Is a second mortgage the right option for your client? It’s a question and a dilemma for mortgage brokers, financial advisors, and debt counsellors as they endeavor to find the path that provides the best solutions for their clients.
An attractive strategy…
There’s no question that second mortgage financing can be a great way to access funds for proactive pursuits such as home construction and renovation projects, investment opportunities, debt consolidation, tax arrears, or shore up working capital for business purposes. If you consider the penalty to break a first mortgage, the blended rate approach of a first and second mortgage can be a more efficient approach to borrowing.
Current economic uncertainty due to the Coronavirus pandemic has only exacerbated the need for business and property owners to seek solutions, such as second mortgages, to consolidate debt and avoid insolvency filings. We have seen a 15.3% increase in insolvency filings in Ontario between March 2019 and March 2020, with the biggest increase being for consumer proposals.
Assessing the benefit against the risk
Still, the risks that come with increased debt can’t be ignored, even if borrowing can provide immediate liquidity. A broker, advisor, or counsellor can help the client measure the costs of additional financing against the client’s income and capital resources needed to meet total obligations, which include the impact of foreseeable adverse events that could put the client off-side.
It’s also critical to consider any covenants attached to the first mortgage on the property, such as a restriction on subsequent encumbrances.
A key risk of a second mortgage is failing to plan a clear exit with the borrower. Brokers, advisors, and counsellors need to ensure the mortgage is suitable for the borrower and this includes ensuring there is a clear exit strategy. A second mortgage is best used as a bridge to keep the borrower on track until they’re able to meet their exit plan which could be in the form of a sale of the property to pay off the debt, or to provide relief through a period of financial instability with the exit being the refinancing of the debt with a financial institution.
Do the math
A second mortgage inevitably comes with an interest rate higher than the first, but on a blended basis, the two rates may be manageable. Take the example of Jane, whose first mortgage with the bank of $150,000 carries an interest rate of 3.5%. Jane has experienced some financial difficulties due to a job loss and she’s had to rely on credit to pay bills. Unfortunately, she has missed a few payments, tarnishing her credit score. Jane has an opportunity to take on a second mortgage for $50,000 at 8.99% in order to consolidate her debt. The blended rate in Jane’s situation would be calculated as follows:
The blended rate of 4.87% equates to annual interest payments of $9,745 on total debt of $200,000. This short-term solution will allow her to pay off her debt and afford her the time she needs to rebuild her credit so she can refinance with the bank.
What’s the long-term solution?
With a new job, Jane is anticipating a situation where she will be able to meet her increased debt burden. Many homeowners who look to secure added debt cannot rely on circumstances like these. For most, the second mortgage should be regarded as a bridging solution that solves a short-term problem and a clear plan must be devised to solve the longer-term issue. Consider the following situations:
- A borrower avoids a pending credit crunch with existing lenders but now plans on exiting the second mortgage by selling the property and repaying the mortgages from the sale proceeds.
- A corporate-commercial client needs working capital for a growing business but anticipates that the additional servicing costs of a second mortgage on his residence can be met with cash flow from the business.
- A homeowner requires capital for a renovation, but foresees the improvements, once completed, will increase the home’s value and enhance its first mortgage eligibility sufficient to take out the higher-cost second mortgage.
A key role for brokers, advisors, and counsellors
The second mortgage can be an excellent solution for borrowers facing financial opportunities or constraints. But the risks involved require borrowers to weigh the pros and cons and to compare against other solutions.
There’s an important role here for brokers, advisors, and counsellors in helping to assess the client’s income and capital resources, calculate the cost of added servicing obligations, identify any legal ramifications of additional encumbrances on the property, factor in other event risks on the horizon, and develop a workable plan to retire or service the increased debt. A second mortgage is a worthwhile alternative for some homeowners, but it’s certainly not for everyone.
Article by Diane Falcione, Manager of Mortgage Administration at Hillmount Capital. Diane can be reached at email@example.com
 Government of Canada (2019). Office of the Superintendent of Bankruptcy Canada: Insolvency Statistics in Canada. Retrieved from: https://www.ic.gc.ca/eic/site/bsf-osb.nsf/eng/br04250.html#table2