Mortgage Menagerie

I got my fist mortgage over 20 years ago, and at the time I was only concerned about two things - term length and rate.  I hadn't heard about HELOCs, and my mortgage broker did not discuss portability, prepayment penalties, debt service ratios, or my credit score.  Even today, my experience is that only a minority of mortgage advisors will get into those details, or discuss the difference between a conventional and collateral charge.  So in this post I'll discuss some of those details and explain why you may want to pay attention to them.

The subject of collateral charges has been given some attention in the media in the past few years, and most of what I've read has been negative.  I don't think collateral charges are a necessarily a bad thing, and sometimes a collateral charge is better than a conventional charge.

Technically the difference between a collateral charge and a conventional charge has to do with how the mortgage is registered in the provincial land titles registry.  From a borrower's perspective, the primary difference is that a collateral charge can be used to secure additional loans such as a HELOC, a personal loan, or even a credit card.  Some people suggest that collateral charges are readvanceable, but that is not always true.  Specifically, it depends on how the lender requires the collateral charge to be registered.  BMO, with their ReadiLine product, instructs lawyers to register the collateral charge for the initial principal amount of the mortgage, which means additional borrowing requires a new mortgage registration and the associated legal fees.  Scotia, when the mortgage is under their STEP product, does not specify an amount, which means it is readvanceable.  I'm informed that TD registers the charge with an amount that exceeds the mortgage principal, which means it is also readvanceable, at least up to that amount.

The argument that a conventional charge is better because it allows you to switch lenders without incurring the legal costs of a discharge and new registration is also not entirely true.  In a recent conversation with a "Premier Relationship Manager" at HSBC, I was told that they will not take an assignment of another lender's mortgage, even when it is a conventional charge.  I suspect HSBC is not the only lender that wants to ensure that their specific mortgage terms are registered on title when they lend.

I think a readvanceable mortgage is worth considering when you intend to purchase and renovate a property.  While an unsecured line of credit would be an option, they generally have an interest rate that is 1-2% higher than a secured line of credit (HELOC) that you can add to a collateral mortgage.

Portability is another mortgage feature that most borrowers should pay attention to.  If you sell your house before your mortgage term is up, you can take out a mortgage for an equal amount on your new property and avoid prepayment charges.  While most mortgages are portable, I recently found out that Scotia's "value" mortgages are not.

When discussing the mortgage terms with your lender, I suggest asking them to show you the contract clauses that specify the details such as portability and prepayment options.  Since most mortgage contracts are boilerplate documents that have clauses covering every different mortgage the lender offers, I'd even ask your lender to initial beside the clauses that apply to your mortgage.  Also, have your lawyer confirm the detail when you meet with them, as your lender could make a mistake in the documents and instructions that are sent to your lawyer.

I considered trying to explain mortgage prepayment penalties and interest rate differentials, but that's a topic only an accountant can find exciting.  If you choose a variable rate mortgage, it's simple because the prepayment penalty is always three months' interest.  If you are inclined to choose a 5-year fixed rate mortgage, I suggest giving serious consideration to a 4-year fixed instead.  When you do the math, prepayment penalties on a 5-year fixed mortgage can often be double the penalties on 4-year fixed.

The Mortgage Qualification Crunch and Lower Housing Prices

Most people that have a mortgage know that interest rates have been going up over the last year and a half.  And some people with a mortgage may have heard about the B-20 rule changes that tighten mortgage qualification requirements.  However I don't think most homeowners understand how much these changes have increased the qualifying payment, which in turn significantly reduces the mortgage they can qualify for when buying a new home.

Two years ago, 5-year fixed mortgage rates were as low as 2%, and the monthly payment for a $100K mortgage was $424.  Now 5-year fixed rates are around 3.5%, and the qualifying rate would be 5.5% (3.5% + 2%).  The qualifying payment for a $100K mortgage at 5.5% is now 45% higher at $614/mth.  In terms of the house you can afford, in an extreme case of a family without any other debt service costs like a car payment, if you could afford a $500K mortgage before, now you can get a $350K mortgage.  Most families will now have to set their sights at least 25% lower than 2 years ago.

With more interest rate hikes likely coming, things will continue to get worse, although we are much closer to the end of interest rate hikes than the beginning.  Even if you weren't planning on moving into a bigger house, there will still be an impact due to downward pressures on housing prices.  That's because housing prices tend to go down as interest rates go up.  When fewer families can afford a $500,000 home, builders will make less of them.  When families move they will buy a less expensive house because they won't be able to qualify for a mortgage as big as they used to.

I don't think the impact on home prices over the next few years will be significant, with prices in most markets dropping by about 5%.  Where I think the biggest negative impact will be is in the real estate industry, with fewer homes being bought and sold.  For some people, like landlords, reductions in housing affordability is actually good news.  One of my tenants told me their plan is to buy a house in about a year.  However they had never heard about B-20, and had not met with a bank or mortgage broker to get an idea of what they can afford.  With more first-time buyers having to wait longer in order to pay down debts and save for bigger down payments, demand for rental properties should remain strong.

