How Much Can You Borrow and Other Private Mortgage Questions
The distinction, terminology, and reasoning behind private mortgage lending can be confusing for consumers and other industry participants. Let's get you pointed in the right direction.
How Much Can You Borrow?
The amount of money a borrower can access is based primarily on the as-is value of the property to be financed, whether an existing property or one that you are about to buy. Location, condition, and property type are also important.
Loan-to-Value (LTV) is a percentage of the loan to the value of the property. For example, a 65% LTV mortgage means the lender will advance as much as 65% of the appraised value of the property, and the borrower would need to provide the other 35%. The more equity or “skin-in-the-game” you have, the better your rate and terms will be. Available LTVs vary from lender to lender and from situation to situation, but generally 80% will be the maximum you could expect for a prime urban property, but more likely 65%.
Understanding how lenders assess and manage risk in a loan transaction is crucial. The primary concern for any lender is the possibility that the borrower may not repay the loan on time or at all, necessitating legal action. Every mortgage lender, whether private or a mainstream bank, must consider the following:
In the event of non-payment, how quickly can the property be seized, how swiftly can it be sold, and will the lender recover their funds?
Typically, the legal recourse for non-payment is foreclosure and a forced sale. Once the sale is finalized, the proceeds are distributed in the following order: first, the court fees are paid, followed by the foreclosure lawyer, then the Realtor, and finally the mortgage lender(s). Any remaining funds are returned to the borrower. By capping the maximum loan or Loan-to-Value (LTV) percentage, lenders aim to ensure there is sufficient money left to recover their principal and interest. Higher LTVs are offered for more desirable properties that are easier and quicker to sell, while lower LTVs are common for properties that may be harder to sell promptly. Higher LTVs or smaller loans pose greater risks for lenders, as there may not be enough funds left to recover their loan after recovery expenses in the event of default.
How Many Mortgage are Allowed on a Property?
You can have more than one mortgage on a property, provided there is a lender willing to provide one. The mortgages are registered on your land title or deed in the order they occur which means that there is a pecking order in the event of borrower default. As the 1st position lender always gets fully paid out before the 2nd and so-on, there are greater risks for lenders expected to be in 2nd or 3rd position and interest rates will be higher in compensation.
There are higher risks associated with private lending for both the borrower and the lender. As such, the interest rates and costs can be considerably higher. A borrower needs to compare the total cost of financing against the benefits he or she will achieve.
How the Lender Makes their Money
Lending money is like most businesses: get for less, sell for more. It should come as no surprise that mortgage lenders intend to earn a profit from your loan. Traditional bank lenders make their profits over time, perhaps a 25-year mortgage relationship, plus they make money on providing you with other banking services and fees. The supply of money comes from savings/chequing deposits and institutional investors, like pension funds. The difference between the interest rate the lender charges you and their cost of money is called the “spread.” From the spread, the lender pays their expenses and makes their profit. A typical bank spread is 1.8% per year, and a deal goes on for years.
Example gross profit for a $300K traditional bank mortgage for a 5-year term.
- 1.8% spread X $300,000 x 5 years = $27,000 gross profit
Private lending is similar in that the lender needs to make a profit/spread. Private lenders typically source and pool money from private investors, often doctors, dentists, and other professionals, and lend out that money to borrowers such as yourself. However, these loans are typically short-term in nature, perhaps 12-months, and often for much smaller loan amounts than bank lending. Even at an equal loan amount, the total interest collected from a borrower less the lender’s cost of money (the “spread”) is small relative to bank lending, but with equal effort to arrange and manage. To augment the spread and fund their lending operations, private lenders tack on a “lender/broker fee” as additional profit for arranging and supplying a short-term mortgage.
Example profit for a $300K private lender mortgage for a 1-year term.
- 1.8% spread X $300,000 x 1 year = $5,400
- 2% lender/broker fee x $300,000 = $6,000
- Total gross profit = $11,400 ($5400 spread +$6000 fees)
As you can see in the example total gross profit illustrations, a private lender for similar effort on their part makes much less profit than a traditional mortgage lender, with the investors for private lenders, making the lion’s share of the interest paid.
In both lending examples, the borrower must pay any associated appraisal, inspection, and legal costs associated with purchasing the property and/or arranging the financing. The loan interest rate, repayment terms, and lender/broker fee are open to negotiation.
In Canada and most other jurisdictions, “predatory lending” (over charging) is illegal and in fact criminal, and the Fair Trading Act with full cost disclosure applies.
When Does Private Borrowing Make Sense for the Client?
While some people look at the cost of the loan, another view point is how does the loan helps you achieve your objectives. This ties into your exit strategy.
Development/Flip Financing
For example, if come upon a property at a very attractive price, you are experienced at rehab/ renovations/ development, and you know what you could sell the property for after rehab (your exit), then a hard money loan might bridge the gap beautifully. To correctly analyze the opportunity, you would determine your purchase costs, selling costs, operating/hold costs, renovation costs and financing costs*, and then calculate your return on invested capital. You would need to convince the mortgage lender that you have the experience and cash resources to execute your development plan.
* an experienced mortgage broker can help you understand the analysis and to determine and access your least cost financing options.
Debt Consolidation / Credit Improvement Loan
In this example, perhaps a loss of income (job loss, health issue, accident, etc.) has got you behind on your bills and your credit rating has been hit so hard, that traditional bank (“A”) lenders can no longer offer to refinance your existing property (you’re in the penalty box, so to speak). With your credit cards running at 19%-29% interest, you can see no way of ever catching up. Assuming you have some equity in your home, in this scenario you would borrow enough money to consolidate all your debts into a single lower payment 2nd mortgage and at a lower interest rate. With all your credit cards and bills paid off your credit score starts to recover. Soon, your credit score is sufficient to get out of the penalty box, and an A-lender will once again give you a mortgage sufficient to pay off the hard money mortgage and you are back on track.
Buy Next Property, Current Property Has Not Been Sold Yet
In this example, a borrower – perhaps a senior - owns a property which is mortgage-free and desires to purchase a different property before her current one sells. Unfortunately, she has no cash to secure the new property until her current one sells – all her equity is trapped in the current home and her income is insufficient to qualify for a bank mortgage regardless. Her options are either to sell her current home first, and hope the perfect property comes up fast, or seek a private lender who will provide a short-term loan based on the equity in her current home. She uses the loan proceeds to pay cash for the next property, gets her current home on the market and sells it ASAP, thereby repaying the private lender in a few months. Note, even if she could qualify for a bank mortgage, her needs are very short-term, which are unprofitable for banks hence not typically available.
Construction Loan Financing
In this example, a self-employed client desires to build a home and needs construction financing. However, the borrower isn’t showing sufficient personal income on his income tax returns to qualify for construction financing, despite a large down payment.
While he cannot qualify for bank construction lending, there are bank lenders that will offer him a self-employed mortgage once his project is 100% complete (a completion mortgage). In this situation, we use a private lender to fund the construction, and his “exit strategy” is a completion mortgage whereby the borrower secures a low rate bank mortgage and the private lender is repaid at funding. Nice soft landing.
In another scenario, the borrower can qualify for bank construction lending but does not have sufficient cash equity for the required down payment because her current home has yet to sell. A private lender might finance 100% of the new project by placing a mortgage on both the borrower’s current home AND the new property.
