Once upon a time, if you had a lot of credit card debt and owned a home, you could get a second mortgage to consolidate and pay off your debt. Interest rates were low and home values were rising. You could borrow against your home equity and pay down your unsecured debt affordably. But interest rates are rising. What’s more, in some areas now, home values are declining. Mortgage rules are becoming stricter which means more people are being turned down for a second mortgage and the cost of borrowing is getting higher.
Enter the 100% consumer proposal. Ted Michalos explains this alternative to refinancing with a very expensive second mortgage.
As more Canadians struggle to qualify for a second mortgage under the new stress test, two things happen: they are denied credit by their traditional lender and so turn to alternative lenders. In other words, they borrow against their homes at a more costly rate. Ted elaborates:
Well so if a bank says no to you, they’re saying that they’re assessing that the risk to lend you money is too great and you’re not going to repay them. That means that you’re going to go to somebody that’s willing to accept more risk, and the only way they accept more risk is if you pay them higher fees.
Those higher fees can mean paying anywhere between 12-29% in interest. That’s a huge expense, when you consider that a first mortgage ranges from only 3-3.5% in interest.
Your primary mortgage lender will often give you a reason as to why you are being denied a second mortgage. It could be because you do not have enough equity to pay off your debt or because they are not convinced your income will be enough to make the payments, even if you have the equity.
Rather than approaching a high cost secondary lender Ted recommends finding out more about an interest-free consumer proposal:
It seems a little counter-intuitive that if you’ve got enough equity in your house that you’d be talking to a licensed insolvency expert, but quite frankly, financially, it may make more sense to file a consumer proposal offering to repay 100% of your debt where there’s no interest charged on that than there is in securing a second mortgage at 15%, 18%, 21%.
Ted outlines the advantages of filing a 100% consumer proposal over an expensive refinance:
Well so the biggest single advantage is it allows you to keep your home. If you can’t get approved for these mortgages or you can’t get approved at a reasonable rate, most people think ‘well I got to sell my house’, maybe you don’t. The consumer proposal allows you to stay in your house, you’re going to pay the money over a period of time. There’s no interest on these debts so unlike a second mortgage that could be a really high interest rate the consumer proposals by law have no interest on them, so you’re paying back the principle of the debt.
What’s more, similar to a mortgage, you only make one payment a month, which allows you to budget and better organize the rest of your finances. Whether or not this is the right option for you will really depend on your specific situation. The important thing is to consider all of your options first before settling for an expensive consolidation loan.
For a more detailed look at the cost difference between an interest-free proposal and a second mortgage, tune in to our podcast or read the complete transcript below.
Resources Mentioned in the Show
FULL TRANSCRIPT – SHOW 192 Second Mortgage or Interest-Free Consumer Proposal?
Doug Hoyes: Many times every day the Hoyes Michalos Helpline at 310-PLAN gets a phone call from someone who owns a home and who also has a lot of unsecured debt. In the past, their solution was to get a second mortgage on their house and use that money to pay off the other debts and that was a great strategy over the last few years. Rising house prices meant people had lots of room to borrow against their home, low interests rates meant mortgages were affordable, but here we are in late spring in 2018 and the world has changed. First, the Bank of Canada has raised interest rates three times in the last year and more interest rate increases are expected. That means mortgages are more expensive than they were a year ago. Second mortgage rules are more strict, it’s harder for many borrowers to qualify for a mortgage than it was a year or two ago; and a more recent change, real estate prices in some areas are lower now than they were when the market was hitting record highs in the spring of 2017.
Many borrowers who had big equity in their home a year ago have less to borrow against now. So what are you supposed to do if you have some equity in your house but you can’t borrow enough to pay off your other debts? One obvious solution is to sell your house but if you have kids and want to stay in the same school district or if your house is modified for your physical needs or if it’s not possible to find an affordable place to rent, what else can you do? What are the options for a homeowner dealing with unsecured debt? That’s the question today on Debt Free in 30 and to help me discuss it, I welcome back to the show a guy who hasn’t been on the show for 10 consecutive episodes. His longest absence since we’ve started doing Debt Free in 30 192 episodes ago, my Hoyes Michalos partner and co-founder, Ted Michalos. Ted, where have you been?
