Private Mortgage

The definitive 2018 guide to private mortgage financing

This guide is meant to demystify and answer some basic questions about private equity financing in order to help you decide if a private mortgage is right for you.

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Chapter 1

The difference between a private mortgage and institutional bank mortgage

First let's define what a private mortgage is and what makes it so different from a mortgage that you might get from your bank or through a mortgage broker.

At it’s core the answer has to do with how each type of lender approaches the 5 C’s of credit:

  • Capacity = Income
  • Credit = Credit history and outstanding debt obligations
  • Capital = Down payment or existing equity in a home
  • Collateral = The underlying real estate asset and it’s value
  • Character = Other life circumstances that have effected the credit application.

Your institutional lenders are looking for the crème de la crème in each of the 5 C’s with very little leniency or flexibility if a borrower doesn’t fit into their narrow categories. This strict lending criteria can marginalize borrowers and lead them to have to deal with pricier home equity loans and private mortgages.

Note that in 2018 with the introduction of stricter bank regulation policy by the Office of the Superintendent of Financial Institutions (OFSI), meeting the criteria of your bank got that much harder. Regulators have argued that it is in the best interest of Canadians to have stricter mortgage qualification rules.

However what we are seeing is that it is hurting some borrowers.

Borrowers who represent low borrowing risk but don’t meet the exigent criteria for A lenders need to pursue more expensive mortgage financing from private lenders.

Private home equity mortgage lenders to the rescue.
Private mortgage lenders consist of individuals like you and me or groups of individuals who have pooled money together to lend. Unlike banks, credit unions, finance institutions etc… private lenders have more discretion and flexibility on their lending guidelines.

From a private home equity mortgage lender’s point of view a private mortgage is an investment opportunity secured on your real estate.

However to believe that private home equity mortgage lenders will throw money at you just because you own a house is completely wrong.

Like banks and institutional mortgage lenders a private lender will still consider the 5 C’s of credit however they will be more willing to make exceptions and pursue opportunity to earn a higher interest rate on their mortgage loan.


Chapter 2

The four most common reasons a borrower needs a private mortgage

Mark Twain once wrote “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.

Unless you’ve been in a difficult financial situation you can’t appreciate just how right Mr.Twain is. Trying to talk to your banker or mortgage broker when life throws you a curve ball can be frustrating and outright demeaning.

The 4 most common reasons why a borrower might need a private mortgage.

#1 Debt consolidation & credit rehabilitation
There is no shortage of reasons why you might have taken on more debt that you can't manage.

Health issues, relationship stress, business failure, consumerism, bad financial advice… all reasons why you might have stretched your credit cards and lines of credit to the limit.

If you’re lucky you’ll be able to consolidate the debt into your existing first mortgage through your bank or “A” lender.

However if you don’t meet the minimum lending requirements and have missed payments on your debt, you can find yourself in trouble.

Debt has an amazing ability to snowball especially if you can’t get help from your bank/institutional mortgage lender. Without an option to consolidate you’ll find yourself with growing debt loads which effect your credit score.

This is where a private second (2nd) mortgage lender or private home equity lender come in handy.

Most private home equity lenders will go up to 75-80% of the market value as determined by an appraisal. This is a rule of thumb and depends on need, location and exit strategy.

With the money made available by the private home equity mortgage lender you’re able to consolidate your debt at a lower interest rate into one payment that is hopefully more manageable.

The purpose of the loan isn’t just to improve cash flow. There needs to be a very clearly defined exit strategy.

In the case of debt consolidation the exit strategy is to pay debts off to improve overall credit score over a 12 month period. With new and improved credit you should be able to approach your first mortgage lender to consolidate into a first mortgage so that life can go on.

The biggest risk of using a private home equity mortgage or 2nd mortgage for debt consolidation is if your score doesn’t improve or you can’t consolidate with your first. In that case you’ll be stuck perpetually with high interest mortgage that can be detrimental to your financial well-being.

If you proceed with a private second or home equity mortgage to consolidate debt you’ll want to make sure that you qualify for the eventual “take-out” mortgage required at the end to consolidate both your mortgages together.

#2 Property or income tax arrears
Tax arrears can be a real issue for homeowners. The smallest arrears can present a major hurdle for most A or institutional mortgage lenders.

