What is a Mortgage?
Few people can come up with the entire amount of money required to pay for the cost of a home. A mortgage is a loan of the money most people require to finance the purchase their home. A mortgage allows individuals to buy property without paying the full value all at once. The mortgagor is the person borrowing money, the mortgagee is the lender of the money.
When negotiating the amount of your mortgage, you should be aware that you will most likely be required to provide a down payment which is the money you put towards the purchase price of your home. The amount of your mortgage is determined by the purchase price of the home less the amount of your down payment. As with all loans, a mortgage must be repaid by the borrower with interest. There are different types of repayment methods which make up the different kinds of mortgages available.
Like all loans, regular payments made over time go towards paying down the mortgage. These payments are made up of two parts – one part goes towards paying the principal (the amount of money borrowed) and other part goes towards paying the interest (the fee charged for borrowing the money.)
The more money you can put down, the less you will have to borrow, and the less interest you will have to pay over the length of the mortgage.
If you have a down payment equivalent to 20% or more of the purchase price, you will have what is called a conventional mortgage.
If your down payment is less than 20% of the purchase price, you will have what is called a high ratio mortgage. A high ratio mortgage must be insured to protect the lender. This insurance is called mortgage default insurance. It protects the lender in case the borrower isn’t able to repay the loan.
Mortgage Terms and Rates.
The term of a mortgage is the length of time a lender will loan mortgage funds to a borrower.Generally, the shorter the duration of a mortgage term, the lower the interest rate, and the less it costs to borrow the money. At the end of each term, you will either pay off the balance owing or renegotiate the mortgage for another term until the entire mortgage is paid back.
Short term agreements or mortgage contracts are usually for two years or less. Short term mortgages offer a lower cost of borrowing (interest rate) than a longer term. People who believe that interest rates are currently higher than they will be in the future generally choose a short term mortgage. They anticipate that interest rates will be lower at the time of renewal.
Long term agreements are generally for three years or more. Long term mortgages cost a bit more than short term mortgages, so the interest rate will be higher. A higher interest rate appeals to borrowers who value the stability and predictability of fixed expenses over a set period of time. A stable mortgage payment is easier to budget and offers peace of mind.
It can take a long time to completely pay off your mortgage – usually from 15 to 25 years. The process of fully paying off your loan by installments of principal and interest over a definite period of time is called Amortization. In recent years, mortgage lenders and insurers have offered consumers longer amortization periods of 30 an 35 years.
There are many ways of repaying your mortgage. Some people find comfort in a pre-determined fixed rate – it helps them budget and plan for other things in their life. Some people desire more flexibility in their repayment – their circumstances might include fluctuations in their cash flow, and they may want to make larger payments whenever possible. Different kinds of mortgages appeal to the different types of borrowers. Your mortgage professional can help you decide what is best for you.
An interest rate is the amount of interest charged on a monthly loan payment, expressed as a percentage. It is based either on the rate the Bank of Canada charges to lend money to money lenders or on bond yields. Interest rates are generally lower if you borrow money for a short period of time and higher if you borrow the money for a longer period of time.
Fixed Rate Mortgage
When you agree to a fixed rate mortgage, your interest rate will never change throughout the term of your mortgage. There are no surprises as you’ll always know exactly how much your payments will be and how much of your mortgage will be paid off at the end of your term.
Variable Rate Mortgage
When you agree to a fluctuating interest rate for the length of the term, then you have a variable rate mortgage. Interest rates fluctuate with the bank’s prime lending rate, and may vary from month to month. When interest rates change, your payment amount remains the same, however the amount that is applied to the principal will change. For example, if interest rates drop, more or your mortgage payment is applied to the principal balance owing. The variable rate mortgage is a good option for homeowners who believe that interest rates are currently high and will drop.
Types of Mortgages.
If you are planning on paying off your mortgage within 6 months to 1 year, an open mortgage makes sense for you. Open mortgages will often come at a higher interest rate than a closed mortgage because the open mortgage allows prepayment without penalty. For example, if you intend to sell your home, or are expecting a large amount of cash in the near future, an open mortgage will allow you to pay down all or part of your mortgage without penalty.
A closed mortgage means that you have to pay a penalty if you wish to payout your mortgage completely during the contractual term of your mortgage. Many closed mortgages allow some prepayment, such as 10% per year on the anniversary date. These partial prepayment terms vary and need to be understood. The benefit of a closed mortgage is that they are often available at the most favourable interest rates. This may suit your needs if you do not anticipate wanting to pay down your mortgage before the term expires.
A fixed rate mortgage is a mortgage where the rate of interest is fixed for a specific period of time. Generally known as the mortgage term, these terms can range from 6 months up to 10 years. Whether you should lock in for a long term or stay short depends on the interest rate trend in the market, as well as your financial situation and degree of risk tolerance.
