Subordination and Substitution of Collateral

In order to understand subordination and substitution, you must first understand the basics of mortgages. A mortgage (also called a “deed of trust” in some states) is a lien placed on a property as collateral for a loan.Unless otherwise stated, mortgages are “first in time, first in line.” A first mortgage is a desirable position, since a foreclosure on a mortgage can wipe out all mortgages that are behind it (called “junior lien holders”).

Subordination

Subordination is asking someone who holds a mortgage (or deed of trust) on your property to agree to make their lien subordinate (or “second in line”) to another lien. For example, suppose you own a property worth $100,000 which has a first mortgage to ABC Savings & Loan for $65,000.

If you want to borrow $30,000 from First National Bank secured by a second mortgage, you would have to pay a much higher interest rate, since First National’s mortgage would be subordinate or second to the lien in favor of ABC Savings & Loan.

If you could convince ABC Savings & Loan to move their lien to second position, First National would now be a first mortgage holder and thus give you a better interest rate. The above example is for illustration only, since no institutional lender would agree to be subordinate without some additional consideration.

Let’s try this same strategy with a private, motivated seller. Every would-be real estate investor is taught you can buy real estate by asking the seller to carry the financing.

All you have to do is convince the seller to take a few thousand dollars down and carry the rest (yeah, right!). Few, if any, people who do such a thing since (a) they don’t know you, and (b) they need cash!

Try this on for size . . . offer the seller 1/3 down. On a $100,000 property, that’s $33,000! That will make his ears perk up. You may be thinking, “where am I going to get $33,000?” Relax, this is where subordination comes into play.

Find a hard money lender in your area who would be willing to lend you $33,000 secured by a first mortgage on the property. Give the proceeds of that loan to the seller at closing. The seller gets a promissory note and mortgage for $67,000, which is subordinate to the hard money first mortgage.

This is a true “nothing down” deal, since you never laid a dime out of your own pocket! Just make certain the total payments on the first and second mortgages do not exceed the fair market rent for the property.

Keep in mind that you can use subordination to draw cash on properties you already own. If you purchased a property with seller financing, simply ask the former owner to subordinate his mortgage to a new first.

This may require you to give the seller some incentive, such as additional cash or pay down of the principal. Either way, subordination is an excellent way to finance a purchase or draw money out of existing properties.

Substitution of collateral

Substitution is a method of moving a lien from one property (collateral) to another. Let’s suppose you own an improved property worth $100,000 with a $65,000 first mortgage. You also own a free and clear vacant lot worth $65,000.

You need $65,000 cash, but you cannot find a lender who will let you borrow against the vacant lot or borrow more than $35,000 on the improved property.

Sell the improved property for cash. Before doing so, get the first mortgage holder to agree to substitute the vacant lot as collateral for the mortgage. This may require paying down the mortgage $35,000 so that the remaining balance is only $30,000.

However, if you receive $100,000 from the sale of the improved property, you still have a net $65,000 cash in your pocket.

The substituted property does not necessarily have to be real estate. You can agree to use a car or boat title as the substitute collateral. Better yet, get the mortgage holder to release the mortgage with no substitute collateral!

You may be thinking, “who in their right mind would do such a thing?” The answer is . . . someone who needs cash!

A real life example of subordination and substitution of collateral

A property owner (we’ll call her “Mrs. Seller”) called me to discuss selling her house. After some negotiations, we agreed to purchase the property for $63,000 as follows:

• $35,000 at closing of title

• Promissory note and second mortgage (subordinate to a new first) for $28,000, payable in installments of $350/month

She owned the house free and clear, so why would she do such a thing? After some discussion, she told me that she was sick of the upkeep and she wanted a brand-new double-wide mobile home.The $35,000 cash was for the new home, and the $350/month would pay her lot rent (just so you know that I didn’t “steal” the property from some little old lady!)

I went to a hard money lender and borrowed $37,500 at 12% interest (the extra cash was for fix-up of the property). We closed title, placing a new first mortgage in favor of the hard money lender, and a second mortgage (subordinate to the first) in favor of the seller for $28,000.

Our total monthly payments were $725/month, and we rented the property for $800/month on a two-year lease with option to purchase at $74,000.A few years later, the tenant exercised his option to purchase. At that time, I called Mrs. Seller to see if she would be willing to take a discount on the amount we owed her, which was approximately $20,000. She said that she liked the monthly payments and didn’t want me to pay her off!

With that, she agreed to release the mortgage from the property and allow us to continue making payments on the unsecured promissory note (I had to “bribe” her with $10,000 cash, applied toward principal).

Not only did we profit from the sale of the property, we also walked away from closing with an extra $10,000 cash in our pockets! As you can see, subordination and substitution of collateral are two powerful tools to Increase Your Monthly Cash Flow.