Published: October 1, 2019 • Last updated: October 9, 2019 at 9:14 am
This is the second in a three part series of articles discussing private mortgages. Private mortgages are becoming increasingly common because of extremely high house prices, especially in Canada’s major cities, and as a result of the mortgage stress test. In Part 1, I covered the basics, answering the most frequently asked questions. In this article, I take a deeper dive into when a private mortgage is the right solution, or sometimes the only solution for home buyers and owners. Part 3 answers the question “What is the total cost of a private mortgage?”
When Would You Need a Private Mortgage, and What Scenarios Make Them a Preferred Solution?
Private mortgages are more expensive than traditional mortgages, tend to be for shorter terms, and you should think of them more as a solution to a problem.
I’ll first discuss the types of problems they are a good solution for, and why a loan through a traditional lender may not be possible (which naturally makes a private mortgage the best or only solution). And because a private mortgage is generally considered a temporary solution, I’ll delve into what happens when your private mortgage term is up, and how you transition to a more conventional mortgage product.Private mortgages are more expensive than traditional mortgages, tend to be for shorter terms, and you should think of them as a solution to a problem. #PrivateMortgageFacts Click To Tweet
There are 5 major considerations that help determine when a private mortgage is right for you. They are:
- What issues preclude you from using an ‘A’ or ‘B’ lender?
- Will a private mortgage transaction fix the problem you’re trying to solve?
- Even though expensive, will a private mortgage be the lowest cost solution to your problem?
- Will you likely need to renew in a year’s time?
- Do you have an exit strategy?
Let’s jump right in.
1. What Are the Issues That Preclude an ‘A’ or ‘B’ Lender?
A-lenders offer traditional residential mortgages at the best rates. They are banks, credit unions and monoline lenders, such as MCAP and First National. However, most A-lenders are required to administer the mortgage stress test, which means you must qualify for a loan at a higher rate than your mortgage is offered at to be sure you can still afford it when rates rise.
This is making a normal mortgage harder to qualify for, even for people who would have comfortably sailed through the process just a few years ago.'A' lenders offer traditional mortgages at the best rates, but must apply Canada's mortgage stress test. Because borrowers must qualify at higher rates, the stress test forces many to consider private lenders. #PrivateMortgageFacts Click To Tweet
Mortgage brokers also have access to alternative mortgage lenders (B-lenders) who offer excellent solutions above and beyond A-lenders. Such solutions offer:
- Tolerance of damaged credit histories—they will reserve their lowest rates for those with high credit scores (720 and above, sometimes less) but at the same time may entertain your mortgage application with a score as low as 500 or even lower.
- Receptiveness to forms of income that traditional lenders cannot consider, such as commission income, Airbnb income, tips and contributory income from spouses and other family members not even on title. And most are welcoming of self-employed borrowers.
- Expanded debt-service ratios—some alternative lenders will allow GDS and TDS ratios as high as 50%, and are not constrained by 35/42 or 39/44 ratios, as traditional lenders usually are.
Both ‘A’ and ‘B’ lenders are federally regulated financial institutions and banks, and they must therefore follow Canada’s mortgage stress test. Exceptions to this rule are credit unions, which are provincially regulated, and may have different guidelines depending on the province.
So, the first question to ask is whether there are reasons that make a mortgage through an A or B lender impossible, or less than optimal solution for your needs. Here are some common reasons why a private mortgage may be required over more traditional or alternative solutions:
Is Refinancing Cost-Prohibitive Because:
- The prepayment penalty may be too large due to the interest rate differential (IRD) calculation. (This is the difference between your current interest rate and what the lender could charge for a mortgage today)?
- You received a cashback payment when you got your first mortgage. Bank lenders typically expect repayment in full of the entire cashback if you break the mortgage early?
- You do not want to give up an extraordinary first mortgage already in place?
- There may be significant Canada Revenue Agency (CRA) debt that seriously limits the number of interested lenders?
- Personal credit history may be in poor condition – with late mortgage payments, collections, writs, and liens. Or the borrowers may be in the middle of a consumer proposal or an undischarged bankrupt?
- There simply isn’t enough income to service the debt, even with alternative lenders’ expanded debt service ratios?
Are You Trying To Solve a Specific Problem With a Private Mortgage?
There are often specific problems that need to be remedied by a private mortgage over a one-year or two-year term. In other words, what led you to where you are today? This may include:
- Paying off high-interest unsecured debt such as credit cards or CRA debt.