Ted Michalos: Well we’ve been unusually busy this spring and I’m just glad that there are all those other professionals willing to fill in and inform our listening public what they need to know [laughs].
Doug Hoyes: Excellent, excellent, so before we turned on the microphones today you were telling me about a client you met with yesterday and you tell me this story all the time, it was a typical story; so I’m going to repeat what you told me but I’ll change some of the facts because obviously we don’t want to be discussion specific clients here on the show. So, the gist of it was the person you spoke to owned a house and it had equity of about $60,000 and he had unsecured debts of about $50,000 and he was getting behind on his payments and he wanted to know his options. So, let’s start with a couple of easy questions, what is equity and what is unsecured debt?
Ted Michalos: Okay so I’m not sure equity is an easy question but let’s keep it really simple, it’s an imaginary number that people use to say, “This is how much money I’d have left if I sold my house, paid off my mortgage and all the other bills to close the house”, so the reason I say it’s imaginary is until you actually sell the house you don’t know what your equity really is going to be, how much is going to be left at the end of the day, and different lenders calculate this number in different ways. Sometimes they deduct the real estate commission, sometimes they don’t, and sometimes they let you put in legal fees. The important thing to focus on is how much money do you think you would have left at the end of the day if you sold your house;
Doug Hoyes: So it’s simple enough I take what I think I’d sell it for, take off real estate commissions, mortgage, penalties, the mortgage property taxes, whatever else is there. Okay so that’s what my house is worth if I was to sell it. What’s unsecured debt and I guess therefore what’s secured debt?
Ted Michalos: Okay so first everybody understands debt is something that you owe someone else. Unsecured debts are the vast majority of the types of debt that people have: credit cards, lines of credit, payday loans, income taxes, debts that you owe to someone but the individual has no recourse against you if you don’t pay; and it’s a technical term but recourse against you means the only way they can get paid if you stop paying is if they sue you; they take you to court.
Doug Hoyes: Yeah so they have resource what they don’t have is collateral?
Ted Michalos: Yeah, so let’s do a typical example, your house has a mortgage, that is a secured debt. If you don’t pay your mortgage they can take your house; your credit card if you don’t pay then their only choice is to take you to court to try to freeze your bank account, seize your wages or something like that.
Doug Hoyes: Got it, so secured debt is something attached to something, a house being the obvious security on a mortgage.
Ted Michalos: Yeah or a car.
Doug Hoyes: Car loan would be another one.
Ted Michalos: Yeah.
Doug Hoyes: Unsecured debt is everything else, okay so back before interest rates went up and house prices started to fall and before the government made it harder to qualify for a mortgage and we won’t go into all that now, we’ve done shows on that; so this person you talked to yesterday could try to get a second mortgage to repay his unsecured debt. Now you obviously, mentioned that to him-
Ted Michalos: Yeah.
Doug Hoyes: -that would be one of the first options you’d come up with and he told you, “Well you know I tried but I’ve been turned down for a second mortgage, I can’t refinance my first mortgage, so what would be the most common reasons for someone getting turned down on a refinancing or a mortgage application?
Ted Michalos: Well so the most obvious one is there really isn’t as much equity in their house as they thought they had, so insufficient equity; so whomever the lender is they’ve done the math and they’ve decided that, you know what there isn’t enough money left in your house if it were sold for us to be paid-off safely, and that’s what – it’s all about the risk of them not getting repaid. There could be problems with their credit history and odds are if someone’s talking to us that’s a likely possibility; they’ve run into trouble paying their credit cards or lines of credit, maybe they’ve missed some payments on things and so now again they’re assessed as a higher risk, less likely to be able to pay. And the last reason is straightforward too, they just don’t have the income to support the payments, so they’ve got equity in their house, their credit is good but the lender just doesn’t believe they can afford the $800 or $900 a month for that second mortgage.