Income tax arrears and/or property tax arrears cannot be financed by most institutional mortgage lenders. It’s generally considered an extremely important indicator of credit worthiness if a borrower has any kind of tax arrears. Your obligation to pay income tax and property tax is the most fundamental responsibility of a borrower.

There is an added risk to the lender if there are tax arrears because Canada Revenue Agency and your local municipality can take legal action to sell a house to recover their arrears. In this case the arrears actually take first position form the mortgage lender diminishing their security position.

A private home equity or second mortgage can provide the liquidity you need to pay your arrears.

After funding the private mortgage you’ll have the ability to pay your arrears. With proof in hand that you’ve made payment you can then return to your 1st mortgage lender to refinance.

Ironically a first mortgage lender can’t refinance to payoff tax arrears however they can refinance to payoff a private home equity or 2nd mortgage. So it’s kind of a two step dance that needs to be done to present your application for the final approval with your A lender so that you can move forward with more conventional financing.

#3 Stop power of sale
To be under power of sale means that home owners have broken the covenant of their mortgage lender(s) and legal proceeding have commenced to recover money owed to the lender via court ordered sale of the property.

This is a terrible and sad situation typically accompanied with a story of struggle. We’ve observed that home owners generally want to do right by their obligation.

A private home equity loan or 2nd mortgage can help to stop a power of sale and give dignity to the home owner to sell on their own terms and timeline.

The financing provided can be used to pay any arrears and legal costs to bring the 1st mortgage into good standing and also provide extra cash flow for living expense and/or home improvement until the property is listed and sold.

The benefit for a homeowner to employ a private home equity or second mortgage is that it allows them to protect the equity they’ve built up in their home. If sold under power of sale a mortgage lender can add any number of sundry charges for legal and admin work eating up huge chunks of equity.

#4 Bridge loan / financing
The need for a bridge loan comes from timing issues. The need for bridge financing typically arises out of need for funds outpacing availability of funds. The most common example is when a home is purchased prior to a home being sold. In this case, money for a down payment is tied up until a home is sold.

Banks and institutional lenders all provide bridge financing however there is one critical condition. There has to be a firm sale on the property you’re selling. That can be a little tricky at times if the market doesn’t co-operate or if personal circumstances prevent the sale.

A private home equity loan is the perfect solution if you find yourself in this situation.

The private lender can typically provide a loan collateralized against both of your properties to provide the required liquidity.

In addition to real estate closings, bridge loans may arise out of business needs or need to pay family etc prior to you being liquid with cash.

The key feature of a bridge loan is that as a borrower your exit strategy is cash that will be made available on a short term basis.


Chapter 3

The difference between a 2nd mortgage, line of credit and home equity loan

This chapter is all about clarifying some nomenclature about mortgage financing. You might be a little confused about what types of mortgage financing are available and what each one is called and how they differ.

Second (2nd) Mortgage, home equity loan and line of credit all can loosely be used to describe the same thing however each one of them definitely refers to something specific.

What is a home equity loan?
Simply put, a home equity loan is any loan/mortgage that has been secured against real estate. Secured means that interest in the property has been registered on title via a mortgage or collateral charge.

Types of home equity loans can include:

  • First mortgage
  • Second mortgage
  • Third mortgage
  • Line of credit
  • Collateral mortgage

While the term is very broad, in the Canadian mortgage origination industry home equity loans refer to something more specific.

A home equity loan typically refers to a type of mortgage where more importance is placed on the equity available in a borrower’s home rather than the personal covenant or credit worthiness of a borrower.

Borrowers who have difficulty showing strong income or have blemishes on their credit reports can rely on private home equity lenders if they have sufficient equity in their home.

Since banks and institutional lenders have stricter borrower guidelines home equity mortgages tend to be the domain of private mortgage lenders. There are a number of reasons why a borrower requires a private home equity loan/mortgage.

What is a second mortgage?
Mortgages are ranked (1st, 2nd, 3rd etc.. ) according to the timing of registration.

For example…

Home purchased September 1st 2012 for $500,000.

First mortgage secured on September 1st 2012 for $250,000

Second mortgage secured on June 1st 2014 for $25,000

If the first mortgage were paid out in full and discharged the 2nd mortgage would move up into 1st position.

