When you borrow money to buy a house, the bank can register a loan in one of two ways. There’s the good, old-fashioned way of registering a conventional mortgage charge on Title. With this approach, the amount you borrow is the amount that gets registered. Fair enough right? You borrowed X dollars and now the bank wants to protect themselves for X dollars’ worth in case you stop paying.
These types of charges have all sorts of advantages, including transferability if you decide that the bank is not serving your needs and you want to switch to another lender at the end of your term. In other words, you still have options that don’t cost you a fortune if your current lender stops being nice.
Then there are collateral mortgages. With this approach, the bank registers a charge for the full value of the house or, in increasingly frequent “are you kidding me” cases, up to 125% of the value of your home. You can only register or discharge these charges; you cannot transfer them to another institution.
When you read the banks’ press on this, they make it sound like they’ve just done you the biggest favour imaginable by allowing you (maybe, if you qualify and if they feel like it) to borrow more money without having to register another mortgage and incurring a few costs.
This is a relatively small benefit for some people who might need more money later on and who can qualify for those additional funds. Access to those funds is not guaranteed – it’s only a possibility that is purportedly made easier by having a collateral mortgage.
And now, the down side that no one tells you about: If you decide that said bankers are not treating you well and you want to move, too bad for you because now it will cost you a large chunk of change to discharge your mortgage. Forget about switching lenders at the end of the term and forget about adding secondary financing behind your first mortgage; your house is now worthless to other lenders.
For a great, in-depth look at collateral versus conventional mortgages, read Dave Larock’s blog post. It’s informative, entertaining and important. Here’s just one snippet from his post: “In effect, TD is making it cheaper for you to borrow more money from them in the future, while at the same time making it more expensive and more difficult for you to move to a different lender.”
Now let’s take a quick look at why collateral mortgages are dangerous for second mortgage investors. As an investor, you should feel about collateral mortgages the same way you feel about poisonous snakes – fascinating at a distance, but don’t get anywhere near them.
Last week, in this blog post, I passed on some suggestions to women who need to raise their income in a hurry. The first thing I would do is invest in second mortgages for reasons I outlined in the post.
Let’s say that you have some cash to invest and either you can’t qualify for a mortgage to buy an investment property, or you would prefer not to for a whole host of reasons. Second mortgages provide an investment opportunity to earn anywhere from 9% to 12% on your funds, sometimes more, while mitigating the risk by securing the mortgage against the property. This is where the type of mortgage plays a vital role.
Imagine that you find a great couple who need a bit of help with a second mortgage. You agree to lend them $20,000 at 12% for one year with the possibility of a one-year extension. You’ve checked them out yourself and you’re comfortable with how reliable they are; you’ve ensured that the mortgages, both first and second, add up to a total Loan to Value ratio that you’re comfortable with; and you have a second mortgage agreement written by a knowledgeable lawyer. Good to go, right? That depends on the first mortgage. If the latter is a conventional mortgage and the charge on title is for the value of the first mortgage, then you’re fine.
However, if the first mortgage is a collateral mortgage, walk away. Do not ever invest in a second mortgage when there is a collateral first mortgage in place. Why? Because there is no value left in the house to protect your investment. In other words, the first mortgage lender has locked up 100% (or more) of the value of the property. If the deal goes south, you have little-to-no protection.
The only way to know if there is a collateral mortgage in place, or if one is being set up, is by looking at the mortgage loan agreement if the house is already purchased; or by reviewing the mortgage commitment if the clients are in the process of purchasing. Don’t expect the lender to put it on the first page in bold letters either. It is typically buried in the document as part of a heap of other clauses. If the parties involved won’t produce those documents for your review, walk away, unless you like gambling with your money.
A few months ago, when I was getting ready to invest in a second mortgage for a couple who were going through a secondary lender (i.e. not one of the Big 5 banks), I asked to see the mortgage commitment. When I asked the clients if they were getting a conventional or collateral mortgage, they had no clue. In fact, they had never heard of collateral mortgages. (This is true of most of the people I have encountered who are looking for mortgages. It’s not that they’re naive; it’s that banks do a terrible job of informing consumers about what they’re signing.)
Back to my case study. A clause, stating that the lender would register a charge for 125% of the value of the house, was buried on page 7 of the mortgage commitment. I told the mortgage agent that I wouldn’t agree to this clause. The lender came back with a generous offer: They agreed to reduce the charge to 100% of the value of the house. I told them that if they registered a dollar more than the value of the first mortgage, I would walk away. They knew that the deal would fall apart without secondary lending, so they agreed, telling me they were making an exception in my case. Lucky me.
Do not for a moment believe that the banks have your best interests at heart. They don’t. Banks are in business to make a profit. There are very good people who work at the banks and who endeavour to provide great service, but the bottom line is that you need to be aware of the documents you’re signing. It is incumbent on you to protect yourself. Just because a bank says it’s awesome, doesn’t make it so.
The next time you’re thinking about setting up a mortgage, ask the following questions:
Look carefully at what product is being offered and if you don’t understand the details (good, bad and ugly) ask lots of questions. If you still don’t understand after the explanations, don’t sign. And if you’re a second mortgage investor the answer is simple: No collateral mortgages ever.