Advice for the small residential landlord

When I first became a landlord over 20 years ago,  I was not focused on maximizing profits.  I had other business interests, and I saw real estate as a reasonably safe and stable investment.  While renting the units did not give a large return on investment, selling them a couple years before the real estate peak in 2001 made for some healthy capital gains.  When I decided to go back to being a landlord a few years ago, I did it with no expectation of getting lucky again and riding a wave of appreciating real estate values.

What I mean by a "small" landlord is no more than 10 houses for rent.  That limit comes from the maximum number of residential mortgages banks will give a landlord.  BMO and Scotia have a limit of 10, while the limit at RBC is only 6.  Once you go over that limit, you'll only be able to get commercial mortgages, which will have a much higher interest rate than a residential mortgage.

My first piece of advice is something that applies to most business endeavors, not just property rentals.  I find many people in business are too focused on growing revenue instead of reducing costs.  I find it is easier to find a way to save $20 a month than it is to get $20 more in rent for a property.  For example, saving 0.2% on a $120,000 mortgage is $20 per month.  Rental mortgages are complicated, so the trouble of shopping around for the best rate may not seem worth it for a $20 monthly savings.  However, once you find a lender that can give you the best rate on one of your mortgages, they'll often be able to give you the best rate on your other mortgages as well.

When you are mortgage shopping, I recommend dealing with branch staff rather than brokers or bank mortgage specialists.  The reason is that the job of brokers and mortgage specialists is to bring in new clients.  Once you want to renew or make changes to your mortgage, you'll have to work with branch staff that will first have to get up to speed on your file.  My wife and I recently saved over $1000 through working with a financial services manager at BMO.  He noticed that we had a 5-year variable rate mortgage at prime - 0.5% with 4 years left.  BMO was offering a special rate of prime - 1%, and our BMO rep had calculated that with the lower rate we would save more than the 3-month interest penalty by renewing early.

Another expense that can vary greatly for landlords insurance.  Until recently our rental properties were insured by Pembridge under a residential policy along with our home and vehicles.  Most insurers have a limit of 4 or 5 rental properties before you have to go with a commercial policy.  At first it looked like we would have to pay a bit more for commercial insurance, but after a lot of shopping around we were able to find a commercial policy for less than what we were paying Pembridge.  With Pembridge, the cost of the insurance with a $5,000 deductible was around 0.3% of the building replacement value, so insurance on a $200,000 property was about $600/yr.  Our commercial Actual Cash Value policy is only 0.21% of the insured value, with an additional separate charge for commercial general liability.  Overall, it's about 10% cheaper than what we were paying under a residential policy.

Probably the most important thing a landlord does is screen tenants.  One bad tenant can turn a profitable rental business into the red.  It's also something that is probably as much art as it is science.  It should be clear that just looking for "nice" tenants is not a good idea.  You could end up with a professional tenant.  I find the best indicator of a tenant's reliability is their work history.  If they have been working full time for several years at the same company, they'll probably make a good tenant.  I ask for both work and previous landlord references, and will ask their boss specific questions that indicate reliability, such as the last time they were late for work.  Don't ask past landlords if they were a "good tenant", ask specific questions like if they ever paid their rent late, or if they even paid their rent early.  I don't waste money on screening services that charge to do credit checks on prospective tenants.  A bad tenant can have a great credit score, and a great tenant can have a bad credit score.  Many people don't realize that something as simple as refusing to pay for a cell phone billing error and switching to a new provider could take your credit score from good to poor if your old provider sends your disputed bill to collections.  Sure, they aren't supposed to send a disputed bill to collections, but you probably even have a friend or two that has had it happen to them.

My last piece of advice for small landlords is to stay out of the big markets like Toronto and Vancouver.  The return on investment for a condo in downtown Toronto will be much less than a couple townhomes in Oshawa.  Some investors think a downtown condo is a safer investment than a residential property in a small city.  Other investors like the idea of having a place in a big city where they can stay for short visits and rent out the rest of the time.   Whatever the reason, if you look at reports on rental investment returns across the country, cities like Toronto and Vancouver are consistently at the bottom of the list, while places like Halifax and London are near the top.

As for what you can expect for investment returns, 10% is a reasonable target.  That is based on putting 20% down, a mortgage with an interest rate of 3%, and a 1-2% vacancy rate.  If you are handy and can do maintenance like painting and minor plumbing repairs yourself, investment returns of 15% are achievable.  Returns of over 20% can even be made if you are in a market where you can purchase properties in need of repair that you fix up and rent.  Flipping houses may seem like the glamorous thing to do from today's TV shows, but buying that fixer-upper and renting it will make you more money in the long run.