Getting into (and staying in) the real estate market is becoming increasingly challenging in Canada. The mortgage stress test and surging interest rates have made homeownership a distant dream for many Canadians. Rising living costs have also added financial pressure for aspiring homebuyers, leading to debt problems and plunging credit scores.
In short, it’s becoming harder to secure a mortgage from traditional lenders, which historically offer the best interest rates and terms. As a result,more and more homebuyers are turning to private lendersfor the financing they need. Maybe you’ve pondered this option yourself after failing to qualify for a mortgage at numerous banks.
However, private mortgages come with unique risks that can worsen your financial situation. In this article, we’ll explain how they work, scenarios where they could be helpful, and what to watch out for to avoid a financial disaster.
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What are private mortgage lenders?
Private mortgage lenders are individuals or corporations that lend their own money to homebuyers looking to finance a home purchase. A private mortgage lender can be a large firm likeRomspenwith billions of dollars of assets under management or a wealthy friend or relative willing to lend you money.
Private mortgage lenders cater to consumers who don’t qualify for loans from traditional banks and credit unions. Whether their credit score is too low or they fail to meet the mortgage stress test guidelines, not everyone can satisfy the criteria of financial institutions like Scotiabank or Servus Credit Union.
Private mortgage lenders fill this market gap, serving as an alternative source of financing. They’re not as concerned about your credit score and income. Instead, they emphasize factors like your home’s value and equity. This trait makes private lenders an attractive option if you face challenges getting a conventional loan from a traditional lender. They may also be suitable if you wish toqualify for a mortgage after a consumer proposal.
While a private mortgage is more accessible, you shouldn’t consider it a long-term solution. Private mortgages are primarily short-term loans. They exist mainly to give you a head start in financing a home purchase. Your goal should be to switch to a traditional lender once your finances improve.
Why might you consider getting a mortgage from a private lender?
There are many reasons why you may want to use a private lender to acquire a mortgage:
You have bad credit
Traditional banks and credit unions have more stringent credit score requirements than private lenders. To qualify for aCMHC-insured mortgagefrom one of these institutions, you’ll need a credit score of at least 600. If your score is below this threshold, you’re unlikely to get your mortgage application approved. Your current mortgage lender may also turn you down for a renewal if your credit standing has dropped significantly since the start of your last term.
UnliA private lender will be more willing to work with you despite your low credit score, excessive debt load, missed payments, etc.
You don’t meet the mortgage stress test requirements
The stress test requires you to demonstrate that you can afford to make your mortgage payments at a qualifying rate, as opposed to the current rate. This test ensures you can still afford your mortgage payments following a rate hike. Naturally, this will limit your borrowing capacity unless you make a down payment of more than 20%.
Suppose you’re an existing homeowner looking to refinance your mortgage. In that case, you must pass the stress test again – failing to do so will disqualify you from getting a new mortgage.
Unlike commercial banks, private mortgage lenders have no legal obligation to impose the stress test on borrowers. Therefore, it’s one less hurdle you can avoid in getting your mortgage application approved.
You lack a credit history
Like a low credit score, having no credit history can hinder you from qualifying for a mortgage. Suppose you lack a proven track record with credit products. In that case, lenders will have more difficulty determining the risk of loaning money to you. They may deem it safer to deny you financing altogether.
You may face this scenario if you’re a young person who’s used credit sparingly until low. Similarly, let’s say that you’re a newcomer to Canada. In that case, you’ll need to build Canadian credit experience to qualify for a mortgage. When evaluating your application, a private lender will be more willing to overlook your sparse or non-existent credit history.
You’re self-employed, or your earnings are unstable
If you’re self-employed, do seasonal work, or your earnings fluctuate widely, you’ll likely be excluded from traditional mortgages. Without a reliable income, the risk of default is higher.
Luckily, private mortgage lenders employ other screening criteria when deciding who to lend to; income is less of a priority. They may be more understanding of your situation and consider other factors in your favour, such as the potential of your home value to appreciate.
You need a short-term loan
A private lender is a good option if you’re not keen on committing to a long-term loan and looking for short-term financing. Private lenders specialize in short-term repayment periods, offering terms as brief as a few months.
You want to pay off or consolidate high-interest debt
Debt consolidation can be a viable solution to pay down high-interest, unsecured debts, such as credit cards, lines of credit, and payday loans. Mortgage interest rates are typically lower than those found on other types of loans, so you can save a nice sum on interest charges by getting a second mortgage on your existing property.
However, second mortgages are riskier for traditional lenders, so getting one could be tricky. But a mortgage approval from a private lender may be more likely to work out.
You need to stop a foreclosure or power of sale
Have you fallen behind on your mortgage payments, and your lender is threatening legal action to seize your home? If so, a second mortgage can halt the foreclosure or power of sale, providing emergency funds to help you get back on track.
A private lender can be your ally in this scenario, qualifying you for financing where another lender would reject you due to the extreme risk they face.
You need to pay for a home renovation or repairs
If you recently bought a used home, you may need to borrow additional funds for renovations. As a result, you may need to secure another mortgage or a home equity loan.
Or, let’s say that you purchased your property as part of anunconditional offerand skipped the home inspection. In that case, you may face unexpected repair work when you’re already in debt and low on cash. A private lender may provide you with a second mortgage or a home equity loan to cover these costs if your current lender turns you down.
The risks of getting a mortgage from a private lender
It can be tempting to turn to a private lender when you desperately need a mortgage loan. After all, they offer flexible lending requirements and lightning-fast approvals. However, private mortgages also come with their share of drawbacks.
