The Pros and Cons of Dealing with Alternative Lending

Since the introduction of the mortgage stress test, the number of borrowers being turned down by the banks has been on the rise.   Undeterred, many borrowers are turning to “alternative” lending options. One listener, who is considering this option, wrote in asking about the pros and cons of borrowing from an “alternative” lender.  Below are the highlights of Mark Ting’s interview with CBC’s “On the Coast” host Gloria Macarenko.

Let’s start with the basics, what are the main differences between a traditional and alternative lender?

A traditional lender is your first choice, typically a bank or Credit Union as they have the best rates and borrowing conditions.

What rate you are offered depends on the alternative lender and your credit worthiness. For example, let’s say you wanted to qualify for a $300,000 mortgage.   At one of the more reputable alternative lenders, you would be offered a rate of 3.99% for a two-year term. Which, at first glance seems reasonable since a bank would be charging around 3%. However the rate is just one part of the equation, you also need to factor in all the setup fees.  After calculating all the fees and interest, I found the “all in” rate you end up paying to be closer to 9%.

So a bank would be offering 3% while an alternative lender is charging three times as much, why is there such a difference?

The customers don’t have too many options. They have been turned by the bank, likely mom and dad as well, so if they want the money, they will have to be okay paying a premium.  That’s what happens when there is a lack of choice. If I want a beer at Disneyland or Roger’s Arena, I know going in that it will be expensive. But what can I do, I want that beer, so I have to pay their price.   Now the difference is that most people can handle buying the occasional $10 beer but can they or should they be okay paying a premium on a mortgage? That’s not always an easy question to answer.

In the end, what was your advice to the listener who wrote in?  I’m guessing you said it wasn’t a good idea.

As a general rule, I don’t recommend dealing with alternative lenders.  For one, if you failed the stress test it is for a reason– you likely can’t afford additional debt.  And just because there are other options out there doesn’t mean that you should pursue them. As Canadians, we are already the most indebted people in the world.

That said, there are plenty of exceptions to this rule, and the listener that wrote in was one of them. It made sense for her to secure the lending, even at an inflated rate.

What about her situation made going to an alternative lender worthwhile?

It came down to what she was planning to do with the money.  If she was treating her home like an ATM to supplement her lifestyle by buying stuff that  she wanted rather than needed, I’d say “take the stress test hint, you failed it so stop spending money.”

However, in her case, she wanted to renovate her home and make it wheelchair accessible so that her mother-in-law could move in.  The loan would be serviced by the mother-in-law who could easily afford the payments as she would no longer be paying rent.

Other situations where an alternative lender can come in handy are for business people in need of short-term financing or someone who needs a temporary loan before qualifying for traditional lending.

So the math worked? Even with them having to pay three times the rate of interest of a traditional lender?

They first tried to get the lending at their Credit Union but were denied.  With the alternate lender, the interest rate is higher but the amount they needed to borrow was less than $30,000, and the loan is expected to be paid in full within two years. Under these circumstances, the higher rate can be justified.

Still, there was a lot to consider, and we didn’t take the decision lightly.  We discussed her situation for some time, and there was a fair amount of research and number crunching involved. As a planner, I wanted to see if I could negate some of the start-up costs by finding some tax savings.  More specifically I wanted to know if they qualified for the “Home Accessibility” or “the Canada Caregiver” tax credits.   In the end, we concluded that, even with the higher rate, borrowing the money still made sense—but barely. If the real interest rate were higher, say 12% or 24% (which some alternate lenders charge), I would have found it harder recommending the deal.

Listen to the full interview here with CBC’s On the Coast. The interview with Mark Ting starts at the 1-hour 27-minute mark.