Shopping for mortgage? Here are some general concepts you might be interested knowing

[protorayish]

I (Ontario-licensed lawyer) posted a first draft to a sub-sub-sub thread and realized that these concepts may be actually generally helpful, so I edited and completed them in a way that I hope will help home buyers understand some of the mechanics. It is still highly technical. Happy to answer clarifying questions and to share further general information, however this is NOT LEGAL ADVICE, NOR FINANCIAL ADVICE. For advice on your specific circumstances, ask your real estate lawyer.

• Interest rate: the interest rate is what borrower (you) pays lender (financial institution) to use lender's money. The higher the risk that the money is not coming back to the lender, the higher the interest rate on the loan.
• Secured vs Unsecured: a mortgage is a loan secured by a pledge on real estate: if borrower defaults, lender takes the real estate, sells it, and gets at least some of the loan back. A personal line of credit, however, is only secured by the promise of OP to pay. If OP does not pay, that promise is not worth the paper it is written on.
• Consumption vs. Production/Investment. Loans used to finance consumption are riskier: no money to come back to the lender from that used TV. Loans used to finance production are better. You need a ride to get to work and earn a wage to pay back the loan. However, part of it is still consumption: you do not need the newer and fanciest car to get to work. With real estate, it is production/investment when it is a rental property. A home is consumption. While real estate's appreciation gives it an air of investment, and there surely is some part to that, if for the same money you get a smaller home plus a rental property, the line between consumption and investment becomes clearer (and you become richer faster).
• Risk: the sum of all possible negative events affecting the loan, each with its own probability (from 0% to 100%) and expected loss (again from 0% to 100%).
• Insurance (Risk Transfer, really): the entity (individual, corporation, institution whatever) subject to the risk pays insurance premium to an insurer for protection against the risk. If the negative event that was contracted out occurs, the insurer compensates the insured. It is a contractual device, so events can be excluded/included and compensation can be total/partial/limited. READ THE FINE PRINT.
• Portfolio (The Economic Principle of Insurance): transferring risk from insured to insurer may seem like a zero sum game, but it is not. The insurer holds a portfolio of similar risks. If the event is triggered once every X cases and the compensation for the event is Y, the insurer makes money when the insurance premium is >Y/X. Each of the X insureds pays Y/X to the insurer, and the insurer pays X*Y to the one insured that had the bad luck of a trigger event. The insurer makes money by investing X*Y between the moment insurance is contracted and the moment the event occurs and is paid out.
• Headroom: When a loan is secured by an asset, headroom is the difference between the money left from the liquidation of that asset and the value of the loan. If headroom is negative, and the borrower defaults, the lender incurs a loss.
• Priorities: When a financed asset is sold or foreclosed, secured creditors (lenders, and other with a claim) come first, unsecured creditors come next, and the owner (equity) is last. Equity is the ultimate provider of headroom, and when equity hits the ceiling, i.e. when there is not enough money to pay out all creditors, some creditors will lose some money.
• Structured Financing: when an asset is financed with different sources of money, they have different priorities (unless pari passu). Debt is paid back before equity. Secured debt is paid back before unsecured debt. Within secured debt, first mortgages are paid back before second mortgages. Collateral mortgages occupy the whole security. This area of creditors' priority is a complicated tangle and was recently subject of an interesting case in the BC Court of Appeal (leave to appeal at the Supreme Court of Canada denied): http://canlii.ca/t/j5jkc -- loans larger than the registered amount on title; a third mortgagee that did not notify first and second mortgagees of their interest; criminal interest rate, lawyer's paradise (I do not practise in B.C.).
• Qualification 1, the asset: loan to value (LTV) is the term used in the industry to measure the headroom in simple cases (one loan, one asset). For multiples loans, subtract from the V part of the equation the liquidation cost of the higher priority loans.
• Qualification 1, the insurer's perspective: the probability that the first dollar of financing will be repaid is higher than the probability that the last loan of financing will be repaid. Higher LTV means higher risk and therefore higher insurance premium (per loaned dollar). It is more expensive to insure 100% of a loan than to insure 80% of same loan.
• Qualification 2, the borrower: consumers just want the bigger houses. they seldom have the financial education to understand the detailed consequences of their wants. Lenders qualify consumers when they decide to lend them money or not, based on their income. There are mortgages that are not qualified/predicated on the borrower, e.g. for new immigrants with no credit history or for entrepreneurs with income stream that is perceived to be riskier than wages.
• Qualification 2, the insurer's perspective: this is your typical life insurance product. another separate topic. How steady and secure is the stream of cash flows generated by the borrower's sources of income?
• Consumers: by nature, consumers are at disadvantage because they have less knowledge and less means than producers. We are all consumers somewhere. I may be an expert in law and finance, but a mechanic can sell me a lemon car and I would not notice.
• Consequences of default: borrower's consequences for defaulting on unsecured loan is a bad credit score. borrower's consequences for defaulting on a secured loan is loss of the securing asset. When consumers borrow against the security of their homes, they need protection from the following moral hazards.
• Moral Hazard 1: absent regulation, lenders have an incentive to let borrower take larger mortgage loans than they can afford, because the borrower provides the headroom. The lender makes a profit even when the borrower loses everything. The lender only loses once headroom is exhausted. Hence we regulate institutional borrowers. But ask me about private mortgages (another essay, and I am even operating a self-written software to administer private mortgages for my wealthy clients). And ask me about Islamic Finance, an elegant form of regulation to prevent this moral hazard.
• Moral Hazard 2: insurers are regulated as well. The moral hazard here is that the insurer does not maintain sufficient reserves to cover the risks or invests them in riskier assets. Upside for the insurer, downside for the insured. That's for another essay.
• Free market: a market can only be truly free when both sides of the bargain can meaningfully exercise their freedom. Take it or leave it is not a free market. When the bargaining power is so skewed against borrowers, especially consumers who are not only financially weaker, but also lack the knowledge to understand the bargain, and caught in a critical vulnerability (home!).
• Regulation 1: the stress test, designed to prevent lenders from pushing borrowers over the cliff. The whole stress test can be an essay in itself. Here is some dry reading: https://laws-lois.justice.gc.ca/eng/regulations/SOR-2012-281/index.html
• Regulation 2: mandatory insurance. Same source as Regulation 1. This is Canada. We are risk-averse. So we explicitly mandate CHMC or similar insurance on mortgages with more than 80% LTV (high ratio loans). It keeps our financial institutions solvent and out of trouble, and they pass on the cost of this insurance on to the consumer. Financial institutions tend to be conservative and risk-averse too. Once they saw the benefit of insurance on the high LTV loans; and the pricing of such insurance for low LTV loans; it was a no-brainer decision: insure across the board.

