Most Canadians, around 66%, own the homes they live in and owe over $1.5 trillion in mortgage balances.
Despite mortgages being this common and widespread, they’re poorly understood by many. And it’s not their fault. Mortgages are complicated, by design. They’re not meant to be easily understood by the average person.
Luckily, the internet has made it easier to learn how Candian mortgages work.
So keep reading to learn everything from how mortgages work to selecting a lender.
After you’re done, I promise you’ll be in a far better position to make an informed choice for purchasing a home.
The Basics of Mortgages
A mortgage is a loan for buying real estate. To qualify, you have to pay some of the property’s cost upfront, a ‘down payment’. A bank or some other financial institution covers the rest.
Suppose you wanna buy a $1.4 million detached home in Kitchener-Waterloo, Ontario.
You’ll likely pay a 10% downpayment of $140,000 down payment.
And the bank will give you a 5% interest rate loan for a 25 year amorization period.
This example simplifies how mortgages work. In reality, they can be more complex. So a good place to start is by understanding the 6 components of any mortgage.
1. The Principal
The Principal is the money you borrowed from your lender.
In our above example, it’s $1,400,000- $140,000 = $ 1,260,000.
2. Interest
This is the fee your lender charged to give you money.
Your interest depends on the mortgage interest fee you agree to.
3. Amortization Period
Your amortization period is how long you’ll pay back your loan. In Canada, it’s between 15 and 30 years.
A longer amortization means lower monthly payments at the cost of higher interest.
Suppose you opt for a 25 years amortization period for your $1.4 million house.
You’ll pay more interest overall over those 25 years than if you opted for only 20 years.
The benefit of a longer amortization period is the lower monthly payments.
4. Mortgage Payment
Your regular payment to your lender. It includes both your principal and interest.
Often, your mortgage payment will also include other costs, like:
- Property taxes
- home insurance
- Mortgage Insurance
Most lenders require monthly payments. Some may agree to other arrangements, like bi-weekly payments.
5. Mortgage Term
This is how long your mortgage agreement is in effect. It’s normally only between one and five years.
Once your term is over, you have to renew the mortgage under new terms. You won’t have to do this if you’ve fully paid off the loan before your term’s end.
A mortgage renewal involves setting new terms, like your interest rate.
6. Mortgage Default Insurance
You must purchase mortgage default assurance if your down payment is less than 20%. This insurance is to protect the lender if you can’t pay back your loan.
You can acquire from institutions like the following:
- Canada Mortgage and Housing Corporation (CMHC)
- Canada Guaranty
- Genworth Canada among other providers.
How do Mortgage Interest Rates Work?
Lenders charge you interest in exchange for lending you money. They charge interest as a percentage of your principal instead of a flat amount.
So your interest payment increases if either your principal or interest rate increases.
Say, you’re charged a 5% interest rate. You owe $5 for every $100 you borrow.
If you’re charged the same interest rate for borrowing $1,240,000, you owe $62,000 in interest payments. That totals $1,302,000 total.
That’s an oversimplified example. In reality, mortgage interest rates are more complex.
What if your interest rate changes mid-payment?
Can that even happen? Yes, if you’ve been charged a non-fixed rate mortgage.
There are 3 main types of mortgage rates:
1. Fixed-Rate Mortgages
Your interest rate remains constant for the entire amortization period.
For a 25-year mortgage with $62,000 in total interest, you’ll pay $206 monthly.
The advantage of fixed-rate mortgages is their predictability. It’s easier to budget when you have to pay $206 every month for 25 years. This type of mortgage is ideal for risk-averse borrowers.
2. Variable-Rate Mortgages
A variable-rate mortgage has a changing interest rate–it can rise or fall. The change depends on the prime lending rate, which is influenced by the Bank of Canada’s key interest rate.
While you may get a lower interest rate at the start, there’s always the risk it will increase over time.
Opt for a variable-rate mortgage if you can afford the risk of higher future payments.
3. Adjustable-Rate Mortgages
Adjustable-rate mortgages (ARMs) also have variable interest rates with more frequent rate adjustments. ARMs usually start with a fixed interest rate. Then it regularly changes depending on market conditions.
Consider an ARM if you expect future interests to be lower. It’s also a good option for anyone who wants to sell or refinance before the adjustable period starts.
Say you take an ARM with a fixed rate of 3% for three years. You plan to sell your home after three years. So you’ll enjoy the initial lower fixed rate and avoid potentially higher future rates.
How do Lenders Decide your Interest Rate?
Unlike consumer goods with fixed prices, you’re charged an interest rate depending on you. Lenders charge you a rate mostly depending on how risky you are to lend to.
Lenders determine your level of risk by considering these factors:
- Credit score
- Income
- Debt
You’ll receive a lower interest rate if you’re deemed less risky to lend to.
Another factor that impacts your interest rate is the prime rate.
The prime rate is the minimum interest rate banks can lend at. A bank’s prime rate depends on the federal funds rate. The prime rate has to be higher than the federal funds rate.
When a bank’s prime rate increases, so does its interest rate, and vice versa. A bank’s prime rate has a massive influence on the interest you’re charged.
You can get a lower rate with bad credit with a low prime rate than with high credit during a high prime rate period.
What Happens to your Interest Rate After you Sign a Mortgage?