Mortgage lenders can provide postponements to allow positions to be changed or permit new lenders to take a lower position.

The ranking of a mortgage determines how secure a mortgage loan is because upon sale of a property the 1st mortgage lender gets paid out prior to the 2nd or 3rd mortgage lender. This is especially important under power of sale because additional charges can be added to each mortgage diminishing the equity/security position of higher positioned mortgages.

For this reason very few banks or institutional lenders will finance 2nd mortgages. It is a highly specialized area of lending typically dominated by private home equity lenders.

What is a secured line of credit?
A secured line of credit is a special kind of credit charge on title which allows credit to be readvanced or revolving. Unlike a mortgage which has specific repayment terms as determined by it’s amortization the line of credit can be advanced and paid back with complete flexibility.

Lines of credit are definitely a type of home equity loan. In fact they are often called HELOC or Home Equity Line of Credit.

Lines of credit can also by a type of 2nd mortgage.

Why?

Because a line of credit might be in 2nd position behind an existing first mortgage.

Lines of credit are limited to a maximum amount of 65% of your home’s value. If your line of credit is in 2nd position it cannot exceed 80% loan to value of your home’s value.

For example...

$1,000,000 valued home

$650,000 would be the maximum size of the line of credit however if there were an existing 1st mortgage of $500,000 then the maximum line of credit would be scaled back to $300,000 due to the 80% LTV limitation.

Banks and A lenders tend to be very strict when it comes to underwriting secured lines of credit and in general they will only take a 2nd position if they are the lenders who hold the first mortgage as well.

Secured lines of credit are reserved for highly creditworthy borrowers and are rarely if not never offered by private home equity lenders.

In general if you are a creditworthy borrower with equity in your home you would deal directly with your bank or institutional mortgage lender to seek additional financing.

 


Chapter 4

How much equity is required to apply for a private mortgage

Home equity is one of the most important factors to successfully apply for a private mortgage. The amount of home equity you have will not only determine how much money can be made available to you. The amount of home equity available will determine the rates, lender fees, broker fees.

What does equity mean?
Home equity is a measure of ownership based on the difference between the current market value of your home versus any existing encumbrances.

Market value of your home.
To determine equity we must first determine fair market value of a home or property.

Private home equity lenders will require an appraisal, which is performed by an independent certified appraiser. The role of the appraiser is to provide 3rd party analysis of your home’s value using recent sales in your neighbourhood called comparables. The appraiser will then making adjustments on the value of your home up or down based on differences in square footage, quality of finishes and other market factors with the comparables that have actually sold recently.

Existing encumbrances.
Existing encumbrances include any existing mortgages (1st, 2nd etc), secured lines of credit and liens.

When it comes to lines of credit secured on your home often they are secured in 2nd position behind an existing 1st mortgage. Even though you might not have any money advanced or owing on the line of credit it will still occupy the 2nd position and be considered as fully drawn when assessing available equity.

In the mortgage origination industry equity and financing is usually talked about in terms of a percentage called loan to value.

What Does Loan to Value (LTV) Mean?
LTV is the percentage of property encumbered by financing.

For example...

$500,000 outstanding mortgage balance.

$1,000,000 appraised home value.

LTV = $500,000/$1,000,000 = 50%

Putting together your understanding of equity and LTV we can now discuss how much you can qualify for via a private home equity mortgage.

The more equity you have built up in your home, the stronger your request for financing.

Private home equity lenders serve a very particular niche end of the market with inherent risks. A private lender is only successful if they get their money back. If default on a loan occurs and they have to take legal action to recover, the more equity available the more likely they’ll exit with all of principal and interest owed.

As loan to value increases, the riskier the mortgage from the private lender’s point of view. This higher risk will get expressed to the borrower with higher rates and fees. Depending on your needs the price of a private home equity mortgage may or may not be worth it.

The mortgage origination industry and private home equity lenders tier their pricing and fees for certain loan to value ratios.

