How Do Mortgages Work? Everything You Need to Know

Why Get a Mortgage?

The price of a home is often more than what a single individual or household can save. Therefore, many choose to buy a home or an investment property by putting down a deposit of typically 20% of the home’s purchase price, and obtaining a loan for the remaining amount. This assistance from a lender is referred to as a mortgage.

A mortgage is a legal and binding contract between you and the lender, which outlines the terms of the loan and is secured by a property, such as a house or a condominium unit. In the event that you fail to comply with the terms of your mortgage, including making timely payments and maintaining the property, the lender is legally authorized to repossess your property as collateral. This is known as a secured loan.

How to Find the Right Mortgage for You?

What is a Mortgage?

A mortgage is a form of loan used to buy a home, land, or any other form of real estate. There are different types of mortgages, such as fixed-rate or variable-rate mortgages, that cater to the various needs of buyers.

When receiving a mortgage, the borrower consents to paying the lender over a set period of time via regular payments. Until the loan is paid in full, it will accrue interest, which you must pay off in addition to the regular amount.

In order to obtain a mortgage, you must first demonstrate to your lender that you meet their requirements, such as a good credit score, bank and investment statements, recent tax returns, and proof of current employment. Additionally, mortgage applications must go through a detailed underwriting process before they get approved.

What Should I Consider When Applying for a Mortgage?

When searching for a mortgage, your lender or mortgage broker will present you with various options. It is essential to comprehend the unique features of each option to select the best mortgage for your financial needs and circumstances. Moreover, it is crucial to ask questions and fully understand the mortgage you currently possess or want.

The main features of a mortgage include:

• Your term;
• The principal amount;
• Amortization;
• Payment Frequency.

Your Term:

Your mortgage term pertains to the duration your mortgage contract is in effect. It includes details such as the interest rate and your payment schedule. A mortgage term can range from several months to five years or more.

Upon completion of each term, you must renew your mortgage if you cannot pay the outstanding balance in full, necessitating several terms to repay your mortgage.

The length of your mortgage term affects several factors, including:

• Your interest rate and the type of interest you can receive, i.e. fixed or variable;
• The penalties you must pay if you break the mortgage agreement before your term has ended;
• When you must renew your mortgage agreement.

The Principal Amount:

The sum borrowed from a lender to buy a home is the principal amount. It typically encompasses the property’s purchase price subtracted by your down payment, along with any mandatory mortgage loan insurance if your down payment is below 20% or if your lender requires it.

Mortgage lenders utilize various factors to calculate your regular payment amount. Each payment typically includes a portion for the interest and principal. The principal refers to the amount borrowed from the lender to purchase your home, while the interest represents the fee charged by the lender for lending you the money. Additionally, if you opt for mortgage insurance, the lender will include the insurance fees in your mortgage payment.

Amortization:

Your amortization period is the duration of time it will take to entirely repay your mortgage. By extending the amortization period, you will be able to lower your regular payments. However, it is important to note that the longer it takes to pay off your mortgage, the more interest you will have to pay off. The average Canadian takes 25 to 30 years to pay off their mortgage.

Most traditional mortgages are fully-amortizing, meaning that regular payment amounts do not change, but the portions that go towards the principal and interest shift as you continue to pay your mortgage.

If your down payment is less than 20% of the home’s purchase price, the maximum amortization period is 25 years. However, Canada’s 2024 Federal Budget proposes to extend the maximum amortization period to 30 years for first-time home buyers purchasing newly built homes in an effort to make homeownership more affordable. This new rule will be applied on August 1, 2024.

Payment Frequency:

Payment frequency pertains to the frequency at which you make your mortgage payments. You have the option of selecting an accelerated payment plan. Through accelerated payments, you can make the equivalent of one additional monthly payment every year, potentially saving you thousands or even tens of thousands of dollars in interest payments over the course of your mortgage.

The payment frequency options available to you may include:

• Monthly—1 payment per month
• Semi-monthly—2 payments per month (monthly payment ÷ 2)
• Biweekly—1 payment every 2 weeks (monthly payment X 12 ÷ 26)
• Weekly—1 payment per week (monthly payment X 12 ÷ 52)
• Accelerated biweekly—1 payment every 2 weeks (monthly payment ÷ 2)
• Accelerated weekly—1 payment per week (monthly payment ÷ 4)

Property Taxes

If you own a house, you are responsible for paying property taxes, which are determined based on the value of your property and where you live. However, some financial institutions may collect and pay property taxes on your behalf. This could also be one of the requirements for obtaining financing. The property tax amount is included in your regular payments in these cases.

Interest Rates

The interest rate is the fee you pay to the lender for borrowing the money you used to buy your home. A higher interest rate translates to higher mortgage payments. Whenever you renew your mortgage term, you are essentially renegotiating your interest rate, which can result in future mortgage payments being higher or lower.

When applying for a mortgage, your lender will propose an interest rate, but you can try to negotiate for a lower rate.

