August 26th 2021
By Lucas Samuels
For most people, buying a home is one of the biggest — if not the biggest — financial decisions they’ll make in their lives, yet many still don't fully understand how a mortgage works. It makes sense that there’a a knowledge gap (they don’t exactly teach this stuff in school), but it’s essential information for any aspiring homeowner, which is why we’re shedding light on the basics of mortgages below.
So, let's dive into one of the most important steps in the homebuying experience: the mortgage process.
What is a mortgage?
A mortgage is a legally binding agreement that secures a loan in exchange for the promise to pay the loan's principal and interest over a certain period of time. A mortgage requires the use of someone's property as collateral until the debt is paid off. A house, in most cases, is used as security to repay this debt with interest..
How does a mortgage work?
A typical home loan agreement has of 3 main parts:
1) Mortgage Principal Amount: The principal amount of the mortgage is the amount that the mortgagor (aka the borrower) owes to the lender for the home, minus the down payment.
2) Payment Frequency: The borrower must make regular payments to the lender, called mortgage installments.
3) Amortization: The length of time it will take for the total loan amount to be paid off, typically between 10 to 30 years.
The down payment is your initial deposit to the bank. It can be as small as 5% of the home’s value, but 20% is the most common amount to put down. Rates and terms for mortgage loans vary depending on a host of factors, such as your current income, credit history, and debt amount. Ideally, it’s advised to make a larger down payment so you can decrease your monthly payments. However, making a bigger down payment means that you need to save more money in advance.
What are the 5 types of mortgages?
In Canada, mortgages are classified into five categories:
- Closed mortgages are the most common type in Canada. These are fixed rate mortgages where you have no flexibility to reduce or increase your monthly payments. If a buyer wants to pay the lender more than the installment amount, they will likely have to pay a penalty. Closed mortgages typically have lower interest rates than open mortgages.
- Open mortgages offer a period where you can pay more than your regular mortgage payment (you will not be charged interest for doing so). The interest rates are typically higher for open mortgages for the flexibility of being able to pay off the mortgage before the term ends.
- Convertible mortgages involve an agreement where the buyer can decide to change the type of mortgage during its term. For example, the buyer can start with an open mortgage and switch to a closed mortgage to benefit from lower interest rates.
- Hybrid mortgages combine elements of both closed and open mortgages. For instance, they might involve paying a fixed interest rate for a set amount of time before switching to a variable interest rate. These types of mortgages are generally recommended for the more experienced borrower who uses this method as part of their overall financial plan.
- Reverse mortgages are for homeowners 55 and older to convert home equity into payments, typically for living expenses. The balance is due once the homeowner’s property is sold.
In 2020, housing loan interest rates decreased for all types of mortgages in Canada.
What is the difference between a variable rate and a fixed rate?
A variable rate mortgage has an interest rate that could rise or fall over the mortgage’s term. A fixed-rate mortgage has a set interest rate over the loan’s term.
Five-year fixed rate mortgages are by far the most common. For the first five years after you take out a loan, your monthly payments will be fixed, and you know how much they will be for the duration of the mortgage’s term.
On the other hand, buyers can’t know with certainty how the interest rate will fluctuate in variable rate loans with a variable interest rate. Interest rates are set by the market, which fluctuates depending on the state of the economy. When interest rates go up, variable rate mortgages rise with them; when they drop, variable payment mortgages fluctuate accordingly. However, historical data has shown that variable rate mortgages end up costing less than fixed rate mortgages.
Variable rate mortgages can be the more appealing option when interest rates are lower than fixed-rate mortgages. Here's an example of how a variable-rate mortgage might work. Let's say that you choose a variable rate mortgage of Prime + 2%, with the prime rate set at 1% at the start of the mortgage, totaling 3%. That means that if the prime rate were to fall to .55%, your monthly mortgage payment would automatically go down at a 2.55% interest rate. But if it rose up to 2%, you would be paying more at a total of 4%.
The pre-approval and approval process
Getting pre-approved for a mortgage is an important part of the home-buying process. It enables a first time homebuyer to see what they can afford before shopping for a home and helps sellers know the buyer is serious. It also means not worrying about financing the entire purchase price since the lender has already confirmed the shopper can afford to make the monthly payments.
To get pre-approved, a potential mortgagor needs to provide the information requested in a mortgage application by the mortgagee, including details such as income, down payment amount, and how much to borrow. The lender will then run a credit check and verify employment, income, and assets.
A mortgage is a large financial obligation, so it makes sense to be fully prepared before taking on this type of commitment. Unfortunately, many people feel pressured into qualifying for a mortgage before they've had time to figure out exactly how much they can afford to spend on a house and before they've had time to shop around for the best mortgage terms. This can lead to a much more costly mortgage than necessary.
Mortgage 101 FAQ
Why do people need mortgages?
People need mortgages because the average household's savings are typically lower than the cost of a home. Mortgages are essentially loans that allow people to pay for a house over time. Mortgage payments usually cover both the principal and interest of the loan—the amount that you borrowed, plus any costs associated with borrowing it. Without mortgage financing as an option, most people would not be able to purchase a home.
Can anybody get a mortgage?
A mortgage lender needs to approve a borrower before they can receive a loan. This usually involves a credit check, income and debt verification, and an appraisal of the property in question to ensure that it is market value for the home. Typically, mortgages are approved to people with sufficient assets relative to their debts. Riskier borrowers will likely be offered higher interest rates.
Where should I get a mortgage?
There are many options out there today when it comes to securing a mortgage for your home. The most commonly used option is going through the bank that you currently have an account or credit card with; even without these services, you should at least have an existing relationship with them so they can better serve your needs. However, you can also shop around at other banks to find better rates and services.
Understanding your mortgage agreement
The mortgage agreement is a lengthy document, and it is important to read it properly before signing. The document covers an array of topics, but here are a couple of things to take note of:
- The terms and conditions of your loan
- A description of your mortgage
- A description of the property to be secured by the loan
- The amount of the loa
Before signing any mortgage agreement, you should carefully read the terms and conditions and consult your representative with any questions you may have. This is especially important for first time home buyers.