Most important takeaway for home buyers: the mortgage terms quoted to you, and particularly the interest rate, include the many factors listed above, and I have probably forgotten some more. Do not hesitate to ask questions. Shop around for a mortgage, talk to mortgage brokers who have access to multiple lenders, but do not limit yourself and talk also directly to large lenders such as the big banks, their sub-brands (Tangerine, Simplii) and other online lenders. Do not forget the credit unions (regulated differently, but the general principles above still apply) and if you are a really good credit, you can also access funds from some insurers and pension funds at very competitive rates (they look for quality). Get them to compete for your business. Insist on soft credit check only until you have an idea with which lender you want to proceed, and only then agree to the one hard credit inquiry, i.e. sign the credit application.

You will need a lawyer to close your transactions most of the time. Avoid lenders that offer you to use their lawyers. Your lawyer has no conflict of interest and must put your interest ahead of hers/his. Engage with a real estate lawyer early in the process and benefit from an unbiased opinion that is absolutely on your side.

Happy Weekend!

 

[1blessed]

@protorayish This is a super handy write up. I wish I had this when I first bought my house. Learned lots, sometimes the hard way.

Regarding the insurance, definitely agree with read the fine print. Could save you a lot of time, money and trouble.

 

[p4m3l4]

@1blessed This is great! Thank you for helping me understand this better.

 

[petronoris]

@1blessed When you and OP say read the fine print, are there some things in particular we should be looking out for? What are the red flags in the fine print, and how can we get that fine print changed if it's not acceptable?

 

[1blessed]

@petronoris I’m not entirely sure what OP was meaning by it, but for me it was more so knowing what I was receiving with insurance.

I had a flood, but was covered because my insurance had a specific clause for the type of flood I had. Others in my area who had insurance, were not covered, despite thinking they would be.

I think it’s just a good idea to know what you’re getting with insurance and understand what might happen if you need to actually use it.

 

[resjudicata]

@protorayish I'm an American who married a very cute Canadian. I lived in Las Vegas, NV (there is a Las Vegas, New Mexico, so you have to be clear) and we bought a townhome in Ontario last year. I refused to do anything other than a fixed rate mortgages, because homes in Las Vegas lost 2/3 of their value after the market sunk. Today I wonder if I was wrong because the interest rates are so low, but I still think all of this is tentative. I guess I'm risk averse.

 

[protorayish]

@resjudicata First of all: hindsight is 20:20. You made the decision based on what you knew then and the circumstances then. You did not have a crystal ball to predict Covid and its consequences on interest rates.