Doug Hoyes: And that’s an even bigger problem now with the new stress test-
Ted Michalos: Oh it is.
Doug Hoyes: -so – and again we’re not going to get into all the mundane details of it but in simple terms in most cases when you go for a mortgage you have to be able to qualify at an interest rate a couple of points higher than what you’re actually going to be paying, so if the interest rate is 3% then you got to show that you could support the payments even if it was 5%; so – and again I’ve grossly oversimplified that so please don’t send me a whole lot of letters. I’m just trying to illustrate concepts here. So when people get turned down by the bank then the go to, you know, secondary lenders, B-lenders as we like to call them, what’s the problem there?
Ted Michalos: Well so if a bank says no to you they’re saying that they’re assessing that the risk to lend you money is too great and you’re not going to repay them. That means that you’re going to go to somebody that’s willing to accept more risk, and the only way they accept more risk is if you pay them higher fees. That’s the whole basis for interest charges, so a bank right now I think a first mortgage is still 3% or 3.5%, a second mortgage at a bank might be anywhere from 11% to 15%; a secondary lender is going to be 12% to 29% depending on the risk assessment. My simple advice to people is if you need to go to a secondary lender, you need to be looking at other options, and I guess that’s one of the things that we’re going to talk about.
Doug Hoyes: Yeah we will and obviously again we’re just illustrating concepts here, you check with your own bank to see what interest rates are. I mean if you’ve got fantastic credit and a million in equity in your house and $100,000 first mortgage when then the second mortgage will be at prime rates too, it’s-
Ted Michalos: Should be.
Doug Hoyes: It’s not the case that it’s the second mortgage it’s just that in most cases you’re really bumping up against that equity limit, so-. Okay so we’ve spend the first seven and a bit minutes here talking about the background issues, house prices are soft, interest rates are higher, and with the new government rules it’s harder to qualify for an affordable mortgage, but we know that Canadians are carrying more debt than ever before so what’s the solution; and before you answer that question Ted because I know what the answer is, everyone listing to this podcast knows what the answer is because we’ve done 191 episodes of this show and the most common answer we give to debt problems is “File a consumer proposal”, so I know that’s the answer you’re going to give, plus it’s right here in the script here-.
Ted Michalos: [Laughs]
Doug Hoyes: But here’s the-
Ted Michalos: You’re telling people we have a script?
Doug Hoyes: Yeah we have a script. This is all very highly scripted shows that we do here, so here’s the problem, can you file a consumer proposal if you have a lot of equity in your house because as you and I both know the Bankruptcy and Insolvency Act in paragraph 66.11 says that you must be insolvent to be able to file a consumer proposal and it would appear that if you have a house worth $60,000 and debts of $50,000 you are not insolvent because you have more assets than liabilities. You own more than what you owe; so can you – how is it even possible to file a consumer proposal, if that was the answer you were to give me, if you have equity in your house?
Ted Michalos: Well that is the answer I was going to give you
Doug Hoyes: I knew it, I knew it.
Ted Michalos: And the funny thing is a year ago this answer – we were less likely to give it to people because of all of the things we’ve already talked about, but the important thing to focus on now is what does it mean to be an insolvent person? The Bankruptcy and Insolvency Act has three criteria and it’s not you have to meet all three it’s either one, two or three, so the first is a person that is unable to meet their obligations that they come to, so you can’t make your payments. The second is someone who has ceased making payments in their ordinary course of business which means it’s not that you can’t make them you stop making them. And the third is that if all of your property were sold at its fair value, there wouldn’t be sufficient money to pay off your debts.