  • Up to 65% LTV: you will find plenty of competition and favourable pricing. Lenders will be a bit more flexible in their underwriting. Use your strong equity position to negotiate with lenders and brokers to get yourself the best deal possible.
  • Between 65% to 75% LTV: this segment represents the average private home equity mortgage. Pricing may approach double digits and lenders will be more particular about their underwriting. Some private home equity lenders will not exceed 75% LTV.
  • Between 75% to 80% LTV: at this loan to value the private lenders available in the market will start to get picky about the terms of the mortgage. Pricing will certainly be double digits with lender and or broker fees as well.
  • Over 80% LTV: There are only a handful of private lenders who will go up this high and if you find one to do it they will price for the extreme risks they are taking.


Chapter 5

Why second mortgages are the most common type of private mortgage

While first mortgages can be arranged privately by far the most common type of private mortgage arranged are known as second mortgages.

What is a second mortgage?
The ranking (1st, 2nd, 3rd etc…) of mortgages is determined by the order in which they are registered on title.

For most Canadian home owners they only have a 1st mortgage which is registered when they purchase their home. As time goes on they may refinance or perform equity take outs over the years. However any subsequent mortgages are registered only after the existing first mortgage is discharged. So the ranking of their mortgages is always a first.

In fact banks and institutional lenders almost exclusive deal in 1st mortgages.

A second mortgage is registered on title when the first mortgage is not discharged.

Similarly if there is an existing 1st and 2nd mortgage registered on title and third mortgage is being arranged without discharging the first two mortgages then that mortgage becomes a 3rd mortgage.

The ranking of mortgages is significant because under a power of sale or enforcement situation the priority determines the distribution and repayment of mortgage funds and expenses. Needless to say 2nd and 3rd mortgage carry more risk than 1st mortgages for this reason.

Why a second mortgage is useful as a private mortgage solution.
In chapter 2 we discussed 4 of the most common reasons why someone might need a private mortgage.

The second mortgage is quick and cost effective way of solving some of the common problems borrowers face.

Let’s take for example someone who has accumulated debt and fallen behind on credit card payments due to an accident at work.

With missed payments showing on their credit report the first mortgage lender will not be able to refinance because the credit score doesn’t meet their minimum credit standards.

Furthermore, being out of work recently may have caused annual income to decrease which is another hurdle for a first mortgage lender to accept.

This is despite our borrower having paid the mortgage on time for the past 10 years and despite having $100,000 of built up equity.

Enter the second mortgage.
There is no sense in replacing an existing first mortgage at a good interest rate with a bank because the arranging of the mortgage will trigger higher rates and fees based on the total loan size.

Instead a smaller 2nd mortgage will allow our borrower to consolidate all their debt into a lower interest rate and monthly payment.

There is an added benefit as well, because all the credit card debt will be paid in full which allows the credit score to recover quickly.


Chapter 6

How private home equity lenders in Ontario determine their interest rates?

Interest rates for private home equity mortgage lenders in Ontario are determined like any other investment. The private lender will evaluate risk vs. reward.

Risk vs. reward is a very fundamental concept in investing and the same applies for the determination of the interest rate on your private mortgage. The higher the risk a lender assumes by selecting a mortgage the higher the reward or in this case interest rate needs to be to compensate for the risk.

Loan-to-value is king when determining private mortgage rates.
The critical defining characteristic of a mortgage is that it is secured debt. That’s important because if default occurs a lender can get the court’s permission to sell the property under power of sale to recovery the principal and any outstanding interest.

So when it comes to pricing or rates for private home equity mortgages loan to value (LTV) is most critical.

LTV % Risk Level
Up to 50% LTV Least amount of risk
50% to 65% LTV Lower risk
65% to 75% LTV Moderate risk
75% to 80% LTV High risk
80% LTV or higher Extreme risk

So, let’s talk private lender interest rates.
Alternative B institutional lenders have a higher risk tolerance than banks and typically cut off their rates to borrowers at approximately 5.50% for a 1 year term.

If 5.50% is the cutoff for institutional money then private mortgage lenders in Ontario who take more risk need to be compensated accordingly.

Using the LTV table above and adding interest rates to reflect the risk:

LTV % Risk Level Interest Rates
Up to 50% LTV Least amount of risk Less than 7%
50% to 65% LTV Lower risk 7% to 8%
65% to 75% LTV Moderate risk 8% to 10%
75% to 80% LTV High risk 10% to 12%
80% LTV or higher Extreme risk 12% plus

NOTE: It’s worth highlighting that if a borrower needs more than about 65% loan to value financing is usually broken down into a 1st mortgage and 2nd mortgage.

