A question so easy to answer but without adequately assessing your needs as a consumer, you might end up with the wrong product. Paying a lot more than you should. After reading this article, you’ll be able to identify what a mortgage is, what kind of mortgage is right for you and what that mortgage represents in real dollar terms.
What is a mortgage?
Mortgages are contracts that borrowers have with lenders, with property being the eggs that keep the cake together. There’s a pool of lenders willing to lend out money (Banks, Credit Unions, financial backers of Mortgage Brokers) and a pool of borrowers (Commercial or Residential clients) ready to accept money at differing interest rates. Interest rates are the cost of taking on a mortgage and are measured as a yearly percentage year cost. They come in all shapes and varieties but mainly in Canada, you can purchase a mortgage with fixed or variable interest rates.
Both have their pros & cons and are summarized in the table below:
|Value over term length||Interest rate is fixed||Interest rate is variable (relative to overnight rate)|
|If economy outperforms…||Fixed could be cheaper||Variable could be more expensive|
|If economy underperforms…||Fixed could be more expensive||Variable could be cheaper|
|At onset of mortgage…||Fixed is more expensive||Variable is cheaper|
Between 2000 and 2009, the Bank of Canada Bank Rate varied from 0.5% to 6.00%. If a bank was charging the prime rate + 2% then under a variable mortgage, at best, someone with a mortgage would be paying 2.5% interest and at worst, 8% interest over that 9 year period. You run into problems with a variable mortgage when you think you’re going to be paying 2.5% for the entire term and the overnight rate ends up going up by a percent or two, consequently increasing your monthly payments unexpectantly.
Where do interest rates come from?
Since interest rates are the cost of the product of money. Commercial banks, in particular, base their rates off of the rate set by the Bank of Canada. This rate is often termed the overnight rate and you can now actually see that rate displayed on many Realtor websites. But based off this rate, the commercial banks (the largest player in the mortgage market) set their variable and fixed interest rates. It is important to remember that mortgages are typically offered in 1-5 year terms. Term length and amortization length are not the same and should not be confused. That rate is set by the Bank of Canada and acts as a general indicator for how well the economy is doing. Currently the rate is 0.5%, a historic low and global phenomenon, often cited by individuals as an underlying reason for why there’s a market bubble in the global economy.
What is credit worthiness
What is credit worthiness and why is it important to you? Credit worthiness determines how likely you are to pay back borrowed money and higher credit scores directly translate into lower interest rates when applying for a mortgage. In Canada, creditworthiness (for residential consumers) is determined by you credit score. A general rule of thumb is getting credit scores above 750 means you’ll be getting close to the prime rate offered by the bank.
Tip to younger readers – Something people don’t tell you when you’re younger is that having a great credit score is a great asset and one all people should have. The earlier you start building your credit score, the better as it usually takes between 3-5 years of borrowing and paying back loans on time to get a great credit score. Many additional factors can affect your credit score including payment history, credit owed, credit history, types of credit & new credit inquiries. Learning how to improve your credit score will be the target of a future article.
Debt Service Ratios
When applying for a mortgage the creditworthiness goes hand in hand with your debt service ratio. The debt service ratio effectively puts a limit on how much you can borrow by seeing how much you can afford based on your current salary & debts you owe (e.g. credit card debt, car payments, line of credit payments, student loans). After looking at your income, the lender will multiply it by a certain percentage and allocate that amount to paying your monthly (debt) bills.
To apply for a higher mortgage make sure that other debts you owe are minimized.
Requirements when applying for a mortgage
Minimum conditions for applying for a mortgage in Canada are as follows:
- Max amortization of 25 years
- Minimum downpayment of 5% (below 20% also requires insurance)
- Minimum credit score of 600
- Selected new loan documentation standards
If one lender is willing to borrow money to you, that does not mean that all will be willing. You are in competition with everyone wanting a mortgage to get the best rate as this will transfer to lower monthly payments. Things you can do to improve your chances of being approved are having a solid credit history, low other debt (e.g. credit card, car loan) & equity. If you don’t have equity, buy a house and start building some.
Note due to a recent legislature change for homes sold for more than 500k, the additional amount over 500k requires a 10% downpayment. What this means is that if I bought a house for 600k, then I’d require 5% of 500k & 10% of the 100k (difference between 500k & 600k).