Doug Hoyes: Which is the one I just mentioned assets or-
Ted Michalos: Right, so the example we’ve giving here is most of these people they’ve got equity in their house so they wouldn’t meet the third criteria, if they sold their house they could pay off the debts and everything would be fine, of course they’d have no place to live. The first two criteria though are probably applicable, so if for some reason you’re not able to make your payments or worse you’ve actually stopped making your payments; and often times when anyone’s contacted well either you or myself it’s because they’re at the point now where the payments are really causing serious stress in their life. They can’t make them without making some very big sacrifices and they have very difficult decisions to make. So – but having said all of that it’s pretty easy for someone to meet the definition of an insolvent person and that’s all that’s required for you to be able to consider a consumer proposal as a solution to this situation.
Doug Hoyes: So you are quoting from section 2 of the Bankruptcy and Insolvency Act so it’s like the-
Ted Michalos: The definition section.
Doug Hoyes: -defection section and you’re right it’s either can’t meet my obligations as they become due, I have ceased them, or my liabilities are larger than my assets; so in this case you’re right it’s the ‘or’ not the ‘and’, so the key is to be insolvent does not just mean that what you owe is more than what you own it also means that you can’t meet your ordinary debt payment. So let’s go back to this guy from yesterday, he has a house equity of $60,000, unsecured debts are $50,000, so what proposal did you recommend that he consider?
Ted Michalos: Well so we know that in a bankruptcy his creditors would get paid that $50,000 from our estimated equity which means he needs to offer a proposal to pay at least $50,000 to his creditors, that works out to $835 a month over 60 months. The comparison you make to that is if he owes $60,000 to his creditors, sorry $50,000 to his creditors and he’s just making the minimum payments those are probably running him $1,200 to $1,400 a month-
Doug Hoyes: And it could be higher than that right.
Ted Michalos: And that’s just using an average interest rate of somewhere around 15% if he’s got payday loans and-
Doug Hoyes: [Laughs] Let’s not talk there, no, no, no.
Ted Michalos: -a high interest credit cards, company credit cards as opposed to bank cards that could easily be $1,500, $1,800 or $2,000 a month in minimum payments.
Doug Hoyes: It’s a huge number, so that makes sense but if I’m one of the creditors, so the people this guy owes money to, and we’re owed $50,000 but out of that $50,000 if he does a proposal we know the trustee gets paid because trustees’ compensation is set by the government so every trustee gets paid the same amount but we’re getting some of that $50,000, and of course the government is getting some of that money because they get a piece of the action too for all the great work that they do; so the creditors aren’t getting the full amount so why would the creditors accept a proposal for less than the full amount owed when they know that hey you got a house that’s worth more than that $50,000 that they’re owed?
Ted Michalos: Well so there are a couple of obvious answers, the first is getting paid something, the vast majority of which are owed today is better than the risk of not getting paid down the road or incurring any kind of legal cost to recover that money, so even they’re getting 80c on the dollar because you’re – of all the different fees that get deducted, that still may be a better deal in the eyes of the bank because it settles out the debt; and in addition the bank doesn’t necessarily have to say yes to accepting the $50,000, they could come back and say, you know what because of your situation, you’ve got this extra equity in your house maybe you should be paying us the $50,000 plus the costs of filing, which means instead of paying $50,000 you might pay $55,000, $60,000, $62,000. Each situation is unique so I’m having a hard time quoting what the right answer would be.
Doug Hoyes: Yeah and we’re not going to go into specific details that’s why we want you to give us a call, we’ll sit down and we’ll crunch the numbers; but what you’re saying is the bank may say okay you got a house that’s worth $60,000, if you were to pay us in full plus interest we’d certainly get all that money and more so we’re not going to just settle for the $50,000 that it appears that we’re owed, well we’re willing to settle for the $50,000 but we want that on a net basis after all the fees have been paid; so what’s your experience then, will the banks accept a consumer proposal in the – for 100c on the dollar like we’ve been talking about?