Fixed vs Variable Rate has no influence on the cost of a home, and even if the home loses significant value, as a borrower you are on the hook for the full mortgage value. When the home value sinks below the loan value, the property is under water. In the US, a lot of home owners under water just walked away from their home and left the keys to the lenders. Because continuing to pay back the mortgage meant to pay for the home more than it was worth it.

Fixed vs Variable Rate: from a pure financial engineering point of view, fixed rate should always be more expensive than variable rate. Sometimes this is not the case. That's when the marketing budget is used to push Fixed Rate Mortgages.

A significant difference between fixed and variable rate mortgages are break-up penalties. They can be much more expensive for fixed rate mortgages if current interest rate are lower than when you entered the mortgage. Penalties is a misnomer. Breaking a mortgage is nothing wrong that must be penalized. What you pay to compensate the lender for the difference between their interest if you would have lived up to your contract and what they can get by reinvesting their money earlier.

I have had clients that paid over $35K break-up penalties. Sold their homes shortly after renewing on a fixed rate at discount. Reasons for sale as varied as: relocation for work; divorce; following stupid advice (but the realtor made a great commission on the sale).

In general:

Get a fixed rate if:

• you cannot afford higher payments;
• you want peace of mind;
• it is unlikely that you will sell your home during the mortgage's term (typically five years);
• you expect rising interest rates (I do not have a crystal ball);

Get a variable rate if:

• you intend to sell in the near future (earlier than the mortgage term, though you can get fixed rate mortgages for short terms too);
• you want to have flexibility;
• you expect falling interest rates (and yes, Denmark and Japan had negative interest rates before Covid hit the fan)

Always compare your options, and to know if you can afford higher payments, simulate them.

 

[alexandria281]

@protorayish You miss the real reason to get variable rate : if your income can significantly increase or if you want to put 20% down a few years

Nobody mentions it because most people are not in that situation but it's the main reason to get variable rate... that and expectation of negative rates

 

[protorayish]

@alexandria281 you are talking accelerated payment. most mortgages -- fixed and variables -- have sufficient prepayment privileges to cover your situation. It has nothing to do with the type of rate. The type of rate only interacts with your scenario when you want to repay faster than the prepayment privilege. In that case, you break the mortgage and it is the break-up penalties of the variable rate mortgage that are attractive to your scenario. Not the variable rate itself.

A more interesting fringe scenario for you are open mortgages: no penalties at all, pay them back whenever and however you want. Available both fix and variable rates.

 

[alexandria281]

@protorayish It seems more variable rates have faster payment as an option. Also ability to earn more money means more safety dealing with rising rates so lends itself to variable rate even if you're right. It's also the opposite of why you pick fixed rates (limited income) so it would make sense that higher income potential leans itself to variable rate more than fixed.

 

[konfesslena]

@resjudicata

I lived in Las Vegas, NV (there is a Las Vegas, New Mexico, so you have to be clear)

You only have to be clear if you're talking about the one in New Mexico...

 

[melista]

@resjudicata What does a home’s market value have anything to do with going choosing a variable rate option versus fixed? That’s a honest question as I’ve never heard of a market downturn affecting rates- except positively- for example, in your situation, variable rates after the financial crisis should of had the effect of lowering the interest paid on the loan dramatically.

Typically speaking, I think the general consensus has always been to choose a variable rate mortgage if the rate is considerably lower than the fixed option (a common tactic this decade). For two reasons: It’s relatively cheap to break a variable rate mortgage and because the interest you are saving for as long as your variable rate holds low, will still beat going with a 5-yr term at a higher fixed rate. The folks who hold variable rate mortgages from maybe a year ago are now ahead of the rest of us and paying very close to 1% (starting at around 2.65% and then dropping to 1.15% within months versus being stuck at 2.5% for their entire term). Today, I think it’s much murkier because there is barely a difference between fixed and variable rates. A simple change of the overnight rate, overnight, and you’re paying more than fixed rates today so most people will likely choose the more predictable, still-low fixed rate option. However, the fed has also publicly indicated that there is no intention to raise rates prior to 2023 and there’s the possibility that rates may go lower still- giving variable rate holders an advantage. It’s often said these days to go for a variable rate mortgage now and then break it in 2 years and go with the fixed option as that’s when we can start to expect an economic recovery.

 

[studytheskies]

@protorayish PIN IT PLEASE

 

[konan]

@protorayish Thanks for all this great info! My questions: How do mortgage brokers fit into all this? I like the idea of requiring only soft credit checks, and from what Ive gathered elsewhere on the forum a broker is generally a good idea. Ho do those pieces fit together?

 

[protorayish]

@konan The function of the mortgage broker is to connect between demand (you, the borrower) and supply (lenders). They are salespeople, and they add value to the sales process with their expertise and connection.

