How do mortgages work?
A mortgage is a loan from a bank or other financial institution to help you purchase a property. When you obtain a mortgage, you are making a promise that the money you have borrowed will be paid back on the terms you have agreed too. Your property is used as collateral meaning if you break the promise, your lender or bank has the right to foreclose on your property. The payments that you make to the lender include interest on the loan plus part of the principal (the total amount of the loan).
Getting pre-approved for a mortgage will help you to understand the responsibilities of homeownership allows you to set a realistic budget. When you get pre-approved you will find out the maximum amount that you can spend on a home, your monthly mortgage payment and what your mortgage rate will be for the first term. If interest rates rise during 120-160 days of your pre-approval, you will be protected by the lender. If interest rates lower, your lender will honour those rates. Getting pre-approved is free and signals to the seller that you are financially capable which could help in a competitive offer situation. Factors that will be considered when you are looking for a pre-approval are credit score, down payment, debt service ratio and supporting documentation. After you are pre-approved, you can use this as a guide to search for properties in your price range.
What is a mortgage interest rate?
There are two types of mortgage rates – fixed (closed) and variable (open). Having a fixed mortgage rate means that the payments you make will stay the same throughout the term of your mortgage. A 5-year fixed rate (5 years being the length of your term before you have to renew the mortgage rate) is the most common in Canada. Although a fixed rate is typically higher, it provides stable consistent mortgage payment for years to come. A variable rate is driven by economic factors and will fluctuate with the market interest rate, also known as ‘prime rate’. If you predict that interest rates will fall, a variable rate is preferred. In 2020, the economy has taken a hit due to COVID-19 and will take years to build. In saying that, choosing a variable rate may be beneficial at this time because it is predicted that banks will not increase their interest rates until the economy begins to grow at a stable pace. When the variable rates inevitably start to raise again, you could remove the additional pre-payment to help make your payment more consistent over time. Keep in mind that if interest rates rise, the value of your property falls or your financial condition changes, you may have a hard time selling your home or making payments with a variable rate.
Choose a term
A mortgage term is the length of time your mortgage will be in effect. Terms typically range from a few months to five years or more. At the end of each term you will have to renew your mortgage. You will most likely require multiple terms to be able to pay off your mortgage in full. When your mortgage is paid off in full you will not have to renew. You are able to choose a short-term mortgage, a long-term mortgage or a convertible term. A short-term mortgage is beneficial if you want to renegotiate your mortgage for a lower interest rate or change lenders without paying extra fees. If you predict that interest rates will go down this is a viable option for you. Although you could potentially benefit if interest rates go down, you also have to keep in mind that if interest rates go up, you will have to renegotiate your mortgage at a higher interest rate. A long-term mortgage is a locked in interest rate for a longer period of time. Long-term mortgages are good for budgeting because you will know exactly how much you are paying, and you will not have to pay a prepayment penalty. If your term is longer than 5 years you may have to pay a low prepayment penalty if you want to make changes to your mortgage contract. A convertible mortgage means that your short-term mortgage can be changed to a long-term mortgage. The lender will change the interest rate based on what they are offering for the longer term.
Different mortgage payment options – payment frequency
Your payment frequency is decided when you and your lender arrange your mortgage. This refers to how often you make your mortgage payments. Your options for payment frequency are:
Monthly – One payment per month for a total of 12 in a year
Semi-Monthly – Two payments per month for a total of 24 in a year
Biweekly – Every 2 weeks for a total of 26 payments per year
Weekly- One payment per week for a total of 52 payments per year
You will also have the option to choose accelerated weekly and bi-weekly payments. This is a great option if you are looking to pay off your mortgage faster and you will save thousands in interest charges. With the accelerated payment options, you will make the equivalent of one extra monthly payment per year.
Choose an Amortization Period
An amortization period is different than a mortgage term. A mortgage term is the length of time you commit to your mortgage rate, lender and associated terms and conditions. A mortgage term has to be renewed, (typically every 5 years) and acts as a “reset” button on your mortgage. A mortgage amortization period is the length of time it will take you to pay off your entire mortgage. As of March 2020, the maximum amortization period is 25 years on CMCH insured homes. If you are putting more than 20% down on your purchase, some lenders may grant an amortization period of 30 years. You are able to choose a short- or long-term amortization period. A short amortization period entails larger monthly payments but is beneficial because interest rates are lower. Longer amortization periods involve lower monthly payments and higher total interest costs. A longer amortization period may also allow you to purchase a home that you may not be able to purchase on a short amortization period. This could be beneficial for you if, for example, the property value increases by $100,000 over time as this will become your profit when you sell.
Paying off your mortgage sooner rather than later will always be beneficial as it could save you thousands in interest down the road. However, there are options for those who want to make smaller payments freeing up more money in your budget for other things. For more information on mortgages refer to the Official Government of Canada website.