rank are paid first. Only if there is still money afterwards will the subordinated lenders have their claims in the last place. This makes subordinated financing more risky for the creditor. Because it is unclear whether there is still money left for the subordinated creditors after the house or apartment has been sold. Especially since the maximum market price is not usually achieved in a forced auction.
In which cases does subordinated financing make sense?
Bridging bottlenecks in construction finance
When building a house, it can always happen that unexpected difficulties arise: The construction pit collapses, the demolition of an old house turns out to be more difficult than planned, unexpectedly new costly planning is required for a renovation – and you, the builder, are suddenly faced with additional costs that are not included in the first home loan. In such cases, subordinated loans can be a way of refinancing.
Subsequent conversion or expansion of a property
Suppose you have already bought a property and the appropriate financing is running. After a few years, you realize that you need more space and plan to add it. If it is not possible to top up your current loan, a subordinated loan can be another way of financing the project.
Simulate equity for home finance
Equity can also be simulated with the help of a subordinated loan, for example in the case of mortgage lending without equity. In short: if the builder takes out a subordinated loan from Bank A, he can use this money at Bank B as equity for the building loan there and thus improve the interest on the first-rate main loan.
This initially has the disadvantage of higher interest rates for the subordinated loan. But if borrowers plan to pay off the subordinated loan with the higher interest rates first, they will later benefit from lower interest rates on the primary senior loan. In the case of construction loans, which usually have a volume of several hundred thousand dollars, even small differences in the interest rate level are clearly noticeable in the total interest. In this respect, an intelligent combination of different-tier loans can help to save money on real estate financing.
Which banks issue subordinated loans?
As a rule, these are the institutes that have already awarded the first-class financing – banks, savings banks or cooperative banks. Banks rarely provide pure subordinate financing regardless of the initial financing. They are paid out or brokered by various independent financial service providers.
What is the interest rate on a subordinated loan?
With the exception of promotional loans from Across Lender, the interest on subordinated loans is higher than for first-rate financing. The difference depends heavily on the individual case. It is best to consult your bank advisor or an independent specialist in mortgage lending. You can find an overview of the current building rates in our mortgage comparison.
What does a subordinate loan contract look like?
Basically, the subordinated loan is contractually agreed like any other loan. Only a subordination agreement, also known as a subordinate agreement, distinguishes the subordinated loan from other types of financing.
How can I take out or grant a subordinated loan from a private person?
Do you have a wealthy uncle, a financially open acquaintance? Then you may also be able to take out a subordinated loan from a private person. This is not uncommon, especially in rural areas, and not only in agriculture. In this respect, it is also welcomed by banks when subordinated private loans are submitted to prove additional equity.
Checklist: This should include a model contract for a private subordinated loan
The private loan contract can be arranged relatively easily. If you use a sample, check it to see if it fits your individual interests. Here are the most important points that such a loan contract should contain:
- Name of the lender and the borrower
- Amount of the loan (in numbers and ideally also in words)
- Costs and conditions: term, amount of interest, due date of annual interest (usually at the end of the year), possibility of special repayment
- Extension of the term: should only be possible before the term expires
- Repayment claim: should only be assigned or pledged by the borrower with the consent of the lender
- Withdrawal modalities – the time of the withdrawal and the account to which the money should go
- Conditions of an extraordinary termination by the lender – usually by the phrase “important reason” with two exemplary reasons, such as delayed payment or significant deterioration in the financial situation of the borrower
Other important aspects:
- As a rule, the lenders agree with the borrowers that their claims from the private subordinated loan will be less than those of the other creditors. So that this does not also apply to future claims, creditors should explicitly exclude this.
- As a last point, it is favorable for the lender to reserve the right to assign the claims from the loan and any contracts for collateral for the purpose of refinancing to third parties.
- Important: The loan contract is only effective if the borrower and lender sign, stating the place of signature and the date.