There are a lot of options to consider when taking out a mortgage, from finding the right lender to choosing between fixed and variable rates. One aspect that is often overlooked, though, is the type of mortgage you opt for, i.e. whether you have a conventional or collateral mortgage.
What is the conventional vs collateral mortgage difference, what are the benefits and drawbacks of each and which one is right for you?
You can find out in the article below.
What Is a Collateral Mortgage?
With a collateral mortgage, you can borrow more than the required mortgage amount by using your home as security for the loan. In this case, your lender would register your property with a collateral charge, which can go up to 125% of the value of the home
For instance, let’s say the home you want to purchase is $600,000 (which is roughly the average price of a house in Canada). You make a 20% down payment, which means the required mortgage amount is $480,000.
The collateral mortgage charge registered can be as high as $750,000 (600,000 x 1.25). Bear in mind that this is not how much you can borrow right away, but the maximum amount the lender will let you borrow.
What are the benefits of a collateral mortgage?
A collateral mortgage is quite similar to a Home Equity Line of Credit—the difference is that with HELOC you will need to apply for another loan once your home appreciates in value.
With a collateral mortgage, on the other hand, the extra funds are approved from the start and you can access them anytime you wish without having to apply for refinancing or pay transactional and processing fees.
Another plus is that some lenders let you secure other loans under a collateral charge mortgage. This way your home acts as security for other financial products, including a line of credit or a car loan.
What are the risks of taking out a collateral mortgage?
Pre-approved credit might sound like a great deal, but you need to be aware of the unique risks involved before you opt for a collateral mortgage.
You can’t transfer the mortgage
A collateral mortgage cannot be easily transferred to another lender. If you want to go for a better mortgage provider you will probably need to pay a huge discharge fee to break your mortgage, even if it is up for renewal,
You will also need to pay off any car loan or line of credit you have attached to the collateral charge mortgage before you can transfer your mortgage to another lender.
Applying for another loan will be hard
Perhaps you will have a large unplanned expense that can’t be covered by the collateral charge. It will be very hard to find a financial institution willing to loan you money when you already owe a huge amount. To lenders, you have a $750,000 debt on a $480,000 asset, so you basically have no equity to borrow against.
The excess amount is not guaranteed
There is no guarantee that you can tap into the extra funds. Should you lose your job or take a pay cut, the lender might choose not to release the excess funds.
Borrowing the extra funds might come with a higher interest rate
Your loan agreement might state that a higher interest rate applies to the extra funds you borrow. You need to read the fine print carefully to ensure that the rate is the same as your original loan to avoid paying more in interest than you can afford.
What Is a Conventional Mortgage?
A conventional mortgage charge is registered as the amount you have borrowed, i.e. the actual amount of the mortgage loan.
For example, if the home you want to purchase is $600,000 and you can put down 20% ($120,000), your mortgage will be registered as 480,000 which is how much you need to borrow to pay for the property.
One of the biggest pros of a standard mortgage is that you will have more equity in your home since you are borrowing less. You can use the equity to buy a second home or cover other expenses in the future.
Having a conventional mortgage will also make it much easier to apply for a loan down the line, refinance or switch lenders—loan providers should be more willing to approve your application since you have lower liabilities than a person with a collateral mortgage.
Conventional vs Collateral Mortgage: How Do They Compare
Here is a breakdown of the biggest differences between a conventional and collateral mortgage.
|Conventional charge mortgage||Collateral charge mortgage|
|The mortgage charge is the same as the required mortgage amount||A higher mortgage charge is registered against the property|
|You have to pay transaction and processing fees for a new loan||You are able to access more funds without paying refinancing or discharge fees|
|You must apply for a separate line of credit if you need more money||You can secure multiple loans by using your home as collateral|
|Easy to switch lenders and move to better rates||Almost impossible to switch lenders|
|You can access equity in your home and borrow more funds in the future, as your property appreciates in value||You can only borrow up to a certain amount|
|The interest rates applies to the entire mortgage balance||You might pay higher interest rates on the excess amount you borrow|
How to calculate your collateral mortgage?
To calculate the collateral mortgage charge and how much you can borrow, follow this three-step formula.
Step 1: Calculate the maximum you can borrow
Say you are buying a home worth $600,000 with a down payment of 25% ($150,000), so you need to borrow $450,000.
The maximum you can borrow with a collateral mortgage is $750,000 ($600,000 x 1.25). Even if your home’s value increased over time to $1.1 million (a possibility if you live in Toronto or Vancouver), the maximum you can get with a collateral mortgage is $750,000.
Step 2: Calculate how much equity you have
Let’s say your home has increased in value as has the amount of home equity you have.
So now your home is worth $700,000. You can borrow up to 80% of your home equity, which in this case is $560,000.
Step 3: Subtract the remaining mortgage balance
Substact how much you owe from the amount of equity you can borrow. Assuming you owe $350,000 on your mortgage, you are eligible for a loan of $210,000 ($560,000 – $350,000).
A mortgage is a long-term contract, so you need to be aware of the type of mortgage you have before you sign. Getting a collateral mortgage may sound appealing (you get pre-approved access to credit and no refinancing fees), but it does come with some risks that you need to consider before you sign on the dotted line.
Having a collateral mortgage can make it very hard to switch lenders and take advantage of better interest rates and conditions—which is not that much of an issue with a conventional mortgage. What’s more, even though the loan increases as the value of your home grows, you can only borrow up to a certain amount, i.e. the original amount you were approved for when you first applied for a collateral mortgage. With a conventional mortgage, you can easily get approved for a second mortgage or HELOC and borrow a higher amount against the equity in your home.
Think carefully and weigh out the advantages and disadvantages of both before making the final call. And as with any major financial decision, it’s best to talk to an expert and get professional advice on the best course of action for your financial situation.