By Darren Richards
Regardless of whether your balance sheet is thin, or you are the co-founder of Twitter, if you get a residential bank loan, it will be a loan like any other loan – you will have to grant the bank security. While doing so is all standard procedure, it is often not very understandable. However, if you’re in the business of buying and selling real estate, you’ll be dealing with loans with virtually every deal. To help you better understand the process, here are four things you really need to know:
- Open and Closed: This has nothing to do with crazy bank hours. Did you know that the bank really doesn’t want their money back unless they are guaranteed to make a good return off of you first? An open mortgage can be paid out before its maturity date (end of the term) without notice, bonus or penalty payment. Banks often don’t like this so it usually comes with a higher interest rate. A closed mortgage is locked in for the term. To get out of it and pay it out early requires the payment of a penalty. This is where it gets scary so always investigate this. Some penalties are equivalent to three months of interest – substantial, but not crazy. But some also state that it could be the greater of that amount or something called the ‘interest rate differential’. It’s a bit complex and many bank commitment letters spend pages showing how to calculate it. It generally means the amount the bank would lose out on if they put the principal amount back into the market at interest rates then applicable. I’ve seen these as high as $20,000.
Don’t miss the importance of this. If you plan to hold the property for the length of the term then it doesn’t matter. But if you have even a remote chance of selling before the term expires, then consider an open mortgage even if rates are higher.
- High ratio: If you can’t put at least 20% equity into the property being purchased then you will need a high ratio mortgage. Here’s the catch: First, you’ll be charged a fee for the cost of the required insurance that covers the lending bank. That’s right, you pay the premium for someone else’s insurance coverage. What a deal! And it will be significant (usually between 2-5% of the loan amount). Second, you will personally be liable for the loan. The bank’s remedies are not (unlike conventional loans) limited to the land (i.e. foreclosure). They can come after the borrower for the difference if the foreclosure sale doesn’t net enough to fully payout the loan.
So while your potential return on investment is significantly higher the less cash you inject into the deal, the potential costs and risks are higher too.
- Linus’ blanket: A mortgage is just the security blanket that banks need to give you a loan. I can’t tell you how many times I’ve been told by clients that they don’t have a mortgage on their property yet they do. Why? They have a line of credit loan and mistakenly believe a mortgage is a different type of loan. It’s not. It’s instead security for a loan. A mortgage can secure a traditional loan that contemplates principal and interest payments over a specific term at a specific rate (i.e. what most people think of when they think of a ‘mortgage’). A mortgage can secure any type of loan – including a line of credit or a HELOC. Evidence for a loan is a loan agreement or a promissory note. Security for a loan can be several things:
- A mortgage registered against title to Real Property
- A General Security Agreement registered at a personal property registry against Personal Property
- Guarantees given by individuals or corporations to back the loan even further
- Other fun stuff like hypothecation of shares (we won’t get into that here).
- Property Taxes: A bank will usually want to get their security blanket (aka mortgage) registered on title as a first position financial charge. That means that nobody else has a higher priority than they do. If you sell that place, they get first dibs on the money. However, those nasty politicians have complicated things a bit. Even without a registration on title, the government has a supra-priority interest to the extent there are any outstanding taxes. So do you think the bank cares? You bet they do! Nobody is going to step ahead of them! Your mortgage requires you to pay property taxes when due. You have basically three options:
- Pay Once: You can pay June 30th (usually) for that year’s property taxes;
- Pay Monthly: Most municipalities have a monthly payment plan where your bank account is automatically debited each month;
- Pay monthly through your mortgage: In that case, a tax component is added to your mortgage principal and interest payment. The bank collects it for a year. For example, they will collect a monthly amount July 2015 through June 2016 so they have enough in your special tax account with them to fully pay the 2016 property taxes.
If you know this much, you can impress most bank representatives (and they may even give you a loan!). If you want to learn more, or you’re having a hard time falling asleep some night, pull out that old report your lawyer gave you and read through your copy of your mortgage. You’ll find even more amazing tidbits I’m sure.
Darren Richards is a partner with Richards Hunter Toogood. He focuses on both residential and commercial Real Estate and Corporate/Commercial Law serving both small and medium sized owner-managed businesses in the Edmonton and surrounding region. Richards also acts for major banking institutions and other lenders in relation to their commercial loan facilities. Reach him at: firstname.lastname@example.org or www.rht-law