An increasing number of lenders are moving towards collateral charge mortgages these days, it has never been more important to understand the differences between a collateral and standard charge mortgage.
The primary difference is that a collateral charge mortgage registers the mortgage for more money than you require at closing, often called a global limit. Collateral charges allow lenders to loan more money to qualified borrowers after closing, without involving a lawyer. That saves you legal costs if you need to withdraw equity from your property.
Collateral charge mortgages however, need to be dissected further. Although the benefits appear great on the surface, there are a lot of additional important aspects that you need to be aware of. Non-investor consumers especially should be very careful about entering into a collateral mortgage.
Ties up significant value of your property with one lender, often beyond the current mortgage loan shown on your statement. Some lenders allow up to 125% of home value (at time of closing) to be tied up, risky as this is more than the current worth of the property.
Prevents you from seeking out additional financing like a secured home equity line of credit or 2nd mortgage.
Used by the lender as a client retention tool, especially at mortgage renewal time, because it is difficult and costlier to transfer to another lender (more legal costs). You lose bargaining power as the lender knows this and may not offer you the best rates and terms. (Note, that a refinance at mortgage renewal is not the same, this will required legal work regardless of collateral or standard charge. A refinance changes the structure and amount of the mortgage.)
Increases bad debt, detrimental to finances for consumers who have spending issues. Provides easier access to additional funds, often quite large sums, allowing home equity to be used like an ATM.
May affect a real estate investor’s debt ratio calculations in future mortgage applications, depending on the structure of the global mortgage.
Risky if there are any payment issues. Multiple loan components are collateralized against the one charge, such as mortgages and secured lines of credit. If payments are missed in any component, the lender can increase your interest rate in any component. If you read the fine print, the maximum interest rate registered is often double digits. In addition, if you hold other loans, credit cards with that lender, they can throw that into the mix as well, if there are payment issues.
Often risks are not fully explained to the borrower, especially when a borrower goes to a bank directly and does not work with a knowledgeable mortgage broker. Bank employees have less incentive to explain the risks and sadly, it is not unheard of borrowers signing documents at the bank without full understanding. A broker does not work for a bank but works for the borrower, has access to multiple mortgage solutions, and is able to explain mortgage details and risks in a broader lending context.
Useful for investors with a solid financial plan and understanding. Loans secured against property are lower interest rate than unsecured loans.
Provides access to additional funds in the future, without having to restructure mortgage or incur legal fees. Note however, you will most likely need to requalify and complete appraisal.
Offers a number of creative and flexible products like a re-advanceable mortgage, see blog related post, or segmenting loan to multiple mortgage components (for example, one component can be fixed, another can be variable rate, providing a risk balance). A re-advanceable mortgage on your primary residence, has the capacity to turn it into a tax deductible vehicle (please consult your tax accountant for proper advice).
In summary, a collateral charge mortgage may be useful in your overall financial plan, as long as you have a good understanding of the risks and benefits. Borrowers not comfortable with a collateral charge mortgage should not resort to signing with banks that only give them this choice, best to work with a knowledgeable mortgage broker.