The key points that influence the interest rate your lender offers include:

• The duration of your mortgage term;
• The kind of interest rate you pick;
• The current interest rate offered by your lender;
• Your credit history;
• Whether you are self-employed;
• Your eligibility for discounted interest rates;
• The type of lender you select (bank, credit union, financing company, or mortgage investment company);
• The specific lender.

Before deciding on a lender, it is best to shop around to get the best interest rate possible, as this could potentially save thousands of dollars.

Types of Interest Rates

There are several interest rate options to choose from with many important distinctions.

Fixed Interest Rate:

This type of rate remains stable throughout the term, and they are generally higher than variable interest rates. Opting for a fixed interest rate ensures that your payments remain the same for the entire duration of the term.

Variable Interest Rate:

A variable interest rate can fluctuate throughout the term. Usually, they are lower than fixed interest rates. With this type of rate, you can maintain the same payments for the duration of the term, which is called a fixed payment with a variable interest rate. Alternatively, you may choose an adjustable payment option with a variable rate in which case your payment amount changes when the rate changes.

Hybrid or Combination Interest Rate:

A hybrid or combination mortgage includes both fixed and variable interest rates, with a portion of the mortgage having a fixed interest rate, and the other part having a variable interest rate. The fixed portion will provide you with some protection against interest rate increasing, while the variable portion will provide partial protection if the rates decrease. However, each part may have varying terms, making it more difficult to transfer such mortgages to other lenders.

If you violate the terms of your mortgage agreement, such as by paying off your mortgage ahead of schedule, your lender may impose a penalty fee that could amount to thousands of dollars.

Moreover, penalty fees may also apply if you choose to sell your home before the end of the term. Therefore, unless you plan to keep your property for the entire loan term, it’s essential to consider flexible mortgage options.

Some of the factors that determine mortgage flexibility include whether your mortgage is open or closed, portable or assumable, and registered with standard or collateral security.

Types of Mortgages

Open Mortgages:

People choose an open mortgage if they are looking for a flexible mortgage that will allow them to pay extra on top of their regular payments and pay off their loan sooner. It’s important to note that the interest rate is typically higher on an open mortgage than on a closed mortgage of a similar length.

Having an open mortgage would be advisable if:

• You plan to pay off your mortgage in the near future;
• You plan to sell your property soon;
• You believe that you will be able to put aside additional money towards your mortgage every now and then.

Closed Mortgages:

A benefit of having a closed mortgage is that the interest rate for this kind of mortgage is usually lower than the rate of an open mortgage. Furthermore, closed term mortgages will often restrict the amount of additional money you can pay towards your mortgage each year. Some lenders will allow a prepayment privilege to be added to your mortgage contract.

A closed mortgage is a good option for you if:

• You expect to keep your property until the end of the loan’s term;
• The prepayment privileges you will receive offer enough flexibility to allow for the extra payments you plan to make.

Portable Mortgages:

If you are planning to sell your home and buy another, then a portable mortgage is ideal. It will let you transfer or port your mortgage balance, terms and conditions, and interest rate.

You may want to consider this option if:

• You are happy with the terms in your current mortgage
• You would like to avoid prepayment penalties from breaking your mortgage contract prematurely

In the case that your home is worth less than the amount you have left on your mortgage, you may still need to pay a prepayment penalty. Ensure that you have all the information you need by talking to your lender before borrowing more money for your new home.

Assumable Mortgages:

This form of mortgage permits you to acquire another person’s mortgage and associated property. When changing hands, the terms of the mortgage must stay the same.

It would be a good idea to take on an assumable mortgage if:

• You are a buyer, and interest rates have increased since you initially obtained your mortgage;
• You are a seller looking to move into a less expensive property and would like to avoid paying prepayment fees as you have several years left on your term.

The majority of fixed-rate can become assumable mortgages. However, variable-rate mortgages and home equity lines of credit cannot.

To assume a mortgage, the purchaser must first receive approval from the lender. If they are approved, the purchaser becomes responsible for the remaining mortgage payments and must adhere to the terms and conditions outlined in the mortgage agreement.

In certain provinces, the seller may still be held personally accountable for the assumable mortgage even after the property is sold. If the buyer fails to make mortgage payments, the lender can request that the seller make the payments. However, some lenders may release the seller from this responsibility if they approve the buyer for the mortgage.

If you are interested in assuming a mortgage, it’s important to discuss with your lender to determine if this is an option for you. Some lenders may charge a fee for mortgage assumption. This will be specified in your mortgage contract.

How to Get Approved for a Mortgage

Mortgage lenders approve their potential borrowers through a rigorous application and underwriting process. Only those who can practically pay off their loan over time are approved. This is determined based on the prospective borrower’s current assets and income relative to any debts they may have. Your credit score also plays a role in whether you will be given a mortgage. If approved, these factors will also affect the interest rate on your mortgage, as those who are seen as risky clients will be given a higher interest rate.