Why is getting preapproved for a mortgage important
A smart tip to all, is before you go looking for a house, get preapproved for a mortgage. It lets you set a realistic budget for your home purchase and may land you the house of your dreams, since you can disregard a financing condition in your offer of home purchase. Preapprovals can also guarantee the interest rate you’ll pay and other mortgage terms however this is subject to your lender’s discretion. After you find the home of your dreams, the preapproval will be transferred into an official mortgage commitment and can be further explained with your real estate lawyer.
What downpayment is right for me?
5% is the minimum downpayment required when qualifying for a mortgage in Canada. If you have between 5%-20% down, you must pay for insurance on behalf of the lender. I’ll take a minute and explain how a downpayment is different from a deposit. This concept was highlighted in last week’s article but to reiterate it, a deposit is what is required to be paid to the home seller within 24 hours of a offer acceptance. If all goes well, on closing this is accounted for in your downpayment, however if the sale doesn’t go through you are at risk of losing it. I also covered the calculation behind CMHC insurance in this previous article (article link). This insurance can be purchased from either Genworth Financial Canada or the CMHC.
What kind of other conditions can be stipulated in a mortgage?
Open vs Closed
We already talked about the difference between variable and fixed rate mortgages however there also exist open and closed mortgages. If someone underwrites a mortgage and is willing to lend you money, they expect to be paid on schedule and not be overpaid, as overpayment in a mortgage is applied to the principal and can lower the rate of return that the lender receives. In other terms, when you overpay a mortgage payment, the excess goes directly to the principal. When you pay your payment as per normal, a predefined amount goes to the lender (in interest) and the remaining goes to the principal, which is what you have remaining to owe. If you pay in excess the loan amount decreases more than expected and the lender gets less than what he agreed to when initially lending out his money. Mortgages where you can overpay are called open morgages and mortgages where you cannot overpay are called closed mortgages
TL;DR – If you didn’t understand that, just remember mortgages where you can overpay the agreed upon monthly mortgage payment are called open morgages and mortgages where you cannot overpay are called closed mortgages
Payment Terms and Additional Features
In this article (article link), we illustrated the savings that could be made when choosing between bi-weekly and monthly payments. Along with adjusting the payment frequency, additional pricing options are highlighted below:
- Amortization – the length over which the loan is amortized (15-25 years is typical), longer amortization values transfer to lower monthly payments but higher interest paid over the lifetime of the loan
- Double up provisions – option of paying 2x your monthly payment for a month
- Skip payment – normally double up and skip payments can be correlated in a mortgage. E.g. you have the option of skipping a payment and then later on you’d have the option of doubling up in one month
- Lump Sum – Paying a lump sum payment at a set time interval as stipulated in your mortgage
- Frequency – highlighted above but changing how many times you pay a year
Additional Features that might be in you mortgage could include:
- Assumable – buyer may take over mortgage balance
- Portability – taking mortgage value to new residence, if you move
My mortgage is coming up for renewal, what do I do?
Mortgages are sold in 1, 2, 3, 4 or 5 year terms. Since mortgages are amortized over 25 years, it’s very likely you’ll face renewal at least once. If you never renewed your mortgage and successfully paid it off that means you amortized it over 5 years or you had a hell of a lump sum payment.
If you take no action, your mortgage can be renewed with your existing lender. If you take proactive measures you can renegotiate a better rate than the one offered. Another option you can take is shopping around to different people (e.g. local mortgage brokers, credit unions, another bank), and signing on a mortgage with a new lender. This may be subject to fees from your old lender and fees from your new lender however in some cases your new lender may be willing to shoulder some of the cost.
What happens if I’m in Y3 of a 5 year term and interest rates fall
You pay a penalty which would represent the difference between the interest rate charged on your mortgage and the one currently advertised by your bank. There may exist opportunities where the penalty you’d pay is lower than the money you’d save in interest and then it would be advantageous to pay the penalty and get your mortgage renegotiated.
In general, if trying to do anything not already stated in your mortgage, you’ll have to pay some kind of fee in order to do it. Otherwise it’s as simple as paying your monthly payment and eventually having full ownership of your house.
What happens if I stop paying my mortgage
It usually takes 30-50 days past payment, for a lender to take position of your house but if this happens they usually just put it on the market and re-sell the home. This is termed Power of Sale and will be covered in a future article.
Article was written by gtareguy (Greater Toronto area real Estate guy) . I release a new article every Friday and I write about economics, the nba and real estate in the GTA.