If you have an existing mortgage common practice is to leave your existing 1st mortgage in place and provide a 2nd mortgage at the approximate pricing indicated above.

A grain of salt.
Also a little disclosure on my behalf. I’m sharing this table as a guide. There may be factors besides loan-to-value that effect the interest rate, a private mortgage lender in Ontario will charge. Factors such as term, credit history, income or other circumstance will certainly affect rates as well.


Chapter 7

How Ontario private home equity lenders determine their lender fees

When it comes to private home equity lenders there are various business models and styles of operation.

Some of the most common types of private mortgage lender types include:

  • Mortgage investment corporations
  • Mortgage administrators
  • Private individuals/corporations
  • Mortgage syndicates

It is common practice for private mortgage lenders to charge a lender fee in addition to the interest rate.

The fees are typically included to cover operational and administrative costs incurred by the lender to manage and administrate your mortgage.

Lender fees are very discretionary.

In my experience I find that lenders get away with charging lender fees simply because they can. As a private mortgage home loan borrower you’re hard pressed to find alternative solutions and lenders know that.

In Ontario it’s common practice for private lenders to charge a 2% lender fee or minimum of $2,000 which ever is greater.
However over the years I’ve seen some crazy high lender fees over 5%. Why? Again it’s completely discretionary and a reflection of the difficulty to finance.

If your private home equity mortgage loan request is a strong one where you have a lot of equity and solid income and credit you’re unlikely to experience high fees.

However if you’re asking for 85% LTV and find a lender willing to take the chance and provide you with financing chances are you’ll pay a high lender fee as a reflection of the difficulty and risk associated with the mortgage.

Is it possible to find a private lender that doesn’t charge a lender fee?

It’s a bit of unicorn but they do exist.

Some of the true private lenders who are individuals operate much more simply and forego lender fees.

From my own experience we tend to lower and accommodate our lender fees and sometime waive them if the opportunity arises.


Chapter 8

Mortgage brokers, why you need one and what are their fees for arranging a private mortgage

There is an entire industry and network of private mortgage lenders throughout Ontario. Many of them are highly specialized in niche areas such as:

  • Geography
  • Maximum loan to value
  • Construction renovation financing
  • Short-term v.s long-term
  • Open term v.s closed term
  • Minimum mortgage amounts
  • Maximum mortgage amounts

Private lenders generally don’t advertise to the public or even have client facing customer relations or origination channels. Instead they rely on a network of mortgage brokers to find and recommend clients.

So as a borrower searching for a private mortgage solution your best bet is working with a mortgage broker.

Your broker should be able to listen to your need and assess the best plan of action. Brokers have a fiduciary responsibility to you to make sure they are exploring all options in your best interest to find you the most economical and suitable solution. Your broker will not only source the financing you need but also advise on how get payoff the high interest debt and explain the risks if the private mortgage is not paid back in full.

How your mortgage broker gets paid to arrange a private mortgage.
Private mortgage lenders do not payout commissions or finders fees to mortgage brokers who bring them business. Instead common practice is for brokers to charge a fee on top of the lender fee as compensation for arranging your private home equity mortgage.

As a general rule of thumb mortgage brokers match the fee charged by the Ontario private lender.

The greater of 2% of the principal amount or approximately $1,500 depending on the degree of difficulty.
There is discretion on this fee and it certainly can be negotiated as part of your deal. As the mortgage amount increases there might be ability to lower the 2%.

However if your mortgage amount is lower it’s difficult to negotiate because whether your private mortgage request is $25,000 or $250,000 there is almost the same amount of work required.

Choosing a mortgage broker for your private mortgage.
In Ontario it’s necessary to arrange financing through a licensed mortgage broker.

In selecting your broker for a private home equity mortgage it pays to shop around a bit.

It's not just about the fees and "low" rate.
Your broker should be someone who truly looks out for you and your best interest and understands how to evaluate your situation.

It’s easy to get someone into debt but difficult to get out of that debt. Your mortgage broker should be someone who comes up with a comprehensive plan to guide you through the private mortgage process and is still there at the end of the term to move you back into main stream financing at the bank.


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