Most fixed-term mortgages allow you to make partial prepayments towards the principal balance during the term; however these privileges vary from lender to lender. We will assist you in making the best decision and can set you up on an accelerated payment plan that can save you thousands of dollars in interest.
A variable-rate mortgage allows you to take advantage of the lowest rates available. The variable rate is usually tied to a mortgage lender’s prime rate and are generally the same as the Bank of Canada prime rate. These rates are often quoted as prime minus 1% or prime plus 2%, etc.
Variable-rate mortgages have been attractive when market experts feel that rates will drop or stay level for a period of time. Variable rate mortgages have the downside of offering little security in a rising-rate environment and payments and interest expense can rise when the Prime Rate rises.
Cash back mortgages are becoming very popular among Canadian borrowers, particularly borrowers with limited down payments. Various mortgage lenders offer cash back programs allowing a percentage of the property’s value to be rebated to the borrower upon closing. The cash back can definitely be helpful with closing costs. Cash back mortgages do come with a higher interest rate than non-cash back options, so borrowers should be aware of the higher interest cost of using these options.
Course of Construction Mortgages
Typically, there are three or more disbursements made by the mortgage lender as construction of the building progresses. The mortgage lender will conduct appraisals during the course of construction and will advance funds in accordance with the appraised value of the partially completed building. Course of Construction Mortgages are often at a slightly higher rate than a standard mortgage, but the advantage is that the borrower is not paying interest on the whole amount of the mortgage at the beginning of construction. Instead, the advancing of funds as the project moves along saves interest costs, particularly where construction takes an extended period of time.
This is temporary financing that can be arranged for a variety of purposes, but generally for situations where a new home has been purchased but the old one not yet sold, or where borrows want to stay in their existing home while a new one is being constructed. Borrowers must still be able to service the debt as required by the mortgage lender.
Second mortgage financing is arranging for additional mortgage funds beyond the 1st mortgage. The second mortgage also is registered on title. Borrowers will often use a second mortgage to supplement their down payment so that they may arrange their 1st mortgage on more favourable terms. For example, most mortgage lenders will give preferred rates on loans of 80% or less of the home’s value. Borrowing additional money as a second mortgage may be at a higher interest rate, but can save a borrower money if more favourable terms can be negotiated on the 1st mortgage as a result.
Equity Lines of Credit
An Equity Line of Credit gives you access to the equity in your home, usually up to a maximum of 75% of its appraised value. The advantages are that if you need to renovate, travel, pay down other debt, etc., the rate of interest on home equity loans is generally much less than other types of personal loans and credit cards.
Home Buyers’ Plan.
The Home Buyers’ Plan (HBP) allows you to withdraw money from your Registered Retirement Savings Plan (RRSP) tax-free to use for a down payment.
How much can you withdraw?
You can withdraw up to $25,000 from your RRSP. Contributions must be in your account for at least 90 days before they can be used for the HPB. If you buy the home together with your spouse, partner, or someone else, each of you can withdraw up to $25,000. The withdrawal from your RRSP does not need to be included in your income on your annual income tax return, and no tax is taken off the money you withdraw.
What is the payback period?
Starting the second year following your withdrawal, you must pay back all withdrawals from your RRSP within 15 years by making RRSP deposits each year. CRA will determine what your minimum yearly repayment will be and will notify you once you need to start repaying the amount. If you do not repay the amount due in a given year, it is included in your taxable income for that year and you’ll have to pay income tax on this amount.
Mortgage Default Insurance.
Mortgage default insurance, commonly referred to as CMHC insurance, is mandatory in Canada for down payments between 5% (the minimum in Canada) and 19.99%. Mortgage default insurance protects lenders if a homeowner defaults on their mortgage.
Although mortgage default insurance costs homebuyers 1.75% – 2.75%1 of their mortgage amount, it is actually beneficial to the buyer market. Without it, mortgage rates would be higher, as the risk of default would increase. Lenders are able to offer lower mortgage rates when mortgages are protected by default insurance, as the risk of default is spread across multiple homebuyers.
A mortgage pre-approval shows you, the homebuyer, what value of home you can afford, and the mortgage payments associated with various purchase prices. It also guarantees a mortgage rate for a period of time; therefore, protecting you against potential rate increases. You are not obligated to the bank or mortgage broker to whom you received your mortgage pre-approval, and there is no cost. So, there is limited downside to obtaining a pre-approval.
Use a mortgage payment calculator to figure out your monthly payments. There are many calculators available on the web, however this is one of our favourites as it allows you to test different down payments, amortization scenarios, and compare mortgages rates. It also factors in all the costs such as land transfer tax and CMHC insurance into the payments.
Click here for Rate Hub’s Mortgage Calculator: http://www.ratehub.ca/mortgage-payment-calculator
Financial Consumer Agency of Canada
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