The process of obtaining a loan secured by property can be overwhelming, and it’s no surprise that many people get confused about the different types of mortgages available. Three common terms that often get mixed up are caveat, first mortgage and second mortgage. In this article, we’ll explore the differences between these types of mortgages and dispel some common myths.
A caveat is a legal encumbrance that can be placed on a property’s title to prevent any further dealings with it until a specific issue is resolved. A caveat can be lodged by anyone who has a claim on the property, such as a creditor who is owed money by the property owner or someone who is disputing ownership. Once a caveat has been lodged, it prevents the property owner from selling or refinancing the property until the issue has been resolved.
The word “caveat” can be traced back to the Latin phrase “caveat emptor,” which means “let the buyer beware.” A caveat is not a mortgage (we will explain what that is below) nor does it grant any interest in the property. It is simply a legal notice that there is a dispute or claim on the property. In Australia however, it’s become somewhat common for a “caveat loan” to be used as a short-term solution to obtain a business loan, cash flow, a bridging loan or quick funds for any purpose. It’s usually found in circumstances when there are already existing charges, such as a mortgage, or indeed another caveat on the property title.
Advantages are that a caveat does not need consent from any other creditor, does not require the borrower to refinance their existing debts, including what could be a very cheap first mortgage, and in the modern world of PEXA, can be lodged in a matter of minutes. On the flip side, the risk is significantly higher to the lender as their claim would rank behind any other encumbrance on title, they would not have consent of prior secured creditors and may not even have a clear idea of what other creditors are owed. So, caveat loans tend to be very expensive to compensate the risk taken by the lender.
Switching from Latin, the word “mortgage” comes from Old French, and its literal meaning is “dead pledge.” In the early days of property ownership, a “mortgage” referred to a pledge or promise of property that was given to a lender as security for a loan. The property was said to be “dead” because it was forfeited to the lender if the borrower failed to repay the loan.
A property can in theory have unlimited mortgages on title, however each one ranks in priority – meaning that in the event of multiple “mortgagees” needing to recover their loans, the first lender gets paid first, anything left over goes to the second lender and so on until all debts are settled, or alarmingly, the proceeds of the property are exhausted.
A first mortgage is often the primary loan taken out to purchase a property. It is secured against the property, which means that if the borrower defaults on the loan, the lender can take possession of the property and sell it to recover their money. The lender has the first priority claim on the property, hence the term “first mortgage.”
First mortgages almost always have lower interest rates than second mortgages (or caveats), as they are considered less risky for lenders. The interest rate and other terms of a first mortgage will depend on the borrower’s credit score, income, and the size of the deposit.
A second mortgage is a loan taken out on a property that already has a first mortgage. The second mortgage is “subordinated” to the first mortgage, meaning that if the borrower defaults, the lender of the first mortgage gets paid back first, and any money left over goes towards paying off the second mortgage.
Second mortgages have higher interest rates than first mortgages, as they are considered riskier for lenders. They are also typically for smaller amounts than first mortgages and have shorter repayment terms. Second mortgages can be used for a variety of purposes, such as business or commercial loans, debt consolidation, cash out (equity release) or any other purposes. Advantages are usually that the borrower does not have to disturb their first mortgage, which would usually be cheap and offered by a mainstream bank. The main disadvantage of a second mortgage is the need for the second lender to obtain consent from the first mortgagee, including the bank confirming the limit of their debt (ie – their maximum claim). This is a slow process and can often be significantly slower than simply asking the first mortgage lender to provide a discharge of their debt entirely! However, whilst more expensive than a first mortgage, a second mortgage would be cheaper than a caveat loan.
Dispelling Common Myths
Now that we’ve covered the basics of caveat, first mortgage, and second mortgage, let’s dispel some common myths about these types of mortgages.
Myth #1: A caveat is the same as a mortgage.
As we discussed earlier, a caveat is a legal notice that there is a dispute or claim on a property. It is not a mortgage, nor does it grant a vested interest in the property.
Myth #2: A second mortgage is always a bad idea.
While second mortgages have higher interest rates and are considered riskier for lenders, they can be a good option for some borrowers. For example, if a borrower has built up significant equity in their property, a second mortgage can provide access to cash for any purpose so often a handy trick for small businesses wanting to use equity in their home. However, it’s important to carefully consider the terms of the loan and ensure that the borrower can comfortably make the required payments.
Myth #3: A first mortgage is always the best option.
While a first mortgage is often the most common way to finance a property purchase, it’s not always the best option. For example, if a borrower has a low credit score or is self-employed, they may have difficulty qualifying for a first mortgage