For a lender, bigger is not always better.
The larger a mortgage gets, the greater the lender’s potential loss if the borrower defaults.
The higher the purchase price of a house, the fewer potential buyers it has, making it more vulnerable to market corrections and more difficult to unload if it has to be seized and sold.
In the world of lending, where return of capital is more important than return on capital, large mortgage loans come with increased risk, and as such, are subject to greater scrutiny.
To offset this increased risk, lenders will use some variation of a sliding scale to reduce a loan in proportion to a property’s value when it exceeds a certain dollar amount.
Definition of a large loan: If you live near a major urban centre, lenders consider a mortgage in the $750,000 range to be a large loan and if you need to borrow more than that, they will invoke a sliding scale to limit their potential loss. (If you live in a rural setting, a mortgage over $350,000 is usually considered a large loan.)
In most cases, borrowers who take out large loans also make down payments of more than 20 per cent. While it may seem counterintuitive at first, these types of mortgages (called conventional loans) are actually riskier for lenders than loans with down payments of less than 20 per cent (high-ratio loans). That’s because high-ratio loans must be insured against default (by CMHC for example) and once they are, a lender’s potential for loss is minimized. By comparison, most conventional loans are not insured and they don’t come with similar protection. This more than offsets the fact that a conventional borrower is making a larger down payment, and to mitigate the increased risk, lenders use a sliding scale for large, conventional loans.
Let’s illustrate how sliding scales work with an example.
Assume that you buy a house for $1.4 million and want to make a down payment of 20 per cent of the purchase price, which in this case would be $280,000. Because you are applying for a conventional loan (a loan that is not insured against default), the lender uses a sliding scale by offering to loan you 80 per cent of the first $750,000 of the purchase price, but only 60 per cent of the next $650,000. This is the sliding scale at work. It is designed so that as a property’s price increases, the maximum loan amount offered decreases on a proportionate basis. In this example, while you wanted to borrow $1.120 million (80 per cent of the property’s value), the lender is only offering you $990,000 (71 per cent of the property’s value) because of its sliding scale policy.
Meanwhile, if you had decided to put down only 10 per cent of the purchase price, this same lender would have happily loaned you $1,260 million (90 per cent of the property’s value) because a 10 per cent down payment would require high-ratio insurance. Good for them but not so good for you, because in this example, high-ratio insurance would cost you an additional $25,200!
Sliding scales are used by most lenders, particularly the major banks. In situations like the one above, the borrower had to choose between borrowing less than she wanted, or borrowing more and paying a substantial high-ratio insurance fee.
But fear not, because an independent mortgage planner should be able to help you avoid this conundrum. There is a subgroup of more flexible lenders who do not use a sliding scale and will loan the borrower in our example the exact $1.120 million she seeks. While these lenders are not generally well known to consumers, experienced independent planners know them, and more importantly, know that they use a different, much cheaper form of insurance on conventional loans (called portfolio insurance), which they, not you, pay for. Borrowing from this group allows you to avoid sliding scale restrictions, and still gives you access to the best rates on offer at no added cost.
Here are a few other points to keep in mind if you are looking to borrow more than $750,000 (or $350,000 in a rural setting), regardless of your down payment amount:
* Pay special attention to the terms and conditions that come with your mortgage, especially your prepayment penalties. Larger loan amounts magnify the differences in the penalties charged by different lenders.
* Large loans have to be escalated up the ranks for management approval, so expect lenders to take an extra day (or two) to get your approval back. If you anticipate tight timelines, get pre-approved first, which is a good move for lots of other reasons anyway.
* While lenders are more cautious with large loans, you should still be offered the best rates in the market (they may take a bit more work, but in the long run, large loans are more profitable for lenders). If you want to know what the best rates are, shop around.
One other important point to keep in mind: when real estate prices flatten or drop, lenders can become much more conservative when underwriting higher-end real estate. As such, there can be wide disparity in the value different lenders will assign to a property. Partnering with an independent mortgage planner will help ensure that you and your property are matched with the lender who is offering the best fit for your particular situation, regardless of whether the market is hot or cold. An individual lender’s appetite for large loans may fluctuate, but to a mortgage planner at least, bigger is still always better.
Dave Larock MBA, AMP, PFPC, CSC is a Toronto-based independent mortgage planner and long-time industry insider who specializes in helping clients purchase, refinance or renew their mortgages. He is an active blogger on mortgage related topics and his posts have been distributed in national media and by Realtors and financial planners. www.integratedmortgageplanners.com.