Before you decide to make one of your most important life purchases, be sure you understand the ins and outs of carrying a mortgage. Read through our mortgage guide here to understand your options and responsibilities.
When purchasing real estate, most buyers typically finance all or a portion of the property purchase price by borrowing money from a financial institution like a bank or credit union and by using the intended home of purchase as collateral for the loan.
1. The mortgage breakdown
Mortgage payments are made up of two components:
- the principal amount (the amount borrowed)
- the interest amount (the amount charged to the buyer for borrowing the money).
Mortgage lenders typically offer various payment period options such as monthly, bi-weekly, or weekly. Most mortgages are for an amount that does not go over 75% of the appraised value of the property or the purchase price, whichever is lower.
A minimum of 25% of the purchase price is required for the down payment. However, with a high-ratio mortgage you may pay less than 25% of the cost of the home as a down payment.
2. Selecting a lender
There are several types of lenders offering mortgages including banks, mortgage companies, trust companies, and credit unions. Different lenders may offer different prices, so it’s in your best interest to shop around to make sure you get the best rate.
It’s also possible to get a mortgage through a mortgage broker. A broker arranges financial transactions rather than lending money directly, which means they find a lender on your behalf. A mortgage broker’s access to several lenders means a wider selection of loan products and terms from which you can choose.
Although it doesn’t usually take more than a few days to receive a mortgage approval, it’s recommended to get a pre-approval if you’re placing offers on properties or looking to purchase pre-construction. Mortgage approval is almost always a condition of purchasing a house as this condition assures everyone involved that you’re able to pay back the mortgage without defaulting.
3. Qualifying for a mortgage
To get started you’ll provide your financial paperwork to the lender, and the lender will provide approval for a predetermined mortgage amount. Pre-approval agreements are generally for a 60- to 90-day term and the agreement may also guarantee an interest rate for a mortgage taken out during that period.
The mortgage lender will inquire about such things including:
- Your marital status
- Number of dependants
- Current employment
- Salary and other sources of income
- List of assets (e.g. vehicles, cash, etc.)
- Liabilities (e.g. credit card balances, car loans, etc.)
Lenders will also run a credit check to determine your payment history. Before applying for a mortgage, you can use a variety of online mortgage calculators to get an idea of the mortgage amount appropriate for your unique financial situation.
4. Mortgage types
Fixed-term or fixed-rate mortgages are characterized by an interest rate and principal payment that remains unchanged for the duration of the mortgage term. A fixed-term mortgage can help with budgeting and protect you from upward fluctuations in interest rates.
An open mortgage allows you the option to repay the loan at any time without penalty. The availability options are reduced to shorter terms (six months or one year only) and the interest rate is as much as one percent higher than closed mortgages.
Open mortgages are typically favoured by owners planning to sell their home or those who expect to pay off the entire mortgage (e.g. through the sale of another property, an inheritance, etc.).
Closed mortgages provide the security of fixed payments for terms between six months to 10 years. Interest rates on closed mortgages are significantly less than open mortgages and can deliver as much as 20% prepayment of the original principal (more than the majority of what people prepay on a yearly basis).
However, there is a penalty charge for paying off the mortgage before maturity (end of term). This penalty is usually three months interest or the interest rate differential.
Variable Rate Mortgage
The variable rate mortgage provides a lot of flexibility for homeowners and is usually chosen when interest rates are decreasing. The interest rate is calculated by adding a certain percentage to the prime lending rate and is subject to change monthly based on current interest rates.
During the first three months of the mortgage term, a sizable rebate on the rate is given as a welcoming offer. Variable mortgage rates usually remain consistent, but the ratio between principal and interest fluctuates. As interest rates decrease, more of your mortgage payment goes towards paying off the principal balance than interest, and vice versa.
If rates rise substantially, the initial payment may not cover both the interest and the principal. Any portion not paid is still owed, or you may be asked to increase your monthly payment.
