Alternative Lending vs. Traditional Lending Guide
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Alternative lending has grown in popularity over the past few years, allowing a wider demographic of borrowers to access loans to finance their purchase of a new home, refinance to access equity to consolidate debt, or use funds for other purposes, such as for renovations or education.
Indeed, alternative lending has many positives and provides more opportunities to obtain funding for many borrowers, especially in this higher interest rate economy where banks are also tightening up on who can receive mortgage approvals. But there are risks that go along with its advantages.
In this blog, you’ll learn everything you need to know about alternative lending when it comes to mortgage loans vs. traditional lending, including the pros and cons of each and how to choose the right alternative lender.
Discover Your Mortgage Options
What is Alternative Lending?
Alternative lending is defined as the process of borrowing funds from lenders other than your traditional big banks, though it may surprise you to learn that some banks do participate in alternative lending. Just as the term suggests, alternative lending looks at lending differently than what is required for a traditional loan or mortgage. When it comes to mortgages, funding can come from five different sources:
- Credit Unions
- Trust Companies
- Mortgage Investment Companies (MICs)
- Individual Lenders, such as friends or neighbours
The majority of alternative lending products are found in the last three sources.
These alternative products allow borrowers who do not meet the bank’s strict traditional lending criteria to access their mortgage from other lenders. There are many of these lenders across Canada, and a mortgage broker is the gateway connection to these sources, helping you sift through your options.
Alternative lending has had explosive growth in volume and popularity over the years because it offers flexibility and easier access to funds for certain borrowers when compared to the rigid traditional lending set out by banks and mortgage insurers. According to a recent CMHC Residential Mortgage Industry Report, “Mortgage lending growth by alternative lenders outpaces conventional lenders.”
Traditional Mortgage Lending
Types of Traditional Lenders
When we talk about traditional lenders, we’re talking about your typical brick-and-mortar bank. In Canada, this includes the big six banks: TD, Scotiabank, RBC, CIBC, BMO, and National Bank. In fact, according to the same CMHC report, the big six banks held 72.5% of all mortgages in Canada as of 2022.
Did You Know? The big six banks work, directly or indirectly, with the mortgage broker community. This means you can access and consider products from more than one bank just by working with a mortgage broker!
The Traditional Lending Process
The traditional mortgage lending process typically involves a borrower applying for a loan at a bank and obtaining approval. The first step is to apply for pre-approval for a mortgage. This helps borrowers get an idea of how much they can afford to borrow and determine their budget while also showing sellers the borrower is a serious buyer. But remember: pre-approval involves an unverified review of a borrower’s finances and is not a guarantee of final approval.
From there, the borrower can begin their home search. Should they find a home and
put in an offer, it will be subject to mortgage approval. If the seller accepts the offer, the borrower must submit a complete mortgage application.
The lender will then assess the full application, the borrower’s credit history, the property itself and its value to determine the final loan amount and terms. Once the appraisal is completed, the lender will provide the final loan approval.
Pros and Cons of Traditional Lending
Obtaining your mortgage through a traditional lender like a large bank means you may be able to access special promotions. Banks will sometimes offer benefits and discounts to existing customers who decide to combine services. For example, borrowers might be able to receive better rate terms if they opt for another bank-offered product, like opening a specific kind of account or applying for a credit card.
Other pros of working with a traditional lender include the following:
- Possibility of lower rates since banks work primarily with low-risk borrowers
- Being able to access a brick-and-mortar bank location to do business face to face
- The convenience of having all your banking in one place
- Peace of mind knowing you are working with a well-known, federally regulated institution
While having the safety net of federal regulation behind banks is seen as a benefit to many borrowers, it also means having to deal with strict lending standards since banks must adhere to compliance and reporting laws.
Cons for working with traditional lenders include:
- Longer mortgage process, approval and closing times
- Strict lending standards mean some borrowers won’t qualify
- Less loan product and/or rate options
- More fees due to additional compliance requirements
- Dealing with cross-selling attempts
Types of Alternative Lenders for Mortgages
Alternative lenders are defined as financial institutions that provide mortgages and
other loan products using alternative methods to approve the loan rather than the traditional lending guidelines. These products are typically for mortgages of 80% or less of the value of the property. Being below this benchmark means that “High Ratio Mortgage Insurance” (from CMHC, Sagen and Canada Guaranty) is not required by law.
Did You Know? Contrary to popular belief, many of these alternative lenders actually do hold a Banking license! In fact, all five sources of lending are regulated by the government (Federal or Provincial). Knowing this can give Canadians confidence in exploring their options to find the most suitable financing for their situation.
Alternative lenders can include some banks, local credit unions, mortgage finance companies, trusts and insurance companies. Some are federally regulated, while others are provincially regulated.
Alternative lenders have the benefit of offering loans to borrowers who don’t qualify with traditional lenders like banks and often have a faster, more streamlined approval process. But there are risks to be considered. For example, non-bank lenders often come with higher interest rates than borrowers would see at a traditional bank.
Mortgage Investment Corporation (MICs)
There has been fast growth in this market especially, as they have always been a lending partner in the industry. But after 2016’s “Stress-Test” rule changes, MICs needed to be more specific on what type of mortgages they wanted to fund. Having access to fewer funds than a bank, they had to be clear on their ideal borrower profile. It had to be more than just equity lending for those with softer credit, they now had to specialize. Today there are lenders in this space that focus on rural properties, working farms, 1St mortgages, 2rid mortgages, and specific regions (sometimes a specific urban area, sometimes province by province), some even offer home equity lines of credit.