Ted Michalos: Yeah we’ve always done these, there haven’t been a lot of them, so in the 200 or 300 proposals that we file every month there might be one that’s 100c on the dollar because if you think back to other programs one of the condition of a proposal is you offer your creditors at least as much money as they’d get in a bankruptcy, so there are scenarios where there’s sufficient assets once they’re converted into cash that people get paid; so 100c on the dollar proposals are not all that unusual and what we’re suggesting today is just because of the unique real estate market that we’re in values have gone down, it’s harder to qualify for a new mortgage now and interest rates are going up. So as – I mean when we started discussing this a few weeks ago intuitively it didn’t make a lot of sense but the further we looked into it and we started doing the numbers and the math, it actually is better for a significant number of people than going out and getting a high interest second mortgage.
Doug Hoyes: Yeah and if I’m the bank, you know, I’m the credit cards or whatever and you come to me and you say, “Well okay I got a house where on paper the equity is $60,000”, and of course that’s on paper, like you said at the start until the house is sold you don’t know exactly what it’s – what we’re going to get for it. If the bank says no to the proposal and the person ends up going bankrupt then it’s quite possible it’s your house now Ted, you’re selling it and could potentially be getting a lot less. So okay people are listening to us now and they’ve got a lot of unsecured debt or they know someone who does and they’re trying to decide if they should try to get a debt consolidation loan or a secured mortgage or a second mortgage or a HELOC; so what’s your advice, walk us through the thought process here?
Ted Michalos: Right well so first and foremost if you have a good payment history with your mortgage company, you should ask your – whosever holding the first mortgage on your house or the secured line of credit, “Is there room to increase my balance, can I refinance in a reasonable way?” The reason you talk to them first is you got a history and relationship with them and likely if they’re going to approve you the cost will be lower. If they will not approve you they’ll probably tell you why, so if the specific concern is your income is too low or there really isn’t as much as equity as you think you had or you’ve just – you’ve got more debt than they’re prepared to deal with, that answer will let you know what your second step should be, so if they tell you your income isn’t high enough and you can’t afford the payments, then looking to a secondary lender probably will not be a useful exercise. If they tell you that you don’t have as much equity as you thought you had, well then again looking to a secondary lender is not going to get you where you want to go.
Doug Hoyes: And before you go on there is there any downside to doing that, so it makes perfect sense ‘okay I should see if I can refinance’, is there a downside to doing that or is that kind of an obvious first step?
Ted Michalos: Well if the lender makes you actually fill out a new credit application there could be hit on your credit report. If they do something informal with you, you’re sitting in the bank manager’s office and you’re talking to them, if they’re decent human beings they won’t do a hard hit on your credit report so this is just an informal conversation. At some point you’re going to have to fill out paperwork but hopefully if you’ve got a good relationship with your mortgage company they’ll do something informal to give you a higher probability that you’re going to get approved before you actually do any of that.
Doug Hoyes: Yeah and you hope that whether you’re talking to a bank or whether you’re talking to a mortgage broker, and in each of our offices we’ve got mortgage professionals that we deal with, we’re not related to them in any way, but we have people who have helped our clients in the past and in a lot of cases they can look at your situation and in five minutes they can go, “Okay look I know what your house is roughly worth. I know what your debt situation is so there’s no way I can place this mortgage”, or, “Yes there’s a really good chance”; so I think you want to get a bit of comfort before, as you say, you go filling out all the paperwork and-
Ted Michalos: And you want to get comfort as to the interest rate, so most mortgage brokers will tell you that, “Yes I can find you money”, the question, is how expensive is it going to be? A fellah that I deal with on an ongoing basis had told me now that he’s having a very difficult time getting people new firsts because of the new rules, so he’s looking at secondary financing for more people, and I mean more than half of those secondary financings are at rates of 15% or higher which – I mean if you compare it to a 3% first mortgage it’s just insane.
Doug Hoyes: Yeah it’s ridiculous, so you want to have some idea of what you’re getting yourself into first before walking down that path, so-. Okay so someone’s got a bunch of debt, your advice is as a starting point see if you can refinance, there is some equity there obviously that’s what we’re talking about; but if either you don’t qualify or if the rate on the requalification is going to be too high that it doesn’t makes then what’s next in the [unintelligible 00:18:38]?
