Therefore, instead of paying a pre-payment penalty to break the mortgage, another option could be to place a second mortgage against the property. Second mortgage financing can be a good way to raise equity when funds are required. Some common uses include borrowing for the purchase of another property, covering the cost of deferred maintenance or other investment purposes.
One misconception, however, is that the interest rates on second mortgages can be expensive. Many property owners think interest rates are in the high single digits or in even in double digits when, in fact, there are other options that make the interest rate cheaper.
Second mortgage interest rates can vary
The interest rate for a second mortgage can vary depending on the type of mortgage (Canada Mortgage and Housing Corporation, (CMHC) versus non-CMHC-insured), the profile of the property, the location, the credit-worthiness of the owner, cash flow of the property, amount of leverage of the first mortgage and the remaining term on the first mortgage the lender will review when underwriting a second mortgage.
All lenders underwrite the property and mortgage from the perspective of a worst-case scenario, and therefore are immediately looking at their risk from the perspective of whether they ever have to realize proceeds from the sale of an asset. Second mortgage lenders want to ensure they retain all of their funds if both the first and second mortgages are in default.
Any conservatism applied to the mortgage underwriting helps provide the lender with comfort on the second mortgage and will help determine the overall cost of placing it.
If you own an apartment building, you have the ability to apply for a CMHC-insured second mortgage. Otherwise, a conventional or non-CMHC-insured mortgage can be placed on the other types of income-producing assets. The difference between the two will help determine which interest rate is available on the mortgage.
In the case of a CMHC-insured mortgage, the lender applying for the second mortgage is usually the lender who holds the first mortgage against the property. If this is the case, there’s an immediate reduction in risk profile since the same lender will have both the first and second mortgages and is secured in the event of a default in both.
They usually have intimate knowledge of both the credit-worthiness of the borrower and of the property and can quickly assess the application to determine the availability of the second mortgage.
Insured second mortgage rates are comparable
What you’ll generally find is that an insured second mortgage has an interest rate comparable to current market interest rates for CMHC-insured first mortgages and not in the high single digits or double digits as is commonly thought.
Conventional second mortgages are generally placed on other asset classes such as retail, office and industrial assets. The interest rate can also be similar to those charged on first mortgages for these types of properties, but the second mortgage interest rate will have a risk premium that’s generally assessed from studying the risk profile of the property and borrower.
Factors that affect the risk of the property can include cash flow, occupancy levels, lease rollover, the current first mortgage terms and the credit-worthiness of the owner. Once these factors are assessed, the lender can determine the probability of the worst-case scenario and determine the interest rate accordingly.
Keep in mind that a second mortgage is considered a new mortgage for the lender. Therefore, when you’re thinking of placing it, you’ll endure the same process required on the first mortgage when it was placed against the property.
This means updating the existing appraisal report, obtaining a new building condition report and updating the Phase 1 environmental report. The new legal documents required will need to be processed by a lawyer, costs that must be factored in.
As a property owner, take the time to contact your lender to discuss the potential of placing a second mortgage against the property. He or she can immediately assess the situation and provide you with details.
In an environment where interest rates are so low, there may be an opportunity to raise equity, and at interest rates that make it affordable.
Darryl Bellwood is assistant vice-president of commercial financing with First National Financial, Canada’s largest non-bank lender. He’s active in most markets in the country and has a focus on investment real estate. All feedback is welcome and he can be reached at [email protected].