In general, MIC lenders specialize in providing loans to borrowers based heavily on equity in the property and have very little to no concern about credit scores, proof of income, unsecured credit owing, etc. They have a very streamlined and quick approval process. They will either fund the mortgage or not and if you need these types of funds, a quick “no” is appreciated as time is usually of the essence.
True private lending is when individuals use their personal funds to lend in a mortgage. These funds are from their savings, but not just in the form of cash. Many use their registered funds or leverage lines of credit to invest in this space.
Did You Know? Private lenders can use cash or lend through a “self-directed” account (such as a TFSA, RRSP, LRSP, RESP, LIRA, etc.) to fund a private mortgage. In some cases, you can even lend yourself a mortgage from your own registered accounts!
Private lenders offer the greatest flexibility in mortgages. It is a one-on-one agreement that can be tailored to your mortgage needs with a lender. Typically, private mortgages are in second place to balance out the risks, but some lenders will fund in first position. If first mortgage funding is required, MICs are usually a better fit.
Private lending is not a new thing, but it has grown in popularity along with other sources of alternative lending. In Canada, private lending is legal, and although it bypasses the traditional banking system, it is still regulated by provincial financial regulators and/or security commissions (FSRA and OSC in Ontario). Though, that doesn’t mean it’s without its risks.
The Advantages of Alternative Lending for Mortgages
Speed and Efficiency
Alternative lenders often leverage technology to make the loan application and approval process easier and more convenient. That means borrowers will be able to obtain loans faster and easier, which can be a plus in a competitive housing market where homes sell fast.
Flexibility and Customization
Alternative lenders often offer more flexibility and customization when it comes to loan terms than what you’d get at a traditional bank, meaning borrowers can obtain a loan option with terms that may fit their individual needs better.
More Accessible and Less Strict Qualification Requirements
Because alternative lenders don’t have the strict regulation and reporting requirements as the big banks do, they can often set their own underwriting terms, meaning they can offer loans to borrowers who wouldn’t qualify for a traditional lender’s loan requirements. While institutional lenders in this area must follow federal guidelines, they do have flexibility in areas of income/credit profile.
The Risks of Alternative Lending for Mortgages
Higher Interest Rates
While borrowers who have been overlooked by traditional lenders like banks have better access to mortgage loans via alternative lenders, they may do so at a higher interest rate. This is because alternative lenders need to offset the risks that come with taking on higher-risk borrowers and a lack of government backing and regulation that makes default a bigger possibility.
Alternative lenders may also have a different cost structure that requires more funds dedicated to technology, marketing and customer acquisition overall that requires higher interest rates to offset costs and maintain profits.
Because alternative lending has more flexibility and options, the borrower must be attentive to the terms and conditions being offered since they are different than a traditional mortgage. Some things to consider:
- What is the total cost of borrowing?
- Are the payments “interest only” (which means no principal is being paid and there is no amortization)?
- Are there other fees?
- What is the term (can usually be one to three-year terms)?
- What is the exit strategy to get back to traditional lending?
- If none, what are the conditions and costs of renewing at maturity?
These and other questions must be answered before engaging an alternative lender. Luckily, there’s help! A good mortgage broker will make sure you understand all the terms and conditions before deciding to proceed.
Probably one of the biggest risks for alternative lenders is the fact that they are not insured by the three mortgage insurers. This insurance protects the lender, not the borrower, but when used, it does require a “second set of eyes” to review.
But how are these alternative options regulated? This is ongoing work with provincial regulators. Province by province, regulators are starting to require higher licensing requirements, and in Ontario, a new level of licensing is required starting April 1, 2023, for those brokers and agents working with clients that require alternative financing options. So, make sure you ask your broker if they are properly licensed.
How to Choose the Right Alternative Lender for Your Mortgage
With tougher mortgage rules and rising interest rates making qualifying for a mortgage more difficult, many borrowers are turning to alternative lending. The recent CMHC Residential Mortgage Industry Report noted that “tight mortgage rules coupled with rapidly increasing interest rates are making it even harder for mortgage borrowers to obtain a loan from conventional lenders.”
With more options on the table for obtaining a mortgage, there are a few things you’ll want to consider when selecting an alternative lender.
Consider Their Requirements
When applying for a mortgage through an alternative lender, you’ll want to consider what they’ll require to assess your application and grant approval. If they require documentation related to your credit score, employment history, income, collateral, debts, etc., ensure these are documents you can provide. You ultimately want to select a lender that has an application assessment process you feel is fair.
Check Lender Reputation and Credibility
This is probably the most important consideration when looking for the right alternative lender. You want to do as much research as possible into a lender’s reputation and history. Check for positive reviews online and good feedback from any organizations or regulatory bodies.
You want to ensure your lender has a solid history of responsible lending practices and provides excellent customer service. You also want to make sure they have transparent data protection policies and strong security protocols in place that protect all your information and financial data.
Compare Loan Terms and Interest Rates
Comparing loan terms and interest rates will definitely be a deciding factor when selecting the right alternative lender for your situation. See how the offered interest rates fit your budget and if the loan terms are appropriate for your needs and financial goals. This includes assessing the length of the loan, repayment options, and any penalties and fees.
Find the right mortgage for you with the help of the best brokers in the business.
When it comes to alternative lending vs. traditional lending, the ultimate goal is to find the best mortgage for your financial needs. Discover all your mortgage options and let The Mortgage Station’s experienced team of brokers do the heavy lifting by contacting us today. Even if you have bad credit, we can help you get approved!