- Consolidating several debts into one single, lower monthly payment to improve cash flow.
- Paying off and completing a consumer proposal early to speed up the restoration of your personal credit history.
- Buying a new home before your existing property has been successfully sold.
- You may only need a fix for a very short time, a few months or even less.
2. Will the Private Mortgage Transaction Fix the Problem You’re Trying to Solve?
Ideally, yes. The whole intention of placing you in a temporary private mortgage solution is to address whatever issue(s) brought you to your current situation. If a private mortgage will not improve your finances, it is important to analyse your goals vs realities. You may want to seriously consider selling your property if it will continue to pose a burden on your cashflow for years to come.
It is imperative you avoid missing payments for any reason. It’s not uncommon to incur a $300 non-sufficient funds (NFS) charge if you do, in addition to whatever your own bank charges you. Missing payments will also hurt your chances for renewal.
And if you run into serious problems and find you cannot make the payments, deal with the problem as quickly as you can. It may even be wise to list your home for sale immediately to avoid expensive legal processes and extreme costs.
3. Even Though Expensive, Will a Private Mortgage Be Your Lowest Cost Solution?
You are now in a world of much higher interest rates and high fee structures. If you have never needed a private mortgage before, this can be quite a shock. Most of the time these fees are paid for from the mortgage proceeds, not from your own pocket.
When you arrange a mortgage with an A-lender, your typical out of pocket costs are for the appraisal, and legal fees and disbursements, including title insurance.
With private mortgages on the other hand, there are more and larger fees to set up the mortgage. You should also expect to pay a brokerage fee (as your mortgage broker is not typically paid by the lender as they would be with a mortgage from an A-lender) and a one-time fee to the lender. This lender fee may be called a placement fee, an administration fee, a setup fee or a commitment fee or some other similar sounding name. Some additionally charge an application fee.Despite being expensive, a private mortgage may still be the low-cost solution to your problem, and that can make it the best option. #PrivateMortgageFacts Click To Tweet
These fees are usually measured in the thousands, not hundreds. Sometimes they will be a percentage of the loan amount, and other times they represent the minimum dollar amount that party requires to enter into this sort of transaction.
Private lenders do not expect to incur any costs whatsoever when making a mortgage loan. The borrower pays for EVERYTHING. Starting with the lender’s legal fees and disbursements, for which $2,000 is a reasonable budget. And you may well be asked for a retainer for their lawyer when you accept their mortgage offer. A $500 retainer is not uncommon.
In most cases, you will also need Independent Legal Representation (ILR) – that is, your own lawyer. You will negotiate the cost for this service yourself. Your lawyer receives instructions from the lender’s lawyer and in many cases is expected to do a fair bit of heavy lifting (much of the legal work) to get the mortgage funded.
All these costs should be clearly disclosed to you in a disclosure document before you sign a mortgage commitment. It’s the law. And in fact, reputable mortgage brokers will provide you estimates well in advance, to avoid last-minute surprises.Carefully choose a highly-experienced + reputable mortgage broker to arrange a private mortgage to ensure proper handling of all details and legalities, cost disclosures and protection from unnecessary risks. #PrivateMortgageFacts Click To Tweet
It takes years to become a skilled mortgage broker of private mortgages, and you should choose your broker carefully. You don’t want to be anyone’s guinea pig unless the agent is being mentored by someone highly capable.
Your broker has access to many lenders and should do her best to find a solution which is fair for all parties, and addresses as many of your requirements as possible. The bottom line though is the riskier your mortgage is perceived to be, the more it will cost you.
What makes a private mortgage risky?
- If the overall loan to value of all mortgages on the property is high, there is less equity to give the lender comfort they will get their money back, no matter what.
- Historically, by their nature, private mortgages were often required because the borrowers themselves had a less than stellar profile. That is not so much the case these days – we are also seeing people seek private mortgage financing just because of the mortgage stress test.
- Others find themselves owning two properties when the one they are leaving does not sell prior to the closing of their new purchase. These homeowners may have excellent credit and a decent income.
- As an investor, if you hold a second mortgage, it means you are in second position usually behind a large institutional lender. If things go sideways, there is an excellent chance that lender will be focussed on getting THEIR money back, and less concerned about the second mortgage.
- If your home is rural, on well water and septic system, or in a small town or village, it will be perceived as riskier than a subdivision property in a densely populated area.