High mortgage rates
Private mortgage interest rates can be considerably higher than what you would get from a traditional lender, easily reaching double digits.You can expect interest rates anywhere from 10% to 18%. Some lenders offer discounted rates in the first year of the mortgage term to entice you into borrowing from them.
With such steep rates, you’ll be saddled with higher payments, increasing your debt load and the risk of default. A private mortgage can be very costly, and you might only realize it once it’s too late.
As mentioned previously, some private mortgage lenders offer interest-only loans. That means you won’t make any progress in paying down your principal during your loan’s term. Once your term ends, you’ll be on the hook for the entire balance, which may be problematic if you’re short on money.
Additional fees
Fees are where private mortgage lenders earn a sizable chunk of their income. These include legal fees, appraisal fees, set-up fees, and possible mortgage insurance. In addition, you, as the borrower, pay the broker’s fee directly, which the lender would generally cover if you were applying for a traditional mortgage.
Private lenders charge high fees as compensation for the extra risks they carry. Private mortgage fees usually range from 2% to 10% of the total loan amount. These additional charges will increase the overall cost of your loan. In the end, you could pay considerably more for your mortgage than the lender initially advertised.
Lack of government regulation
Private mortgage lenders are not subject to the same federal regulations that Canada’schartered banks(including the Big Five) must follow. It’s for this reason they operate under more looser lending standards.
Unfortunately, for you as a borrower, this also means little to no legal protection by your side if you approach a private lender for financing. As such, you’re more likely to be exploited by afraudulent mortgage lender.
Fewer long-term financing options
Given the elevated risk of default associated with long-term financing, private lenders prefer to issue short-term mortgage loans to homebuyers. Terms range anywhere from a few months to three years. This is a far cry from conventional mortgage lenders’ typical 25-year amortization periods, where you can lock in your interest rate for five or ten years.
There are two problems with relying on a short-term mortgage:
- You’re vulnerable to rising interest rates when your term expires, as you can only lock in your rate for a brief period.
- You risk getting trapped in a cycle of short-term borrowing for your mortgage, which will be more expensive in the long run.
There is also the risk that if your credit score has not recovered or credit has become harder to come by, you might be able to obtain any financing when it comes time to renew. There is always a chance that you’ve only delayed the problem by turning to a private mortgage without facing the source of the problem.
Potential to lose your home
The biggest risk of getting a private mortgage is losing your home. Because private lender mortgage rates and fees are so high compared to those offered by traditional lenders, it’s much easier to fall behind on your payments.
With a private lender, falling intomortgage arrearscan be very dangerous. They’re generally less forgiving if you fail to meet your payment deadlines and will act quicker to foreclose on your property than a bank or credit union,
In contrast, a bank or credit union wants to see you keep your home rather than go through the hassle of foreclosing the property. They’ll be more willing to work out a deal to allow you to catch up with your payments.
What to consider before getting a mortgage from a private lender.
If you’re considering obtaining a mortgage from a private lender, do your homework beforehand to avoid signing a contract that could spell financial trouble. Here are some tips to follow when dealing with private mortgage lenders:
- Review your current budget to assess how much mortgage debt you can handle on top of your current financial commitments.
- Understand the interest rates and fees inside out. Ask the mortgage agent to provide your effective interest rate (the one you’ll pay once all the extra fees are rolled into the loan). Also, ask if there are any renewal fees to pay if you cannot move your mortgage to a traditional lender once your term expires.
- Ensure the lending institution is being honest and transparent about the terms and conditions of your loan. If they evade your questions and concerns, it’s time to seek a new lender.
- If you’re working with a mortgage broker, find out whether they have any personal ties to the mortgage lender they connected you with. Working with an experienced and ethical mortgage broker is crucial.
- Ask your lender if the mortgage payments are interest-only or if a portion is applied to the principal.
- Ask what happens if you’re late on mortgage payment – it’s important to understand the severity of the consequences so you’re not caught off guard and can plan ahead to avoid them.
- Find out what happens after the term ends – will the lender offer a renewal option if you’re still ineligible for a traditional mortgage?
- For more loan customization options, seek out a larger lending firm than a single individual or smaller financing company.
- Ensure the mortgage agent or broker you’re working with is properly licensed to practice their profession in the province or territory (for example, in Ontario, they must hold a license from theFSRA)
- Check for reviews online about the lender.
Lastly, ensure you have a sensible exit strategy for your private mortgage. These types of loans are designed to be short-term solutions. They serve as a bridge to help you cross into traditional mortgage financing from a prime lender. Plan to have enough cash on hand to pay off any remaining principal. And work to improve your credit score along the way.
How to improve your finances to qualify for a traditional mortgage
There’s no denying that private mortgages can be a feasible solution in some cases. However, turning to a mortgage from private lenders can be risky. Private mortgages are more expensive due to their higher interest rates and fees. And private lenders tend to be much quicker to enforce payment delinquency.
Before approaching a private lender, consider tackling the root of your financial problems. Whether that’s dealing with mounting debt or repairing your credit score. Reducing your debts is the quickest way to improve your credit and, in turn, transform yourself into a more appealing mortgage applicant. Our articles about debt reduction tips and strategies can help you get on the right track:
- DIY Debt Relief Strategies: 10 Ways to Get Your Finances in Order
- How to Manage Debt When Living Paycheque to Paycheque
If you’re turning to a private mortgage lender because you carry more debt than you can afford, you could risk your home when insolvency can be a better solution. Two insolvency solutions are available in Canada: personal bankruptcy and consumer proposal.
These two federal debt-relief programs can help eliminate or reduce unsecured debts like credit cards and payday loans. As a result, you’ll have more money to put toward your mortgage. And you’ll be free to rebuild your finances and credit score so you don’t have to rely on a private mortgage in the future.