Variable rate mortgages are fully adaptable at any time without penalties (for a three-year term or longer) and offer a 20% repayment privilege at any time throughout the year.
Equity mortgages are evaluated based on the equity of the home (market value minus the mortgage amount). You can receive as much as 80% of the purchase price or value of the property.
These are generally offered to applicants that do not meet the normal income and/or credit qualifying mortgage guidelines (i.e. little or no income verification, self-employed, and/or less-than-perfect credit).
Multiple Term Mortgage
This type of mortgage provides both the convenience of the lower rates of a short-term mortgage and the security of a long-term mortgage. Your mortgage can be split in to as many as five parts, all having different terms, rates, and amortization periods—in one convenient monthly payment.
However, you should be aware of any market changes with this mortgage. This type of mortgage is not for everyone, as the amount of time and stress involved is quite high.
Six-Month Convertible Mortgage
When interest rates go down, or you suspect that they will in the near future, a six-month convertible mortgage gives you a temporary commitment at fixed payments, with the bonus ability that while within the term, the mortgage is fully adaptable to a longer-term from one year to 10 years.
When the six-month period is over the mortgage becomes fully open, and it can be renewed with the current lender or moved to another lender. This type of mortgage is offered at most financial institutions, but each lender’s terms are different.
All-Inclusive Mortgage (AIM)
The minimum AIM term is five years and this mortgage takes care of everything for you automatically. For purchases, it includes:
- Solicitor’s legal fees and standard disbursements to close the purchase and mortgage
- Title transfer
- Title insurance from LandCanada for clients
- CMHC application fee or appraisal fee
- 1% cash-back to cover land transfer tax
- Registration of deed and mortgage
For refinances, it includes:
- Legal fees and standard disbursements to prepare and close the mortgage
- Title Insurance from LandCanada
- CMHC application fee or appraisal fee
- 1% cash-back
- Registration of new first mortgage
- Registration of discharge of existing first and second mortgage
Secured Lines of Credit
A secured line of credit allows you to use the equity in your home at rates as low as the prime lending rate in order to purchase investments, renovate your home, buy a car, etc. Up to 75% of the purchase price or value of the home can be arranged.
It’s very easy to access the available credit, with many lenders also providing an issued credit and/or debit card. The money does not have to be drawn until you need it, and you can pay off your balance at any time or make monthly payments. As the balance is paid down, more credit becomes available (revolving credit).
As it is a secured product, the conventional legal and appraisal fees are applicable. Sometimes a lender will offer promotions that cover part or all of these costs. You should be cautioned that although these lines are very flexible and versatile it can be extremely tempting to use it for unnecessary purchases.
5. Mortgage glossary
The costs banks and mortgage companies charge usually include the following:
- Application fee: the money paid by you, the borrower, to the lender for processing mortgage documents
- Insurance: homeowner’s coverage for fire and casualty to the property
- Origination fee: Often a percentage of the loan, this fee is charged by a lender to a borrower on initiation of the loan
- Closing costs: the various expenses outside of the property price that buyers and sellers incur to complete a real estate transaction
- Interest: the cost of borrowing money (based on a percentage of the amount borrowed)
Every lender or broker should be able to give you an estimate of their fees. Many of these fees are negotiable. Some fees are paid when you apply for a loan, and others are paid at closing. In some cases, you can borrow the money needed to pay these fees, but doing so will increase your loan amount and total costs. “No cost” loans are sometimes available, but they usually involve higher rates.
The down payment—the amount of money a buyer needs to pay upfront to secure a home—is one of the most misunderstood concepts in real estate. Most loans are based on a 20% down payment. There are some mortgage options that only require a 5% down payment, and sometimes even less.
If a down payment of less than 20% of the purchase price is made, lenders generally require the buyer to purchase private mortgage insurance (PMI) to protect the lender against any loss incurred to the institution if the buyer fails to make the required mortgage payments.
