protorayish
New member
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.
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!
- 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.
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!