Due Diligence: Private LendingBy sedoo
Private mortgages are defined by the Law Society of Ontario as mortgages in which the lender “is not a Schedule I or II bank, registered loan or trust company, a licensed insurer or a subsidiary of any of them; pension fund or any other entity that lends money in the ordinary course of business”. As it becomes more difficult to qualify for traditional mortgages, many home owners are looking towards private mortgages as a short-term solution to their lack of financing options.
The most common characteristic amongst private mortgage borrowers is that while they may have accumulated debt and possess low credit scores, they have a good amount of equity in their homes. Such characteristics will diminish their chances of passing a traditional mortgage stress test, notwithstanding that there is enough equity in the home to support secured financing.
While private mortgages can take any position on title, they are frequently registered subsequent to an existing first mortgage. The home owner may wish to utilize the remaining equity in their home; consolidate debt; or stop a power of sale. Private mortgages which take second priority on title can expose the lender to unique risks which are not faced by lenders in first position. For this reason, private lenders must not rush into a transaction, and should conduct proper due diligence with the assistance of their lawyer.
An often overlooked aspect of due diligence relating to a private mortgage transaction lies in understanding the borrower’s exit plan. Since private mortgages are frequently short-term, interest-only loans in which the borrower must pay back the principal upon maturity, the lender must be apprised of how the borrower intends to pay it back. Are they planning to sell the property by the end of the term and pay the mortgage out? Will they be refinancing with a traditional lender? Understanding the borrower’s exit strategy can provide an indication of whether they are likely to default on paying back the loan at the end of the term.
The terms of prior ranking mortgages must be thoroughly investigated. It is not sufficient to check whether the mortgage is in good standing – it should be determined whether the terms allow the first lender to re-advance funds to the borrower, such that the equity in the home as contemplated by the second lender is further diminished. If this is the case, the second lender must provide notice to the first lender of the registration of the second mortgage, and advise that any further amount advanced under the first mortgage will rank in subsequent priority. This type of notice is not full-proof, therefore second mortgage lenders are advised to explore the option of purchasing a second mortgage priority endorsement as part of their title insurance policy. This endorsement provides protection to the second lender should the above mentioned scenario take place.
Private lenders must also be wary of any tax amounts owed by the borrower to the Canada Revenue Agency. The CRA has the power to register a “super priority lien” on title to the property of the tax payer who is in arrears. This type of lien takes priority over any security interest of a secured creditor. This means that if you are a lender who has a second ranking mortgage on title, you are now ranking behind not only the first lender, but also the interest of the CRA. This creates a precarious situation for the second lender and puts them at a higher risk of not having their loan repaid. Fortunately, title insurance companies are now providing an endorsement to protect lenders from super priority liens. This option is worth discussing with your lawyer.
While the risk of a borrower defaulting on a loan is always present, this risk can be reduced by performing proper due diligence with the assistance of your lawyer, and exploring the protections available to lenders through title insurance.
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|Reem Haroon is an Associate Lawyer at Kormans LLP. Her practice areas include Real Estate Law, Corporate Law and Wills/Estates Law. You can reach Reem at email@example.com.
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