Ted Michalos: Well then so the revelation we’ve come across very recently was you actually should be talking to somebody like you or myself. It seems a little counterintuitive that if you’ve got enough equity in your house that’s you’d be talking to a licensed insolvency expert but quite frankly financially it may make more sense to file a consumer proposal offering to repay 100% of your debt where there’s no interest charged on that than there is in securing a second mortgage at 15%, 18%, 21%; it just may make financial sense.
Doug Hoyes: So what are the advantages then of doing the proposal over the bank – over the refinance? I mean we can see what the advantages of the refinancing are, obviously I keep my house, my credit rating still looks good I guess, I mean depending on what the rates are and everything but let’s assume that you qualify and it’s still good, I’ve still got that one monthly payment now or maybe two monthly payments if I got a first and second mortgage; so I can see the advantages of doing the refinancing, what are the advantages of doing the consumer proposal?
Ted Michalos: Well so the biggest single advantage is it allows you to keep your home. If you can’t get approved for these mortgages or you can’t get approved at a reasonable rate, most people think ‘well I got to sell my house’, maybe you don’t. The consumer proposal allows you to stay in your house, you’re going to pay the money over a period of time. There’s no interest on these debts so unlike a second mortgage that could be a really high interest rate the consumer proposals by law have no interest on them, so you’re paying back the principle of the debt, the amount that you owe not the amount that you owe plus interest. Just like a mortgage or a second mortgage it provides you with one manageable monthly payment, so you’re not worried about paying four or five credit cards and the government and a line of credit, you’ve just got one monthly payment which you can do weekly, bi-weekly or whatever to the trustee which makes budgeting simpler.
And they’re almost always going to be more affordable, so that single monthly payment is going to be more manageable than the minimum monthly payments on all of your unsecured debts. That’s the example I gave you earlier, the client that we were talking about the fellah’s payment was going to be $835 a month and his minimum payments before were easily $1,300, $1,400, $1,500 a month. That’s $600 that he’s saving every month makes a difference, it lets him keep his house, lets him maintain his quality of life.
Doug Hoyes: Yeah it’s huge and the numbers are really big, so – so okay so the answer is then if you’re in that situation where you’ve got a bunch of unsecured debts and you own a home then what you’re saying is give us a call?
Ted Michalos: Yeah and I know it doesn’t sound like it’s sensible and people are sometimes afraid to call a licensed insolvency trustee but you want to look at all your options and quite frankly based on the analysis we’ve done recently right now it actually makes sense to come and consider filing a consumer proposal for 100% of your debt as opposed to going out and getting a second mortgage at high interest rate.
Doug Hoyes: Yeah in a lot of cases, and again we’re not saying that’s going to be perfect for you, we’re saying, ‘well consider all your options and we can help you find the one’.
Ted Michalos: Right.
Doug Hoyes: Excellent, Ted thanks very much for being here. That’s some very good practical advice and I think that’s a great place to end the show. So here’s the summary, if you have a lot of debt and you own a house you can sell it and use the money to pay off your debts, it makes sense; if you want to keep your home you can apply for a debt consolidation loan secured by your house, that could be a new first mortgage or a second mortgage or a HELOC which is a line of credit secured by your home, but with interest rates going up and tighter mortgage rules that may not be possible so to keep your home, you should consider as one of your options, a consumer proposal. If you have a lot of equity in your house you may need to offer the creditors the full amount you owe but that’s, as Ted just said, a lot cheaper than what you’re paying now on your minimum payments in a lot of cases and you get to keep your house and there’s no more interest on those debts.
A consumer proposal is not the right solution for everyone but to find out if it’s the right solution for you talk to a licensed insolvency trustee, the only professionals licensed by the federal government to do consumer proposals. That’s our show for today, a full transcript and links to everything we discussed on today’s show including links to how you can file a consumer proposal when you own a home can be found at Hoyes.com, that’s h-o-y-e-s.com. Thanks for listening, until next week I’m Doug Hoyes here with Ted Michalos and that was Debt Free in 30.