Buying a home can be a busy time. None of your regular errands – grocery shopping, picking the kids up from school, or making dinner – disappear when you start house hunting, so when you do find your dream home and make an offer that’s accepted, it’s time to celebrate with a glass of champagne.
But don’t forget you still have to find time for one more major decision: your mortgage.
Mortgages come in all different shapes and sizes: closed vs. open, fixed rate vs. variable rate, and conventional vs. collateral. While the first two are the subject of much discussion among home buyers, you may have never heard of the term “collateral mortgage.” Don’t beat yourself up too much -- many Canadians haven’t.
In this article, I’ll shed some light on the collateral mortgage and provide some insights that will hopefully help you make the right decision -- because while a collateral mortgage can be great to have, it can also handcuff you.
Let’s take a closer look at this lesser known mortgage type and when it does and doesn’t work for homeowners.
What is a collateral mortgage?
It’s easy to confuse conventional and collateral mortgages. In fact, if you’re shopping for a home right now and looking for a lender, you may come across a collateral mortgage without even realizing it. (The banks don’t always do such a good job explaining the distinction.)
A conventional mortgage is the most common type – it’s probably what you think of when you think of a mortgage. When you sign up for this type of home loan, the amount that gets registered by your lender is the exact amount you need to borrow to purchase the property. Let’s say you’re buying a $500,000 condo in Toronto with a $100,000 (20%) down payment. That means you’ll qualify for a low-ratio mortgage and you’ll need a $400,000 loan from your lender to finance the purchase. It doesn’t get much simpler than that.
With collateral mortgages, on the other hand, it’s not always so straightforward. With a 20% down payment, a collateral mortgage can register a charge that’s more than you need to borrow to purchase the property -- for up to 125% of your home’s value. In the same scenario mentioned above, on a $500,000 home, your lender could register a charge of up to $625,000.
Why would a lender want to do that? Because they assume you’ll be borrowing money from the equity in your home down the road.
Collateral mortgages aren’t one of the products offered only by fringe lenders. In fact, you may be surprised to learn that some of Canada’s biggest mortgage lenders, such as TD Bank and Tangerine Bank, offer collateral mortgages.
When does a collateral mortgage make sense?
If you’re planning to borrow money from the equity in your home through a Home Equity Line of Credit (HELOC), a collateral mortgage can be a better option. You’ll be able to tap into your home’s equity when you first purchase your home, without incurring the typical legal and set-up costs a HELOC would require.
Borrowing this extra amount can make sense in certain cases, for the same reasons that refinancing your home or taking out a HELOC can be beneficial for homeowners. Some use this strategy to finance home renovations on a fixer-upper property, or to consolidate debt from other outstanding loans. If you have a car loan or a balance on your credit card at the time you purchase your home, you could roll all of these debts into your mortgage, which likely has a far lower interest rate.
Keep in mind, however, that you still have to qualify for the full amount borrowed in your collateral mortgage. If you initially qualify for a $500,000 home (or a $400,000 mortgage with 20% down), but you want to take out a mortgage that will allow you to make another $100,000 worth of renovations on your home, you may not qualify.
When does a collateral mortgage not make sense?
Collateral mortgages also have a couple of shortcomings. First of all, they can make it difficult to shop around among other lenders for better terms or a better interest rate once your mortgage comes up for renewal.
That’s because if you’ve used this option to consolidate debt, then not only is your mortgage tied to a specific lender, so are your other debts. Also, because your collateral mortgage is a larger amount than a conventional mortgage would be on the same property, this can be considered a higher-risk loan and could mean you don’t get the best possible interest rate. Even if you stay with your current lender, it’s less likely they will offer you their best rate at the time of renewal.
If you ever decide to break your mortgage in order to refinance, you may be faced with a heftier mortgage penalty than you would otherwise have to pay.
It’s also worth stating that the bigger the mortgage, the bigger the payments. If you want to take out a collateral mortgage, weigh the pros and cons and be prepared to pay down a larger loan.
Still not sure which mortgage type is right for you? An experienced mortgage broker can sit down with you to help you decide whether a collateral mortgage makes more sense than a conventional one in your particular case. Feel free to reach out to us for more guidance.