Last January I wrote about the upcoming increases in default insurance premiums. Just a reminder, those new rates go into effect this Friday, March 17th, 2017. In fact, most lenders have set today or tomorrow as the deadline for processing applications under the current rates. The new rates represent a significant increase in the cost of default insurance. One which warrants re-examining the 1st and 2nd mortgage alternative.
As a quick reminder, those lenders regulated by the Bank Act, are required to get default insurance on all loans over 80% loan-to-value (LTV). Of course the borrower pays for this insurance, but s/he can avoid this by capping the first mortgage at 80% LTV, and arranging a second mortgage, with a lender not regulated by the Bank Act, for the difference. A second mortgage comes at higher rates and different terms than the first mortgage. That begs the question, is it more advantageous to get one insured loan, or two uninsured loans?
To begin to answer that question, please refer to my spreadsheet below:
There are three key metrics to take away from the numbers. The first is equity as measured by LTV. The borrower starts and ends with more equity going the 2nd mortgage route (Start: Financed at 83% LTV vs. 85.32% LTV…YR5: Financed at 71% LTV vs. 72% LTV). The difference is the added cost of the insurance ($17,430) plus the interest paid on it. The second metric worth noting is the interest cost. Over the five years the insured loan costs $6,864 less ($86,270 – $79,406). Finally, the always important, cash-flow. This one’s almost a draw with the insured loan slightly less at $2,928/month vs. $2,962/month.
In our example (CASE 1), we used 83% LTV. This is a good benchmark to show how the second mortgage strategy could work. But with a higher interest cost every year, and the equity gap/advantage narrowing quickly, for the second mortgage strategy to work, a much more aggressive amortization is necessary. CASE 2, is a better example of the approach to take wherein the second mortgage is retired in five years, a significant equity gap (financed at 68% LTV vs. 72% LTV) after five years , the interest cost is much closer ($81,140 vs. $79,406), and cash-flow is only $303/month more under the second mortgage scenario . It goes without saying the sooner you can pay off the second mortgage the better.
One caveat to consider is any additional costs that may come with arranging your second mortgage. Today, this mortgage space is almost the exclusive domain of private lenders. Broker fees, and lender fees will occur. You can subtract this amount from the equity gap to base your final decision.
If I can help, let me know.