- If the borrowers have a proven track record of late payments, collections and poor attention to their personal finances, they are a risky investment.
- According to CMHC’s Residential Mortgage Industry Report loans originated by MICs and private lenders are eight times more likely to default. (1.93% versus 0.24% of all such loans)
4. Will you likely need to renew in one year’s time?
Even if the intent is to exit the mortgage at the end of the term, life happens, and the best-laid plans can go awry. Sometimes it is clear from the get-go that you will need to stay in the mortgage for longer than a year.
This is why it can be important we select a renewal-friendly lender to ensure a subsequent term is offered that is reasonable for clients who demonstrate reliable repayment history.
Some lenders will require an updated appraisal, a personal credit report or even confirm income and employment at renewal. This will help set their minds at ease that their money is at no greater risk at renewal than it was when they first funded your mortgage.Your goal is to exit a private mortgage as quickly as possible, but if there's a chance you'll need to renew, make sure the chosen lender is renewal-friendly. #PrivateMortgageFacts Click To Tweet
Some private lenders warn us upfront not to expect a renewal offer. They want to be paid back in one year so they can lend the money out all over again, earning one-time lender and administration fees, and perhaps even higher interest.
Private lenders who offer renewals often charge a renewal fee, which can be a percentage of the money borrowed or a flat dollar amount. There are some horror stories out there, so make sure you ask about this before you commit to taking on a private mortgage.
Will you need to pay off the mortgage in under a year? Your broker may be able to arrange reasonable prepayment terms. For example:
- A one year mortgage, open without prepayment penalty after as few as two months (Fisgard Capital Corporation offer this)
- A one year mortgage, with the ability to pay off early with only a one-month penalty. (Three months prepayment penalty is standard)
5. Do You Have An Exit Strategy?
Mortgage brokers and lenders agree the most important thing to plan for when securing a private mortgage is the exit strategy. In other words, what is going to change in the future so that you no longer need a private mortgage?
The higher the loan-to-value ratio, the more pressing a concern the exit strategy becomes. For example, a private mortgage that begins at 80% LTV in a flat or declining real estate market may have nowhere to go in one year at maturity.
How High Can Your Private Mortgage Financing Be?
There are lenders accessible by the mortgage broker community who will consider a loan to value ratio of 85%, or even higher. I do not generally recommend such financing unless you simply must buy time till the core problem can be solved in some other way – like selling your property, or perhaps you have a large sum of money headed your way.
Otherwise, if your situation requires a mortgage that high, you may be doing the wrong thing by trying to solve a problem with a private mortgage solution.
These days, many lenders are reluctant to lend beyond 75% or even 70% LTV – even in the GTA. Exceptions in major metropolitan areas can sometimes be made to 80% LTV when accompanied by a strong client backstory. And, in smaller towns and other provinces, you may be looking at a maximum of 50% to 65%.Make sure your exit strategy from a private mortgage is planned up front, and then do everything possible to stick to that plan. #PrivateMortgageFacts Click To Tweet
What Is Your Plan To Pay Off the Private Mortgage?
A private mortgage is meant to solve a problem, and, in most cases, should not be a long-term solution. It should be the first step in the journey back to traditional lenders as soon as possible.
When you finish your private mortgage and are ready to pay it out, be sure it is discharged properly by a lawyer. You can expect to pay legal fees and disbursements, as well as lender statement preparation and discharge fees.
These costs should be disclosed to you upfront with your mortgage loan documents.
You did it! You are now ready for more options with traditional or alternative lenders at lower interest rates. It is our pleasure to negotiate on your behalf to ensure you receive the very best mortgage product and rate catered to your unique situation. Click here to if you have additional questions about when a private mortgage is the best solution, or if you want to ASKROSS to assist in crafting the right mortgage solution for your needs.
That concludes my deep dive into when you might need a private mortgage solution, and the scenarios that make them a preferred solution. Watch for Part 3 of my 3 part series which focuses on the costs of a private mortgage, and what to expect in terms of interest rates. If you missed Part 1, but the scenarios described in this article sound like you have a situation that demands a private mortgage, you can review the basics and most frequently asked questions about private mortgages by clicking here.
Thank you to all the mortgage brokers whose knowledge I draw upon each and every day in forums such as I Love Private Mortgage Brokering. Special thanks to Tina Stewart at Canadian Mortgages Inc., and Aaron Phinney at Mortgage Architects.
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