Collateral mortgages are becoming more popular, even in conventional residential settings. In fact, some mortgage experts believe that all the major Canadian banks will eventually use only collateral mortgages and cease using conventional residential mortgages. Currently several banks offer collateral mortgages and at least a couple banks offer only collateral mortgages. Therefore, it’s important to understand the differences between conventional mortgages and collateral mortgages, because a collateral mortgage may be offered to you one day.
Conventional mortgages are simple. The bank registers the mortgage on title to your home for the same amount as the loan. For example, if your mortgage loan is $200,000, the bank registers the mortgage for $200,000. All the mortgage terms are contained in the document that is registered on title. If you later decide to use the equity in your home to borrow more money, you will likely have to pay legal fees and appraisal charges in order to refinance your existing mortgage. In addition, if you refinance a closed mortgage before the end of the term, there may be a prepayment penalty or a higher interest rate imposed if rates have increased (i.e. blended rate). Alternatively, you could consider a second mortgage to access the home equity. However, second mortgages often have higher interest rates and fees; particularly lower tier and private mortgages, which may have additional lender fees, broker fees, higher interest rates, and higher administrative fees. However, if you do not need to refinance or take out a second mortgage, but simply wish to switch banks at the end of the mortgage term to get a better interest rate, a conventional mortgage can easily be transferred to a new bank with no legal fees or appraisal charges.
Collateral mortgages have some significant differences.
First, the bank may register the collateral mortgage for an amount that is equal to the value of your home rather than just the loan amount. For example, the bank may register the mortgage for $500,000 (value of house) even though the loan is only $200,000. This does not mean you owe $500,000. It just means that the bank has registered the charge for a higher amount in order to allow for future lending under the collateral mortgage. Furthermore, the terms of a collateral mortgage loan are usually in a separate document that is not included in the charge that is registered on title to your home. So, what does this all mean? Well, this collateral mortgage arrangement has certain advantages and disadvantages when it comes to: (1) discharging the mortgage; (2) using the equity to borrow money in the future; and (3) transferring to a new bank at the end of the mortgage term.
Discharging the Mortgage
Unlike a conventional mortgage, a collateral mortgage usually cannot be transferred between banks. Therefore, when switching banks, the collateral mortgage must be discharged by a lawyer, which usually costs approximately $1,000. This usually becomes relevant when refinancing, or when switching banks at the end of the term in order to get a better interest rate, as discussed below.
Using Your Home Equity to Borrow in the Future
Remember that a collateral mortgage is usually registered for the full value of your home. One of the great advantages of this collateral arrangement is that you may be able to borrow further funds from your bank under the existing collateral mortgage without incurring additional legal fees, appraisal charges or discharge fees. This is something your bank could not do under a conventional mortgage. This arrangement could come in very handy indeed for those who wish to access the equity in their home in the future. That is, of course, assuming they qualify for future advances of funds from their bank. But, what happens if the bank declines the application for further advances under the collateral charge? This could happen, for example, if your credit rating becomes damaged, your family income drops, or you lose your job. This may be one drawback to the collateral mortgage for many people. If the bank denies the application for further advances under the collateral charge, then there may be no alternative but to seek out financing from another institution. In that situation, a second mortgage is likely out of the question because the bank has registered the collateral mortgage for 100% of the value of the home, and a new lender will likely be unwilling to grant a second mortgage under these circumstances. Therefore, the only option may be to refinance the entire collateral mortgage before the end of the term and, thereby, incur a hefty pre-payment penalty, and additional legal fees to discharge the collateral mortgage. This pre-payment penalty may be higher than expected because it may be based on the posted interest rate, as opposed to the lower discounted rate that the monthly mortgage payment was based on.
Transferring a Collateral Mortgage at the End of the Term
One of the disadvantages of the collateral mortgage is that it will likely not be possible to transfer the collateral mortgage to a new bank at the end of the term. Therefore, if you want to change banks at the end of the term (e.g. to get a better interest rate), you may have to pay legal fees to discharge the existing collateral mortgage and register a new mortgage. In addition, the new bank may require you to pay for an appraisal. It’s possible, but not certain, that the new bank may pay these fees in order to obtain your business. For more information about the differences between conventional mortgages and collateral mortgages, visit the Canadian Bankers Association website at: https://www.cba.ca/information-on-mortgage-security