What Is a Mortgage Pre-approval?

Homebuyers may apply for a mortgage after choosing a property or while they are still looking. We strongly recommend getting a mortgage pre-approval before looking for a home so you know what you can afford, what your monthly payments could be and you can receive a locked-in rate that will protect you from interest hikes.

The latter process is called a pre-approval. This method can prove favourable in a hot market as a potential buyer can show sellers that they have the money to back up their offer.

Mortgage lenders offer a procedure that can let you know:

• The largest mortgage amount you are eligible for;
• Roughly how much you can expect your mortgage payments to be;
• A locked-in interest rate for 60 to 130 days.

This procedure is called getting a mortgage pre-approval. Other names include mortgage pre-qualification or mortgage preauthorization.

The process to get a mortgage pre-approval may involve several steps. Individual lenders may utilize different definitions and require different qualifications in every step.

The process consists of the lender looking at your personal finances to gauge the maximum amount they will be able to lend you and at what interest rate. To do so, they will request your personal information, a variety of documents, and will likely run a credit check. Participating in this process doesn’t guarantee a mortgage approval.

Where to Obtain a Mortgage Pre-approval:

Both mortgage lenders and mortgage brokers provide mortgage pre-approvals.

Mortgage Lenders:

Mortgage lenders have the ability to lend you money directly. Several types of lenders offer mortgages, including: Banks, Caisses populaires, Credit unions, Mortgage companies, Insurance companies, Trust companies, and Loan companies. Alternative and private lenders are also available, but exercise caution when borrowing money from a less established lender. Learn about the differences between A lenders and B lenders here.

Mortgage Brokers:

Rather than lend money to you directly, mortgage brokers help you choose a lender and arrange the transaction between you and the lender.

What You Will Need to Provide:

Before a mortgage broker or lender pre-approves you, they will assess:

• Your income;
• Your assets;
• Your level of debt.

To demonstrate these factors, you will provide:

• Identification;
• Proof of employment;
• Proof you will be able to pay for the down payment and closing costs;
• Information about your other assets, such as a car, cottage, or boat;
• Information about your debts or other financial obligations.

To show proof of employment, you may choose to provide:

• Proof of your current salary or hourly wages such as a recent pay stub;
• Your position and the length of time you have held your job;
• If you are self-employed, you will need to provide notices of assessment from the Canada Revenue Agency for the past 2 years

Additionally, your lender or broker can request that you prove recent financial statements from bank accounts or investments to determine if you will be able to pay the down payment.

To display your debts and financial obligations, you may show your monthly payments towards:

• Credit card balances;
• Child or spousal support;
• Car loans;
• Lines of credit;
• Student loans;
• Any other debts.

What Is A Mortgage Rate Hold?

A mortgage rate hold means that you are locking in a mortgage rate for a specific amount of time. A rate hold can vary from lender to lender and can usually last for 120 days or 3 months; however, other rate holds can last 60 or 90 days. A rate hold typically applies to fixed-rate mortgages, and variable rates fluctuate. A mortgage rate hold means that if interest rates rise while you are within your rate hold period, you are locked in at that specific rate, and the rise of interest rates will not affect you during that time period. If interest rates decline during your rate hold period, you will still have access to those lower rates ultimately benefiting you in the end. If you acquire a rate hold from a bank, you can lock in the current mortgage rate for a specified time period. However, if you work with a mortgage broker, they will generally try to lock in a few different rates with various lenders. It’s important to explore all of your options before locking in a rate hold.

Although a rate hold guarantees you a locked-in interest rate for a specified time period, it doesn’t necessarily mean that a lender has approved your mortgage application. That’s why a mortgage pre-approval is always recommended.

What to Consider When Getting Pre-approved

Your pre-approved mortgage amount represents the maximum you can receive. This pre-approval does not guarantee that you will get this amount. Instead, your down payment and the value of your property will determine your approved mortgage amount. Before giving you a mortgage, the lender will ensure the property you intend to buy meets their requirements, which differ from lender to lender.

If a lender does not give you a mortgage, you may ask for other options including:

• Getting approved for a lower mortgage amount;
• Paying a higher interest rate;
• Paying a larger down payment;
• Having someone else co-sign with you on the mortgage.

Closing

After agreeing on the terms of their deal, the buyer and seller or their representatives will have a meeting called a closing, at which point the buyer makes a down payment to the lender. The seller then transfers ownership of the property to the buyer in exchange for the previously agreed-upon payment, and the buyer will finalize any remaining mortgage paperwork. It’s worth noting that the lender may change the buyer for creating the loan, which may take the form of points, during the closing.

Foreclosure

If you miss a specific number of regular payments determined by your lender or if you fail to abide by other terms in your mortgage contract, you may experience a foreclosure. This is a legal process in which the lender will attempt to recover the money still owed to them on a now-deflated loan by taking ownership of the property and selling it.

For more information on the difference between Foreclosure and Power of Sale, contact Stan at 604-202-1412.