This is the third, and final, installment in my series on collateral mortgages. My intention with this series is to provide consumers with as much information as possible so that they can make informed decisions when the time comes to obtain a mortgage or, in the case of second mortgage investors, lend money as part of a real estate investment.
In Part 1, I shared the reasons why I think collateral mortgages are mostly a bad idea for consumers and why they are downright dangerous for second mortgage investors.
In Part 2, I presented the views of two bankers. One of them really didn’t like what I had to say, so I dug deeper into the concerns expressed.
Now I’d like to look at collateral mortgages from a legal perspective. I spoke with three lawyers from different firms in Ottawa. Individually, they have significant experience in real estate law; one of them also teaches a law course. Two of the lawyers asked to remain anonymous since they work with a lot of banks. Let’s call them John and Nathan for the purpose of this article. The third, Leslie Kirk from Kirk Law Office, agreed to go on the record.
Here are the questions I put to them and their responses:
Neither John nor Nathan have experienced any real issues with collateral mortgages though they both noted that they are seeing more and more of them come across their desks.
Leslie, however, had this to say about her experience with collateral mortgages:
The instructions I receive from some of the financial institutions that commonly or always use the collateral format do not include details of the client’s actual loan terms. This means that I am not able to advise them on this. Another issue is that often clients do not understand/know that the mortgage will be registered as a collateral charge. When they see me, they are alarmed that the principal amount is greater than the actual amount borrowed and the rate is also much higher (some institutions use “prime + 10%”). The client may have been given this information but 9 times out of 10 the details were not explained or it wasn’t made clear.
My experience is that the individuals working for the financial institutions don’t understand the differences between collateral and traditional mortgages. This means that they can’t provide all of the relevant information to borrowers to allow them to make an informed decision.
Nathan also noted that roughly 50% of his clients are surprised or confused by collateral mortgages. He has had clients go back to the bank to switch to a conventional mortgage when they realize they have been given a collateral mortgage. He is not aware of any clients who ran into trouble when refinancing their home under a collateral mortgage.
Nathan didn’t think that it was much of a problem that collateral mortgages might prevent the use of second mortgages. “Most collateral holders have no intention of seeking 2nd or 3rd mortgages so the issue doesn’t come up regarding their total equity being secured by one bank.” (See below for my comments regarding this point.)
John and Leslie took a different view. John expressed concerns that the bank could include other debts in their charge and that this posed a risk to the clients.
Leslie expressed it this way:
It is an issue that unsecured debts owed to the institution are now secured debts. The common language is to the effect that “the charge secures every indebtedness existing or future with the institution”. The result is that missed car loan payments or credit card payments can potentially lead to a default on the mortgage. Another result is that the client will have to pay these debts when they refinance or sell even if that is not what they wanted to do. If I had a collateral mortgage, I would be sure to cancel all other credit products with the institution.
John: “As lawyers we’re in a bit of a conflict of interest. On the one hand, we’re working for our clients but the reality is that we benefit from collateral mortgages because now clients have to come to us to discharge and secure a new mortgage. We end up making more money from the transaction. I haven’t seen a lot of this but the conflict nonetheless exists.”
Nathan: “Typically the costs are $1,000 – $1,500 to discharge and secure a new mortgage. This has not come up as a ‘real’ issue in our office.”
Leslie: “It is harder to switch lenders. By harder I mean more expensive as the transaction will require a lawyer whereas switching a non-collateral mortgage can be done by the new lender in-house or through a Title insurance company at a lower fee. This extra cost discourages people from exploring options. It’s good for me as a lawyer since a lawyer is required when clients who have collateral-type mortgage want to switch lenders.”
Nathan: “I wouldn’t advise placing a second mortgage behind a collateral mortgage as the total equity will be secured by the collateral.”
John: “From a second mortgage standpoint, they’re dangerous. Whatever the amount registered, just assume that’s the amount owed because you don’t know how much they might add to their indebtedness after you provide second mortgage funds. Look at the face value of the registration and ask yourself, would you be OK if they owed that much?”
Leslie took a different view but her final recommendation was similar to John and Nathan’s:
My opinion is that, legally, the collateral mortgages will work like construction mortgages. Prior ranking mortgages only have priority to extent of funds actually advanced (or to credit “actually” available to clients).
If a first mortgagee has a charge registered at $500,000 but only advances $300,000 and gives additional credit of $50,000, the first mortgagee would only have priority to $350,000 against a second mortgagee that registered when this was the situation. If the first mortgagee advanced beyond the $350,000 or opened up additional line of credit room after the registration of a second mortgage, these funds would rank after the second mortgage.
From a practical point of view, likely that first mortgagee would claim all money owing despite the priority issue. The second mortgagee would have to fight to get their priority recognized. This would include proving what exactly was owing on the first and actual available credit at the time of the registration of the second. This possibility might make investors stay away from such situations if there are non-collateral properties available.
John: “Yes, the banks can serve you easily and quickly if you need additional funds, so that’s good. The flip side is that this may encourage clients to keep borrowing money and increase their indebtedness.”
Leslie: “This product has a place and options are good for consumers.”
I’m a big fan of having options. While collateral mortgages do present an option for consumers, I don’t like the strings that come with them and make it more difficult or costly for me to change lenders.
Nathan said that since his clients don’t plan to get second or third mortgages it’s not an issue for them. Here’s the thing: Virtually no one plans to get a second mortgage down the road. Second mortgages are not the preferred path for consumers; they’re typically a solution for people whose options are limited for one reason or another. It’s true that investors use them all them time to buy investment properties because the judicious use of seconds can reduce their cash in the deal and thereby increase the Return on Investment. However for most consumers, they’re a stop-gap measure to get past a difficult situation and you can’t always predict future difficulties.
If you take on a collateral first mortgage, you pretty much guarantee that second mortgages are out of the question. When life happens, I personally think that it’s good to have as many options as possible.
As a second mortgage investor I maintain that collateral first mortgages are dangerous. Even if Leslie is correct that a second mortgage takes priority over debt incurred after the second was put in place, I wouldn’t want to count on the bank playing nicely. If they claim all the money owing and you’re stuck going to court against them, just ask yourself, who has the deeper pockets? Right. Why take that risk? Look for investments where the first mortgage is a conventional mortgage.
In the event that you do select a collateral mortgage, I would take Leslie’s advice and transfer all other credit products (i.e. loans, credit cards, lines of credit) to another institution.
In all cases, ensure that you understand what’s on offer and proceed with caution.
Until next time, Survive, Thrive and Grow.