Be sure to ask about the lender’s requirements for a down payment, including what you need to do to verify that funds for your down payment are available. Make sure to ask if PMI is required for your loan, and also find out what the total cost of the insurance will be.
This refers to the act of paying off the mortgage debt in regular installments over a period of time, e.g. 30 years. If you pay the same monthly amount according to the terms of your agreement, your debt will be paid in the exact number of years outlined.
You may make additional monthly payments that are applied directly to the principal mortgage amount, reducing your mortgage term substantially.
Some loans offer attractive low monthly payments, but in some cases, the low payments don’t cover the interest portion of the loan. In this case, part of the principal amount is deducted, resulting in what lenders call “negative amortization”. Simply put, it means you’re losing equity in your home.
The interest rate is the monthly effective rate paid on borrowed money, and is expressed as a percentage of the sum borrowed. A lower interest rate allows you to borrow more money than a high rate with the same monthly payment.
Interest rates can fluctuate as you shop for a loan, so ask lenders if they offer a rate “lock-in” which guarantees a specific interest rate for a certain period of time.
Remember: a lender must disclose the Annual Percentage Rate (APR) of a loan to you. The APR shows the cost of a mortgage loan by expressing it in terms of a yearly interest rate. It is generally higher than the interest rate because it also includes the cost of points, mortgage and other fees included in the loan.
Note: If interest rates drop significantly, you may want to consider refinancing your mortgage. Most experts agree that if you plan to be in your house for at least 18 months and you can get a rate 2% less than your current one, refinancing is smart. However, refinancing may involve paying many of the same fees paid at the original closing, plus origination and application fees.
Discount points are prepaid interest and allow you to buy down your interest rate.
E.g.: One discount point = 1% of the total loan amount.
Generally, for each point paid on a 30-year mortgage, the interest rate is reduced by 1/8 (or .0125) of a percentage point.
When shopping for loans ask lenders for an interest rate with 0 points and then see how much the rate decreases with each point paid. Compare the monthly difference in payments with the total discount points you are willing to pay, and see how many months you need to stay in the home to recoup your money.
Note: Points are tax-deductible when you purchase a home and you may be able to negotiate for the seller to pay for some of them.
Established by your lender, an escrow account is set up to manage monthly contributions to cover annual charges for homeowner’s insurance, mortgage insurance and property taxes.
The borrower contributes 1/12 of the annual costs monthly so that the lender will have sufficient money to pay for the taxes and insurance. Escrow accounts are a good idea because they assure money will always be available for these payments.
6. Credit score
Credit scores are calculated using a statistical process and provide a guideline for lenders to extend credit (and if so, how much) to a borrower. Mortgage companies, banks, and insurance companies determine the interest rate they will charge based on the borrower’s credit score.
The credit scoring process encompasses both your pay history and the amount of credit you currently have. The credit score is a substantial portion of the entire credit report.
Low credit scores will result in higher payments on loans, credit cards, and insurance.
The credit score is sometimes called the FICO Score, which is an acronym for the creators of the FICO score: Fair Isaac Credit Organization. The following table can give you a general idea of the different score ranges:
Personal credit history
Don’t assume that minor credit problems or difficulties stemming from unique circumstances, such as illness or temporary loss of income, will limit your loan choices to only high-cost lenders. If your credit report contains negative information that is accurate, but there are good reasons for trusting you to repay a loan, be sure to explain your situation to the lender or broker.
If your credit problems cannot be explained, you will probably have to pay more than borrowers who have good credit histories. Ask how your credit history affects the price of your loan and what you would need to do to get a better price.
Lenders now offer several affordable mortgage options, which can help first-time homebuyers overcome obstacles that made purchasing a home difficult in the past. Lenders may now be able to help borrowers who don’t have a lot of money saved for the down payment and closing costs, have no or poor credit history, have quite a bit of long-term debt, or have experienced income irregularities. There are companies that specialize in consumer credit repair.