What Is Preferred Debt?

Certain financial obligations held by individuals or corporations take priority over others. Preferred debt is one such category, and borrowers are required to repay these issuers before any other creditors are considered. A mortgage loan is a type of preferred debt and must be paid before any second home loan or mortgage security payments are addressed.

A mortgage is a loan extended by a financial institution or a government agency that allows the average individual to afford a home without having to pay cash for the entire amount. Payments are made to the mortgage issuer, and some of that repayment goes toward the principal amount of the loan while the rest goes toward interest. After a while, when the home owner has established equity in a home, a second mortgage can be taken out. The original mortgage loan is preferred debt over the second mortgage in a home.

Preferred debt also includes the interest that is paid on a home loan. The interest is also considered tax deductible. Any money in taxes that might be owed to a federal government is another form of preferred debt, and these obligations must be paid before most others.

The priority of debt comes into play when there is a lien placed again a loan due to a default by the borrower. If the borrower becomes unable to service loan payments, the lien order determines who takes priority when money is obtained. The creditor may need to wait for a liquidation process in which all assets are sold in order to generate cash to repay creditors, including preferred debt, at the direction of a court-ordered trustee. If there is collateral on the loan, those assets are sold, and the cash is applied toward preferred debt issuers first. Any remaining assets from the sale go to secondary and tertiary loan issuers.

Debt as an investment category has some benefits over equity. If a company or individual files for bankruptcy, for instance, debt holders take priority over equity shareholders. This means that, if there are any bond holders of an investment security, these investors will be repaid first before stockholders are paid anything. Debt investments are subsequently considered safer than equity because of the pecking order in which creditors are repaid.

Not every form of debt or loan is preferred. Auto loans, college debt, and credit card debts are not treated as preferred obligations. Personal loans issued by banks are not preferred debt either.