You have these two options when you get a mortgage:
Pay a set rate for the entire mortgage term or pay the prevailing rate each month.
Suppose you have a variable-rate mortgage with a current rate of 3%. Your monthly payments are $100. The prime lending rate drops to 2.5%. Your new monthly payments are now around $83.
Conversely, if the prime rate rises back to 3%, your payments will again increase to $100. So with a variable-rate mortgage, you should expect fluctuations in your mortgage payments.
| Fixed rate | Variable Rate | |
| Interest rate details | You have a fixed rate for the entrie mortgage term regardless of market conditions. | Your rate changes if the market rate changes. |
| Pros | You have predictable mortgage payments. | Your mortgage payments decrease when the market rate decreases. |
| Cons | You don’t benefit from falling market rates. | You’ll pay higher mortgage payments if the market rate increases. |
Can you Pay Off your Mortgage Early?
Yes, most lenders let you pay off your mortgage early. Doing so saves you on interest, but it can have penalties, too. So consider these 3 factors before deciding to pay your mortgage off early.
- Prepayment Privileges
You’ll have prepayment privileges on most mortgages. That means you can make extra payments without penalties. These privileges usually include:
Lump-sum payments: You can pay a large sum directly towards the principal. Doing so will decrease your loan balance.
Increased payment amounts: You can increase your regular payments.
- Prepayment Penalties
You may suffer penalties if you exceed your prepayment privileges. These penalties are intended to compensate the interest for lost interest.
Fixed-rate mortgages typically have more prepayment penalties than other types.
- Portability
Your mortgage is portable if you can transfer it to a new property without penalties. You want a portable mortgage if you want to relocate before paying off your mortgage.
How Long do Mortgage Contracts Last?
A mortgage lasts anywhere between 15 and 30 years, with most being around 25 years long. The exact length of your mortgage depends on multiple factors, including:
Mortgage Term
As explained above, your mortgage term is the length of your Mortgage agrement. It’s normally between 1 and 5 years.
During this time, you have constant terms and conditions, including your interest rate.
You have to renew the mortgage term at the end of this period.
Don’t confuse it with your amorization period, that’s the total length of your mortgage. It’s normally between 15 and 30 years.
Amortization Period
Your amoritzation period is how long your mortgage lasts. It’s typically between 15 and 30 years.
You’ll have multiple mortgage terms within your amorization period.
For instance, you could have a 30 year amorization period with 6 mortgage terms of 5 years each within it.
Renewal
You have to renew your mortgage when your mortgage term ends. Renewal involves negotiating new terms and conditions with your lender.
Renewal is your opportunity to receive better terms if your financial situation improves.
Refinancing
Refinancing is when you obtain a new mortgage to replace the old one. You’ll typically do this to:
- Benefit from lower market interest rates
- Access home equity
- Change your mortgage terms.
Refinancing can save your money, but it may involve penalties if done before your current term’s end.
How to get Approved for a Mortgage
Follow these 7 steps to get approved for a mortgage.
1. Pre-Approval
You need a mortgage pre-approval before the home-buying process. During pre-approval, a lender analyzes your financial situation. Their goal is to determine how risky you are to lend to.
Getting pre-approved gives you a clear budget for buying a home. Being pre-approved also proves to sellers that you’re a serious buyer.
2. Documentation
You need to provide various documents to be pre-approved, including:
- Proof of income: This includes letters of employment and pay stubs.
- Credit history: They’ll need a credit report to analyze your creditworthiness.
- Down Payment Verification: Provide bank statements to confirm your downpayment’s origin.
- Identification: Government-issued ID to confirm your identity.
3. Mortgage Stress Test
All mortgage applicants must pass a mortgage stress test in Canada. This test ensures you can make your mortgage payments even if interest rates rise.
You need to qualify at the higher end of the Bank of Canada’s five-year benchmark rate or your contract rate plus 2%.
4. Debt-to-Income Ratio
Lenders calculate your debt-to-income ratio to assess your ability to make monthly payments. They use your total monthly debt payments and gross monthly ratio.
A lower ratio improves your chances of approval as it signals financial health.
5. Down Payment
Providing a larger down payment gives you better terms since it reduces the lender’s risk. The minimum down payment depends on your home’s price:
Up-to $500,000: 5%
For the portion of the price between $500,000 and $1,000,000: 10%
Over $1,000,000: 20%
6. Choose a Lender
Consider these factors when choosing a mortgage lender:
- Interest rates: Compare interest rates from multiple lenders to find the lowest.
- Customer service: Prioritize lenders that provide good customer service and support. You will need it to navigate your mortgage and deal with potential problems.
- Flexibility: You want a lender with flexible terms and prepayment options.
7. Final Approval
Your lender will make this final approval process after you find a home and make an offer:
- Appraisal: To confirm the property’s value.
- Final submission: You’ll submit your documents to verify your financial situation.
- Mortgage agreement: You’ll sign the mortgage agreement to finalize the loan.
The end
Congratulations on finishing the article! And for improving your financial literacy by learning about mortgages. You now have an above-average understanding of how mortgages work. As such, you’re far better positioned to sign up for one.
Author: Ramish Kamal Syed | Editor: Syed Hamza Ali | SEO Editor: Muhammad Waqas Aslam