This analytical brief focuses on the financial paths of Ontario’s mortgage borrowers at the end of their mortgage loan term with an alternative lender. We explore the effectiveness of exit strategies.
Alternative lenders — a growing segment
From 2015 to 2020, alternative lenders held the national ranking of the fastest-growing segment in the Canadian mortgage lending industry. This is because of:
- greater demand in the context of regulatory changes
- rising housing prices
- a low-interest-rate environment
The alternative lender portfolio increased from an estimated $9 billion in 2015 to $15 billion in 2020.
Their growth slowed significantly during the COVID-19 pandemic. This is because alternative lenders reacted to rapidly changing market conditions that led to numerous investors requesting equity redemptions.1
Their steady growth before the pandemic and their unconventional underwriting practices have raised questions regarding their potential to introduce new vulnerabilities into the housing finance system.
This is especially the case in regions where they have reached a larger market share, such as Ontario (figure 1).
One of the potential risks of mortgages secured through an alternative lender is that borrowers are unable to improve their financial situation. These borrowers are then committed to high-interest mortgage loans, resulting in long-term affordability issues.
|Year||Alternative share of mortgage transactions|
What is an exit strategy?
An exit strategy is a plan that is developed and assessed when a loan is originated as part of the underwriting process.
The exit strategy outlines the ability of the borrower to improve their financial situation and exit the alternative lending space at the end of the loan term. A borrower can sell their property as part of their exit strategy, without being delinquent on the loan.
The exit strategy is planned in conjunction with the borrower prior to the origination of the loan, typically as part of the approval process.
A well-defined exit strategy is vital. Some borrowers may face challenges paying higher interest rates on a mortgage loan for an extended period.
For this analytical brief, we consider an exit strategy to be effective if the borrower can contract a mortgage in the conventional lending space or sell their property. They would do these things without being delinquent on the alternative loan (figure 2).2
This indicator is important for monitoring the affordability implications of the alternative lending segment. If the effectiveness of exit strategies decreases, affordability may become a challenge for borrowers in alternative lending space. This is because mortgages secured through alternative lenders are typically more expensive than conventional mortgages.
Alternative mortgage lenders are an alternative to conventional mortgage lending institutions. Having their mortgage application rejected by conventional lenders is the main reason why borrowers use alternative mortgage lenders. Borrowers who tend to leverage alternative mortgage loans include:
- the self-employed
- employees with poor or no credit history
- borrowers with short-term cash needs
Alternative lenders charge significantly higher interest rates than conventional lenders and typically offer interest-only loans.
There is a key underwriting difference between alternative and conventional lenders. For alternative lenders, the approval process is mainly driven by:
- the equity built in the property
- the borrowers’ cash flow in the short term
For conventional lenders, the borrower’s ability to make regular monthly payments until the loan is paid off is the main factor determining the approval process.
Their success relies on having an effective exit strategy that would determine:
- the borrower’s ability to get approved by a conventional lender at the term of the loan
- the ability to sell the property rapidly to repay the loan since long-term repayment to the alternative lender is unlikely to be sustainable for the borrower
- The majority of alternative mortgage borrowers (72%) had an effective exit strategy in place in 2020. These borrowers were able to get a loan with a conventional lender at the term of their alternative loan (64%) or sell their property without defaulting or the property being foreclosed (8.5%). This share has remained stable in 2021.
- Properties with an alternative lender lien represent 80% of foreclosures in Ontario.
- Foreclosures dropped significantly in 2020 (from 63 in 2019 to 23 in 2020) likely due to mortgage relief measures and lockdown measures, which put some activities on hold.
We adapted data from Teranet Inc. for this analysis. The data includes land registry variables matched from the Municipal Property Assessment Corporation of Ontario. This dataset only covers the Province of Ontario.
Alternative mortgage loans had an effective exit strategy in 7 out of 10 loans
In 2020, nearly 32,245 alternative mortgage transactions were closed as borrowers either switched to another lender, or the properties were sold or foreclosed.
Of these, 72% had an effective exit strategy in place (figure 3). Over 23,000 borrowers successfully contracted a mortgage with a conventional lender, gaining access to a longer-term mortgage and lower interest rates.
Others were able to sell their property without being delinquent on the loan. This effective exit strategy indicator had been decreasing in the years leading up to the pandemic.
Between 2006 and 2015, approximately 80% of mortgages had an effective strategy. In 2019, this percentage had fallen to just around 70% (figure 4). From January to November 2021, the indicator remained stable relative to 2020 at 71%.
The decrease in changing to conventional lenders during the last decade is due in part to a series of macroprudential regulations and tighter underwriting standards. This makes it more difficult for borrowers to return to the conventional lending space.
|Year||% switched back to conventional lender||% property sold|
Most of the other 28% of mortgage borrowers remained in the alternative lending space to fund their properties. These borrowers either changed to another alternative lender or renewed with their initial alternative lender.
While we consider this evidence of an ineffective exit strategy, it is important to note that the borrower could return to the conventional lending space if:
- the loan was renewed with the same lender
- the loan was with another alternative lender
Only a very small share of the loans ended in foreclosure.
Foreclosures remain low but higher than for conventional lenders
In the period from 2015 to February 2020, only 0.17% of alternative lender mortgage transactions involved a foreclosure.
During the pandemic (March 2020 to July 2021), the foreclosure rate remained stable (0.08%), representing just 23 properties in Ontario. This, however, does represent a significantly higher foreclosure rate than in the conventional lending space.
Despite accounting for 12% of mortgage transactions, alternative lenders are involved in 65 to 90% of foreclosures each year. This value peaked in 2016 at 88%, due in large part to very few foreclosures occurring in the conventional lending space.
During the pandemic period, this value (71%) remained consistent with the 2017 to 2019 values (74%).
Fewer properties with an alternative mortgage were sold in 2020
During the pandemic, another interesting phenomenon was the decreasing number of properties sold on alternative lenders’ portfolios. This seems to contradict the strong activity in the housing market in Toronto and Ottawa.
Before the pandemic, between 10% and 20% of properties with an alternative mortgage would be sold. However, in 2020, only 8.5% of properties were sold. Possible explanations include:
- property type
- property location
- deferral programs
Support programs, such as mortgage payment deferrals, allowed borrowers to avoid default and, therefore, having to sell their property.
The 2021 data may also be slightly skewed given the lagging in property sales data in the land registry.
Successful exit strategies have decreased since 2011
The success of exit strategies has decreased by 10 percentage points since 2011 and stabilized during the pandemic. This decrease before the pandemic implies that the borrowers served by alternative lenders are remaining in this segment longer than anticipated.
Given the higher interest rates, this may pose long-term affordability issues for these borrowers.