When you’re focused on buying a home and securing a mortgage, it’s unlikely you’re thinking too hard about borrowing even more money in the future.
But the high cost of home ownership — and life, circa pretty much any time in recent history — can do a number on a household’s cash flow, making it difficult to pay for eventualities like home renovations, car repairs or much needed vacations.
If you think you may need to borrow more money in the future, you can lay the groundwork by opting for a collateral mortgage when you purchase your home.
What is a collateral mortgage?
A collateral mortgage allows you to borrow more than your required mortgage amount from your lender, using your home as collateral. You’ll choose the additional amount when you’re approved for your mortgage, so even if your lender offers up to 125% of your home’s value, you can be a bit more conservative and borrow for less.
You might be wondering, why would a lender approve you for a larger mortgage than you need? To better understand the purpose of a collateral mortgage, it may be helpful to think of it as a pre-planned home equity line of credit, or HELOC.
Both HELOCs and collateral mortgages are ways of turning home equity into cash, but with a HELOC, you would likely apply after your home has appreciated, and your equity has grown over the course of several years. With a collateral mortgage, the amount you can access — that amount in excess of your original mortgage — is determined when the mortgage is initially approved. Since your lender has already signed off on the additional funds, you won’t pay any transactional fees to access them like you would when getting a second mortgage or refinancing.
Though you may not have heard of the term, collateral mortgages are actually pretty common. Most lenders offer both conventional and collateral mortgages. Some lenders will even allow you to secure other loans using a “collateral charge mortgage” in which the home acts as collateral for other financial products, such as an auto loan or line of credit.
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Collateral mortgage vs. conventional mortgage
With a conventional or “standard charge” mortgage, only the actual amount of your mortgage is registered. If you need to access home equity later, you’ll have to formally apply, re-qualify for the additional funds, pay fees and register a new mortgage.
A collateral mortgage means you’ve already been approved for both your original mortgage and an additional loan amount. Because the approval process has been completed, accessing the funds when you need them should be quick and frictionless.
» MORE: What is a second mortgage?
Risks of taking out a collateral mortgage
Easy, no-fee access to home equity sounds pretty sweet. But whenever you’re tapping into your equity or borrowing large sums from a lender, you need to be aware of the risks involved.
1. Those extra funds aren’t guaranteed
If your financial situation deteriorates — lose your job, take a pay cut or suffer a non-insurable injury that prevents you from working, for example — your lender isn’t obligated to release the funds they originally agreed to loan you. Would you lend $100,000 to someone with no income?
2. You might pay a higher interest rate on the additional amount you borrow
Without reading the fine print of your mortgage contract, you could wind up agreeing to pay more in interest on the additional funds you borrow. Depending on your financial situation at the time, you may have to pay an interest rate you can’t afford.
3. Other lenders may not want to do business with you
Lenders regularly agree to collateral mortgages that exceed 100% of a home’s value. That’s not a great situation to be in if you need to borrow money and your collateral funds are either inaccessible or not enough to cover a sudden, large expense.
Let’s say a lender provides you a $625,000 loan on a property valued at $500,000. To you and your lender, it’s a bet on appreciation and increased equity. To other lenders, you’ve accrued $625,000 in debt on a $500,000 asset, a scenario that makes you look like a credit risk. In these cases, you can pretty much forget about applying for a second mortgage.
How to get a collateral mortgage
If you decide it’s right for you, here’s a look at what you can expect from the collateral mortgage approval process.
Let’s assume you’re purchasing a property for $500,000 and you have a 20% down payment ($100,000). That means you’ll need a $400,000 mortgage. Your lender might offer you a collateral mortgage of up to 125% of the value of your home. That means your collateral mortgage could be registered with a value of $625,000 ($500,000 x 1.25).
Every lender has its own criteria to determine how much extra money they’ll register as part of a collateral mortgage. Some lenders might not allow more than the original mortgage amount. Either way, per government regulations, you can borrow up to 80% of the appraised value of your home (minus what you still owe) — which is especially helpful if the value of your home goes up.
Let’s say it’s been a few years since you bought your home and its value has gone up 10%. Your home is now worth $550,000, 80% of which is $440,000. Because you still owe $350,000 on your mortgage, you have $90,000 ($440,000 – $350,000) in equity available to borrow. If your property continues to increase in value, you’ll have access to more funds. However, the maximum you’ll be able to borrow is the original $625,000 at which your collateral mortgage was registered.
Pros and cons of a collateral mortgage
Some people see benefits in collateral mortgages. Others are firmly against them as financial tools. Understanding the pros and cons of a collateral mortgage is essential, as it’ll help you decide if it’s the right product for you.
- Access to funds. If you need money, and are in a stable financial position, a collateral mortgage lets you access the equity you’ve built in your home. You can use the funds for anything you like, such as home renovations or paying down high-interest debt.
- No legal costs. Since a collateral mortgage is set up from the start, you won’t need to pay additional legal costs when borrowing the money, like you would when refinancing.
- Debt. Other lenders may not want to loan you money if you owe significantly more than your home is worth. And while it can be tempting to treat your equity like an ATM, it’s important to remember that whatever equity you access eventually needs to be repaid.
- Interest. You may have to pay a higher interest rate on the additional funds you access.
- Fees may apply when switching lenders. Since collateral mortgages are registered with the lender, you may need to pay fees to port your mortgage to a new lender, even if your term is up.
Collateral mortgages: The bottom line
A collateral mortgage could be the key that unlocks the equity you’ve built in your home. But it could also shackle you with an additional loan that hampers your overall finances. Before moving forward with a collateral mortgage, make sure to ask your mortgage advisor for clarity around the overall cost involved and the impact it could have on your creditworthiness.
What Happens If You Break Your Mortgage Contract?
You will face a penalty for breaking your mortgage contract if you refinance before your term ends. The potential benefit may be worthwhile.
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Home Equity Line of Credit vs. Mortgage: Differences, Pros and Cons
Home equity lines of credit, or HELOCs, are second mortgages that function as revolving lines of credit, while mortgages are primary loans used to buy property.