Collateral Mortgages vs. Conventional Mortgages
When you take out a loan to buy a property, your mortgage is registered either as a conventional mortgage or a collateral mortgage. The average borrower likely won’t even notice a difference between the two and may not even be aware which one they have. Nevertheless, there are a few important distinctions in the following scenarios: you want to take out equity from the house, you want to switch lenders, you need a second mortgage.
Otherwise, the process from the borrower’s perspective (in terms of amortization, interest, monthly payments) is exactly the same. Let’s take a look at the two kinds of mortgages in more detail.
In This Article:
Collateral vs Conventional Mortgages: At a Glance
|Taking Out Equity||Easy, low or no-fee||Must get a second mortgage or get a HELOC|
|Switching lenders||Must discharge mortgage and re-register it which comes with legal fees||Super easy, simply transfer mortgage|
|Second mortgage||Only possible with the same lender||Easy to get as long as you are approved|
What is a Conventional Mortgage?
A conventional mortgage, also called a traditional mortgage, is the one borrowers are most commonly familiar with. Your loan is registered for the amount you take out, and as you pay it off it decreases. If you get a mortgage for $500,000 and pay off $100,000 in five years then your mortgage will only be $400,000.
What happens when you want to take out equity from the house? You have a few options:
- Take out a Home Equity Line of Credit (HELOC), which is itself a collateral charge, and pay set-up fees around $500-$1,000
- Take out a second mortgage from your current lender, a different lender or even a private lender
At the end of your term you can easily transfer your mortgage to any lender. A new lender may charge a couple hundred in set-up fees but you can usually find a promo to avoid these.
Pros & Cons of a Conventional Mortgage
- Simple to switch your mortgage to another lender at the end of your term to get a better interest rate, or terms.
- Easy to take out a second mortgage even if your current lender refuses based on your qualifications.
- Predictable, clear and transparent. You take out a loan for a house in the exact amount you need, pay it back, and the loan decreases.
- If you want to take out equity from your house you’ll have to register for a new loan, which is most likely a HELOC.
What is a Collateral Mortgage?
The best way to explain collateral mortgages is that it’s a re-advanceable mortgage, similar to a HELOC. Your lender registers the mortgage as the loan you took out, or occasionally even higher, but the loan amount doesn’t technically decrease as you pay it down. That lets you access the equity in your home quite easily without having to take out a second mortgage or a HELOC.
Using the example from above, with a collateral mortgage your lender registers your mortgage at $500,000 and even when you pay off $100,000 your total mortgage would still be registered as $500,000.
That doesn’t mean you’re not paying off your mortgage over time or that you’re on the hook for more payments.
Instead what it means is that that the higher loan amount always exists and is available for you to use. So instead of paying set-up fees for a HELOC, you can simply talk with your lender and possibly get access to that money cheaper. If you never want to take equity out then this aspect doesn’t affect you.
The issue is that it’s more difficult to take out a second mortgage from a different lender and you may be constrained to taking out an additional mortgage with the same lender. Of course, if you don’t run into huge financial difficulties and don’t need to take on a second mortgage then this also won’t affect you either.
The other drawback is if you switch lenders at the end of your term, you can’t just transfer the mortgage from institution to institution as simply. Instead, you’ll need to register a whole new mortgage. But this all happens behind the scenes with your lender; you don’t have to do anything special. You may just have to pay around $1,000 in legal fees, but again, these can be at least partially reimbursed if there’s a promo.
Pros & Cons of a Collateral Mortgage
Both the advantages and disadvantages of a collateral mortgage are only relevant when you want to take equity out or transfer your mortgage to a new lender.
- Easier and cheaper to take out equity on your house because the loan you started with is still there available for you to use.
- It will be hard to get a second mortgage from a different lender and it may cost up to $1,000 to switch lenders and the end of the term.
How Do Both Work?
As we said, both collateral and conventional mortgages work pretty much identical from the point of view of the borrower. So whichever you’re thinking of getting, it’s important to understand how mortgages work.
You put down at least 20% of the purchase price. If you put down less than 20% then you have what’s called a “high-ratio mortgage” and you will need to purchase insurance from CMHC or Genworth to cover your lender, as you’re at higher risk of default.
You take out a loan from a lender for 80% or less of the home’s value and agree to pay it back over a certain length of time, usually 25 or 30 years.
Even though your mortgage will likely take decades to pay off you only need to agree to an interest rate term of one to five years. Five-year lengths are the most popular. The only issue is that many people sell their house within five years, in which case they have to break their mortgage. That comes with steep penalties: most often three months interest for variable mortgages and three months interest plus a calculated interest differential for fixed mortgages. If you think you may sell your home sooner it may be best to choose a shorter term or a variable rate.
Variable vs. Fixed
For any term length you can choose between a fixed or variable rate, depending on where you see interest rates going. Usually, you save money with variable rates, since they’re discounted, but most Canadians prefer fixed for stability.
There’s a misconception that your monthly payments can fluctuate with variable rates but that only happens if interest rates rise dramatically, usually over two percentage points during your term. Instead, the same amount is taken out of your bank account every month. Only the proportion of your monthly payment that goes towards interest versus the amount you pay down on the principal, will fluctuate.
At the end of your term, you can either negotiate with your current lender for a new term or switch your mortgage to a new lender with better rates or conditions. There may be some fees involved but you can usually get them rebated with a promo.
Which Should You Choose?
Both mortgages are suitable for the average Canadian who buys a property within their means and is focused on paying down the mortgage.
A collateral mortgage may be more appropriate if you:
- Buy an expensive property and know you will want to take out equity at some point
- Are loyal to your lender
- Have a short amortization (less likely to need to switch lenders)
- Are a resale buyer, are high income or are not concerned about ever having to take out a second mortgage
A conventional mortgage may be more appropriate if you:
- Love to rate shop and anticipate switching lenders
- Don’t plan to take out equity from the house because you want to be mortgage-free
- Anticipate running into financial trouble and being forced to take out a second mortgage on the house, potentially with a private lender
- Are a first-time home buyer and have a long amortization
Note that while most Canadian banks offer both conventional and collateral mortgages, a few of them only offer collateral mortgages. If you’re set on a conventional mortgage make sure to avoid those lenders.
HELOCs have become insanely popular with Canadians in recent years and are far more popular than second mortgages. That’s likely because home values have gotten so incredibly high that it seems silly not to tap into that equity and access historic low-interest rates. Chances are you’re going to want that opportunity someday.
You can still, however, take out equity fairly easily with both kinds of mortgages. It’s just that your collateral mortgage is basically already a HELOC, and with a conventional mortgage, you’d have to register a HELOC loan. It’s pretty much a wash there.
If you’re on the fence we recommend speaking to mortgage brokers who will be able to explain the pros and cons of your specific situation.