Should you be someone else’s mortgage lender?
Tuesday October 12, 2010
Last week we discussed the concept of holding your own mortgage inside your RRSP. This week we’ll take a look at holding someone else’s mortgage as an investment in general (which can be inside or outside your RRSP).
While holding your own mortgage inside your RRSP is a non-arm’s length transaction subject to CMHC insurance premiums, holding someone else’s mortgage can be an arm’s length transaction and potentially not subject to these premiums.
The best analogy for remembering the difference between an arm’s length transaction and a non-arm’s length transaction is to think of only being able to hug people who are close to you. You would probably only do this with family. This would be “less than arm’s length” or non-arm’s length. Dealing with someone at arm’s length means they are too far to hug. You wouldn’t hug a stranger, would you?
If you are lending funds to a borrower to purchase a property that you are selling, this is known as a vendor take back mortgage. You could lend out the full mortgage amount, or it could be a partial amount.
For example, let’s assume you are selling your house for $500,000. You find a buyer and you agree to the sale contingent on the buyer arranging financing. The buyer is having some trouble coming up with the full purchase amount required – perhaps they are $20,000 short, or maybe they are real estate investors and want to keep some capital at their disposal. There are a few different reasons buyers may be interested in a vendor take back mortgage.
You could sell your house for $480,000 plus a $20,000 vendor take back mortgage. The purchaser could agree to pay back the $20,000 principal plus interest over time as per the terms you negotiate. The vendor take back mortgage could carry an interest rate higher or lower than prevailing market rates: This would depend on the tradeoff between their credit worthiness and the amount of time within which you need to sell the house, among other factors. Payments from the borrower are partly principal repayment, which is not subject to tax, and partly interest, which is taxed at your marginal rate.
Usually all that is required is to complete an agreement between the vendor and buyer and then to find a trustee to administer the terms of the mortgage for you. Of course, you’ll want to assess the credit quality of the borrower and it’s recommended to engage a real estate lawyer who is familiar with handling these types of transactions.
While many private mortgage investors may be accustomed to high rates of interest being earned, the tradeoff comes in the form of liquidity and risk. If you want out of the mortgage investment, it’s not like you can go online and place a sell order, which gets filled almost instantaneously. But more importantly, if the borrower defaults, you could be faced with the troubling prospect of weighing the risk of proceeding with a power of sale.
“Under Ontario law, a lender can begin a private power of sale proceeding 15 days after default and must give at least 35 days notice of intent to sell,” says Albert Luk of Nesathurai & Luk LLP, a Toronto law firm. “However, the borrower can bring the mortgage up to date at any time within that period of time, along with payment of legal fees.”
But that only describes half the picture,Mr. Luk says. “As the second mortgagee, the risk is twofold. If the borrower defaults on the first mortgage, the other mortgage lenders have to buy the first mortgage lender out or accept the risk of not recovering the loan if the first mortgage lender sells for less than the amount of the first mortgage plus legal fees and real estate commission.”
He adds: “If the borrower can pay the first mortgage but not the second or subsequent mortgages, obtaining a writ of possession (the end result of a power of sale proceeding) may simply result in the second mortgagee acting as collection agent for the first mortgagee if the sale price is not enough to satisfy the first mortgage plus fees. This is a real possibility in highly leveraged properties or in a non-appreciating real estate market. For this reason, thorough due diligence is required for anyone seeking to become a mortgage lender, especially if it is a second or third mortgage.”
What’s that? Right. Potentially higher returns come with higher risk. Never forget that.