As interest rates have steadily increased over the past year, it's created financial hardship for many existing mortgage borrowers, as well as those shopping for a new rate or coming up to renewal – and a larger proportion of those distressed borrowers are turning to the private mortgage market.
According to a poll conducted by the Financial Services Regulatory Authority (FSRA) of Ontario, the number of borrowers who pursued a private mortgage (via a licensed broker) jumped by 10.6% in 2021, with that number anticipated to clock in even higher for 2022 and 2023. The FSRA findings also show the dollar value of private mortgages rose by a whopping 72% between 2019 to 2021, from $13 billion to $22.4 billion.
Sizzling real estate demand during the pandemic prompted many buyers to enter unconditional agreements on their home purchases over the past two years, making them vulnerable to appraisal gaps during the mortgage closing process. Other borrowers have found themselves squeezed by rapidly rising rates due to the Bank of Canada’s recent hiking cycle, are struggling to pass the mortgage stress test, or are facing prohibitively higher rates at renewal – all reasons they may be forced to turn to a private lender.
What is a private mortgage?
A private mortgage is a type of home financing that is provided by an individual, or a pool of investors, rather than via a traditional mortgage lender. These loans, which come at much higher interest rates than mortgages offered by A- and B-lenders (in the 10-18% range), are meant to be short-term solutions to secure a property in times of financial stress.
They typically have terms of one to three years, and payments are interest-only. That means the borrower won’t make a dent in their mortgage principal over the course of their private financing, but will ideally come out of the arrangement in a stronger financial position and able to make the transition to a B-alternative lender at a better rate.
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Private mortgages are an alternative for borrowers who fall through the cracks in the conservative lending guidelines used by traditional lenders; while they may be financially solvent and able to make their payments, factors such as being self-employed or having a low credit score may have disqualified them from getting a mortgage. A private lender can step in to fill this financing gap – but at a higher cost, and often with additional broker fees heaped onto payments.
However, the same FSRA poll finds a good chunk of borrowers don’t understand the risks associated with private mortgages; for example, 54% of respondents mistakenly believe private mortgage payments go towards both the interest and principal payment.
“FSRA’s polling demonstrates the importance of understanding what you are getting into,” said Huston Loke, FSRA’s Executive Vice-President of Market Conduct. “With rising interest rates, high inflation, and a slowing economy, more consumers are struggling to qualify for a traditional loan. It’s critical that homeowners who enter into private mortgages fully appreciate how their loan works, the pros and cons of the arrangement, and the true cost of a private mortgage.”
A “short-term stop gap”
“The borrowers are having a really tough time qualifying for even the ability to shop around for better rates while renewing their current mortgage terms,” he says. “The way mortgage rates have been shooting up over the last year have been a contributing factor and ultimately correlates to a higher stress-test qualifying rate, thus a lower affordable mortgage situation. So borrowers have nowhere else to go, don’t want to sell their home, or really want to buy a home without having the perfect mortgage application scenario.”
He says that for borrowers who are “on the edge” of qualifying at an A-lender, the team absolutely exhausts all potential options at the conventional level first. Next down the ladder are B-lenders, who charge a 1% lender fee on the mortgage amount, have higher interest rates, and who allow slightly higher borrowing possibilities for a borrower by offering higher total debt servicing ratios.
If going to a B-lender still can’t get the deal done, Bricknell says only then will they seek a private lender – but adds the marketplace has tightened up as real estate prices have considerably softened over the last year.
“Even the private lenders have recently pulled back on the amounts they are willing to lend out with how uncertain the appraised home values are in the current market,” he says.
As FSRA’s Loke puts it, borrowers should approach the private mortgage market with caution, and be aware of the ways these loans differ from traditional mortgages.
“Higher lender fees, interest-only conditions and shorter terms are just some of the things you may need to navigate,” he stated. “Private mortgages can be an option for some consumers, such as those who are unable to qualify for a traditional mortgage. But remember, for many people private mortgages should be a short-term stop gap, not a long-term solution.”
The bottom line
While private mortgages can offer more flexible terms and easier access to urgently-needed cash, those perks come at a cost. Prospective borrowers should keep their eyes open to additional lender fees and brokerage commissions, and – most importantly – have an exit strategy for moving from a private mortgage term to a traditional product offered at the A- or B-lender level.