Today, we're going to dive into a topic many people are facing – using a second property as collateral for a bank loan. How risky is it, how long does the property have to be tied up, and how do you even explain the whole situation to someone willing to let you use their property? Let's get into it.
In a previous article, I covered how to finance the entire purchase price of a property with a mortgage, even without your own funds. And the most common solution is exactly this: offering the bank a second property as security in addition to the one you're buying. This provides the bank with a higher total collateral value, allowing you to finance 100% of the purchase and sometimes even a bit extra for things like furniture or other equipment.
But as soon as you bring up this topic, a ton of questions pop up. People want to know if it's worth it, and they also need answers for the person who might be providing their property as collateral – usually parents or other relatives. So, let's walk through the most frequently asked questions.
What Value Does the Collateral Property Need to Have?
The answer is actually pretty simple. It needs to cover the amount you're short on or don't want to pay out of your own pocket. Let me show you with an example.
Imagine you want to buy a property for 10 million crowns and you don't want to put a single penny of your own money down. This means that the 10 million loan must make up no more than 80% of the total collateral value (known as LTV – loan to value).
The calculation is simple: take 10 million, divide it by 0.8, and you get 12.5 million crowns. This is the minimum combined value of all properties that will be used as collateral.
Now, let's assume the property you're buying is appraised at 10 million (it's not a guarantee, but it's likely). That means 10 million of the required 12.5 million is already covered, and you just need to find the remaining 2.5 million. And that's the minimum value of the second property you need to offer the bank. So, if your parents have an apartment worth 2.5 million or more, you're good to go, and it will allow you to finance the ten-million-crown apartment with no money down.
If you're under 36 or if the bank grants an exception, you might be able to go up to a 90% LTV. This changes things, because then you'd calculate 10 million divided by 0.9, which comes out to a little over 11 million. In that case, a second property worth just over 1 million crowns would be sufficient.
You can use the same calculation for other scenarios. For example, if you want to finance 9.5 million and have 500,000 of your own funds – you just take 9.5 million, divide it by 0.8, and you'll see what the total required collateral value is.
What Restrictions Does This Place on the Parents (or Whoever Owns the Property)?
The property is simply a guarantee that you'll repay the loan. If you were to stop paying your mortgage, the bank would first try to settle the debt by selling your property, but it's important to know that legally, there is no difference between the two properties held as collateral.
I know, that sounds pretty scary, but this is truly a worst-case scenario where the bank would step in to sell a property on your behalf. It happens very rarely. Before it ever gets to that point, the bank will offer options like payment deferrals, temporarily lower payments, a modified payment schedule, and finally, the chance to sell the property yourself to avoid foreclosure or an auction. Banks don't want to repossess properties, and trust me, you don't want to let it get that far.
If you ever think you might have trouble making payments, it's always best to act early. And if you have a solid financial cushion, you can avoid this scenario even if you experience a loss of income.
What Other Restrictions Does a Lien Imply?
- The property cannot be sold unless a portion of the mortgage is paid down, so the remaining loan balance is fully covered by the value of the property that will remain as collateral.
- If you want to undertake major renovations or construction, you must notify the bank. This is because if someone guts the property down to the studs and then runs out of money, the collateral value temporarily drops, which the bank wants to avoid.
How Long Will the Second Property Have to Be Used as Collateral?
Here's the good news. It's extremely unlikely that it will be held as collateral for the entire mortgage term. Usually, it's for about five years at most, and often even less. Why? Two factors work in your favor:
- You're paying down the mortgage, which reduces your outstanding debt.
- Property values tend to rise over time, which increases their collateral value.
Combined, these factors mean you can sometimes "release" the second property from the lien after just a couple of years. The process is pretty straightforward. You ask the bank to reappraise the property that will remain as collateral (the one you bought). If, after two or three years, the bank appraises its value at the 12.5 million from our example, the second property is no longer needed as collateral, and the bank will be willing to release its lien on it.
What If Your Parents Change Their Minds?
This happens sometimes, and there's often a quick fix. What you can do is take out an unsecured loan (for example, from a building society), make a lump-sum payment on your mortgage to reduce the principal, and bring your LTV into a range where only your primary property is needed as collateral.
Of course, this will increase your monthly payments, as an unsecured loan typically has a shorter term and a higher interest rate. It's not the ideal solution, but if your parents have had a change of heart or need to sell their property, it's a viable option. And you can do this even just a few months after your mortgage has been disbursed.
