When it comes to mortgages, there are two main types that borrowers should be aware of: collateral mortgages and standard mortgages. The key difference between the two lies in how they secure the value of the property and the potential for future borrowing against the property.
Standard Mortgages:
A standard mortgage operates in a straightforward manner. When you obtain a standard mortgage for a specific amount, such as $80,000, on a property valued at $100,000, the mortgage’s maximum charge against the property is limited to the initial amount borrowed. As you make regular mortgage payments over time, the outstanding balance gradually decreases until the mortgage is fully amortized.
With standard mortgages, the principal amount within the mortgage cannot be increased. If you wish to borrow more against the property later, you would need to explore other options, such as obtaining an additional mortgage, securing a line of credit, or refinancing the existing mortgage to take out a new one.
Collateral Mortgages:
Collateral mortgages differ in structure from standard mortgages. These mortgages are designed to secure not only the initial amount borrowed but also additional value beyond the original advance. Using the example above, with a collateral mortgage for $80,000 on a $100,000 property, the mortgage will occupy the entire present value of the property, plus an additional amount, up to a specified limit beyond the purchase price.
The implications of this structure are that collateral mortgages do not leave room for adding charges or borrowing against the property. Unlike standard mortgages, where you may build equity over time, collateral mortgages use up all available equity to secure the loan. Therefore, borrowers cannot add new charges, loans, or lines of credit to a collateral mortgage without paying it off and refinancing it based on a new appraisal, which can be costly.
Standard Approaches to Refinancing
While the idea of purchasing a home and committing to paying off the mortgage over time is a noble ambition, life’s realities often make it more complicated than that. For most individuals, borrowing is a common occurrence, especially during the early stages of their careers. As a result, the goal shifts towards borrowing at the lowest possible interest rates.
Collateral mortgages, which secure more than just the initial advance, can limit the flexibility to add new debt without incurring significant costs. Borrowers need to consider the expenses involved in setting up new secured products, such as hiring a lawyer for title searches and registration. To make financial sense, the interest savings from refinancing must outweigh the associated costs.
Even if the interest savings are substantial, incurring expenses to refinance debt can create inefficiencies. The money saved on interest might not fully compensate for the costs incurred during the refinancing process. In some cases, borrowers may need to discharge and set up new secured products, adding further legal fees to the equation.
Ideally, homeowners would prefer to leverage their home equity to refinance other debt without incurring additional costs. However, the practicalities of doing so often involve unavoidable expenses. For instance, setting up a secured line of credit or refinancing a mortgage to accommodate additional debt will usually involve legal fees and other associated costs.
While maximizing home equity to access lower interest rates is a smart financial strategy, it’s essential to weigh the potential savings against the costs involved in refinancing. Careful consideration and financial planning are crucial to determine whether the benefits of lower interest rates outweigh the expenses incurred during the refinancing process.
Collateral Mortgages Build In the Ability To Borrow More
Opting for a collateral mortgage offers borrowers a different level of flexibility compared to standard mortgages. While adding additional charges to the mortgage is not possible, collateral mortgages provide a unique advantage in accessing extra funds without incurring significant costs.
When a lender registers a collateral charge on a property, they establish a legal claim to a specific amount, which can exceed the original purchase price or the property’s value at the time of the mortgage. This means that if the property’s value appreciates over time, borrowers may have the ability to access additional equity without the need to refinance the existing mortgage.
Using the previous example of purchasing a property for $100,000 and borrowing $80,000, the lender may register a collateral charge of $125,000. This gives borrowers the potential to borrow up to $125,000 without the requirement to break the original mortgage and incur costs associated with registering a new charge.
In situations where additional borrowing is necessary and exceeds the registered collateral charge, refinancing the mortgage becomes a viable option. However, collateral mortgages provide more leeway compared to standard mortgages, allowing borrowers to access significant additional funds before needing to consider refinancing.
The Benefits Recap:
- No Additional Charges: While borrowers cannot add new charges to a collateral mortgage, the need to do so is minimized due to the ability to borrow additional amounts against the existing equity.
- Flexibility in Borrowing: Collateral mortgages allow borrowers to tap into their increased equity without the costs and processes involved in refinancing.
- Potential for Higher Registered Amount: Lenders can register a charge on the property for an amount beyond the initial mortgage, giving borrowers the potential to access more funds without refinancing.
How Collateral Mortgages Function
The Upsides:
Flexibility in Borrowing: Collateral mortgages provide the advantage of having a line of credit built into the mortgage. As the loan portion is paid down, the line of credit automatically increases relative to the original loan-to-value ratio. This offers borrowers easy access to additional funds without the need to refinance or apply for a fixed line of credit later.
Potential for Increased Credit: Some collateral mortgages may allow for the line of credit to increase as the property value appreciates, without requiring further credit checks. This provides added convenience for borrowers seeking to access more funds when needed.
Lower Interest Rates: Collateral mortgages offer lower interest rates compared to unsecured credit products like credit cards. This can be beneficial for those who responsibly manage their credit and prefer to use lower-rate debt to finance their borrowing needs.
The Downsides:
Potential for Over-Borrowing: While the accessibility of the line of credit can be advantageous, it can also lead to additional borrowing that might not have been made otherwise. Borrowers need to exercise responsible financial management and avoid taking on more debt than they can comfortably manage.
Difficulty in Changing Lenders: Transferring collateral mortgages to a different lender can be more challenging and costly compared to standard mortgages. This can limit borrowers’ bargaining power when their mortgage term is up, as they may face higher refinancing costs and less competitive offers.
Less Shopping Flexibility: With standard mortgages, borrowers can shop around for better deals when their term is up, potentially negotiating better offers from their current lender. However, with collateral mortgages, the options for refinancing may be limited to lenders who offer collateral mortgages.