Think of getting a mortgage like buying a phone: you can

1. walk into an Apple Store or shop on apple.com, and you get only iPhones;
2. walk in or get online to Best Buy and get more choices; or
3. shop on the internet direct from those suppliers that sell direct but do not have a shop near you (OnePlus, Samsung, etc.)

In mortgage terms:

1. you walk into a bank or credit union that has a branch near you or shop on their website;
2. you walk into a mortgage broker and get access to the lenders that work with the mortgage broker; or
3. you shop the internet for lenders that do not have a shop near you but do offer online mortgages.

Much like Best Buy or other stores, the mortgage broker has relationships with multiple suppliers (lenders). The mortgage broker is typically paid by the lender, and, you guessed it, that cost is factored into what you end up paying. Sometimes opaquely blurred into the interest rate. Sometimes clearly indicated as a brokerage fee that is deducted from your mortgage amount.

Unlike Best Buy's associates, agents at the mortgage broker are licensed professionals that have passed training and exams, and most of them add significant value to the sales process. They fill your mortgage application, they pre-qualify you, and they forward your application to a lender that in their experience is a good match for you. Sometimes there is a conflict of interest here, as lenders compensate their brokers differently, and a broker will tend to send you to the lender that offers them better compensation.

Some lenders do not work with mortgage brokers. They may give you some of the savings back in the form of lower interest rate or other incentives. They prefer model 1 or 3 above. Lenders that use both models sometimes price the mortgage differently, because the direct channel is less expensive than the local branch.

The salesperson at the local branch does a work similar to the agent at the mortgage broker, but with a limited set of products (think iPhone only).

Like with any salesperson, remember that it works for the seller, not for you, the buyer. Get a second opinion, and ask directly big banks or online lenders like Tangerine. Mortgage brokers avoid you the hassle of knocking at a few dozens doors, but you should knock at a few doors and compare offers.

 

[resjudicata]

@protorayish How does Islamic Finance regulate moral hazard 1

 

[protorayish]

@resjudicata Shariah law forbids Riba. The concept of Riba is difficult to describe, and different scholars have different opinions. It can be simplified as the prohibition to make exploitative gains in trade or business. As a result, the Western concept of separating debt from equity is illegal. Islamic finance requires participation of the lender to the equity risk.

For mortgages, this is done in two ways:

Murhaba Contract:

1. the homebuyer approaches the lender with the price of the home
2. the lender agrees with the homebuyer on terms of finance (roughly equivalent to the amortization of a conventional mortgage), on an end-price (roughly equivalent to the total principal amount + interest of a conventional mortgage), and on a payment schedule.
3. the lender buys the property from the seller for the price of the home
4. the homebuyer pays the first installment (roughly equivalent to downpayment of a conventional mortgage) and continues making payments according to the agreed schedule, typically on a yearly basis (unlike the monthly or more frequent schedule of the conventional mortgage)
5. at the end of the amortization, ownership is transferred from the lender to the buyer

This is roughly equivalent to a fixed term mortgage that cannot be broken.

Diminishing Musharaka Contract:

1. The homebuyer and the lender buy the property jointly under a musharaka (partnership) contract.
2. The homebuyer has exclusive occupation and pays rent on the part of the property owned by the lender.
3. Part of the rent paid is applied to shrink the lender's part of the partnership over time. The homebuyer slowly buys out the lender.

The cash flow resembles much that of a variable term mortgage.

Under both contracts, the lender becomes part-owner. As such, it cannot benefit of the homebuyer not being able to make payments. The moral hazard was that under conventional mortgages, the lender makes a profit even when the borrower is pushed beyond his/her capacity to repay the loan. Here, the opposite is true: the lender carries the risk of holding the property if the homebuyer cannot make payments.

 

[xososaxo]

@protorayish

the lender carries the risk of holding the property

...But isn’t that effectively the same recourse as a regular lender? The regular lender will foreclose or power of sale the home, and they are stuck dealing with the property until they can sell to recover...?

If the Islamic lender owns the property, do they get to keep any excess profits on sale if the borrower defaults?

 

[protorayish]

@xososaxo The outcome of a bad situation is indeed the same and the lender will be stuck with the property. What differs is that the lender has no incentive to push the borrower over the cliff and get stuck with a foreclosure / power of sale proceeds of which the borrower bears the cost and the lender bears the benefits. Their interests are aligned.

My experience with Islamic mortgages is extremely limited. Never closed one. Came near setting up a private (Islamic) mortgage for a client, but in the end the borrower decided not to live above their means and bought a less expensive property with their savings.

Plenty of experience with Power of Sale here in Ontario, unfortunately...

 

[xososaxo]

@protorayish Oh, so most of the incentive difference is who pays the costs associated with unwinding, and I guess, the Islamic lender is more screwed if the property is underwater?