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Home Loans 101: Rates, Payments, and How to Qualify
Whether you’re a would-be first time buyer, or a current homeowner looking to downsize or upsize, we’ve put together this Home Loans 101 blog post to help you navigate the waters of real estate financing. We hope the content here will help simplify what can be a complex process and give you some base knowledge when entering in to the mortgage and home loan landscape.
Since a mortgage is by far the most common kind of home loan, we’ll look at them in some detail. Let’s start at the beginning by asking…
What is a Mortgage?
A mortgage is a legal contract by which a bank or other creditor lends money at interest in exchange for taking title of the debtor's property, with the condition that the title becomes void upon the payment of the total debt.
In English, that really means that the bank or creditor will lend you money to buy the house and you will pay them back the full amount over a period of time, plus some interest.
Like houses themselves, mortgages come in a variety of shapes and sizes. As well as the different types of mortgages, you’ll also want to consider a couple of important factors: the amortization period and the interest rate. Let’s take a look at what all this means.
There are more mortgage types than you could shake a set of house keys at! These include (deep breath): conventional, high-ratio, open, closed, fixed rate, and variable rate. (And relax.)
While this may seem like a lot to digest, in many respects your mortgage type will choose you. The mortgage that suits you best will take into account a number of factors, such as your credit history, age, general financial situation, and more.
Let’s take a closer look at these various types of mortgage.
A conventional mortgage is when you (the purchaser) are able to pay at least 20% of the purchase price. It’s always good to be able to make a downpayment up front, as it can help to secure a more favourable interest rate.
Why will this give you a more favourable interest rate? The bank/lender will see that you have the financial restraint and self-control to not only manage your expenses, but also to save money as well. Also, by investing a significant portion of your own money, banks see you as a less risky borrower (you’re less likely to default and lose your house if you’ve invested 20% of the purchase price). And finally, with a conventional mortgage, you will not be required to pay for mortgage protection insurance.
A high-ratio mortgage comes into effect when you are not able to pay at least 20% of the purchase price. This type of mortgage still requires an upfront downpayment, at a minimum of 5%, and will also require you to pony up for homeowner insurance.
Homeowner insurance generally comes at a premium and will be an additional regular amount to pay on top of what you are paying for the mortgage. The benefit of this mortgage type is, of course, that homeownership is attainable for those without access to that chunky 20% downpayment, but you will generally end up paying a lot more for the home in the long term.
An open mortgage provides the opportunity to pay off the mortgage without any penalty. That means if you are able to pay lump sums above your regular payment along the way (you master money manager, you) or in the event you can stump up the cash to pay the mortgage off in full (your Richy-Rich Lotto winner, you) you can do so at no extra cost.
Open mortgages are typically set up to have a shorter term, but longer terms can sometimes be negotiated, and the increased flexibility they offer comes at a price. Interest rates are higher for open mortgages versus closed mortgages on the same terms.
A closed mortgage is a mortgage agreement that cannot be prepaid, renegotiated or refinanced before maturity, except according to its terms. In short, what you sign up for is what you get.
These terms can be negotiated at the beginning of the loan, and you better make sure you’re comfortable with them, because once you sign on the dotted line, there’s no way to adjust.
Fixed rate mortgages are locked in for the term of the mortgage. Lenders can offer different prepayment options for quicker repayment of the loan, but the rate you sign up for is the one you are stuck with for a fixed period of time – or term – (usually three, five, or seven years), at which point you will be subject to the new mortgage rate.
Variable rate mortgages follow market changes, meaning that the interest rate can change depending on market conditions. This means that, at specific intervals, your payments can fluctuate. In some cases, the amortization period may be altered to cover the new monthly payment.
What is the Amortization Period?
Now that you have a sense of the various mortgage types available, let’s dig down into some of the key components of that mortgage, beginning with the amortization period.
Quite simply, the amortization period is the length of time it takes to pay back to mortgage in full. This period can be as low as 5 years and as long as 25 years in Canada (longer amortization periods may be available in other countries). A longer timeframe will reduce the monthly payment, but also means you will pay more interest over time.
What about Interest Rates?
Mortgage interest rates are a huge factor in the cost of purchasing a home through financing. A lower interest rate – even by as little as 0.5% – will have a big impact on the amount you will be paying out overall.
As a borrower, the lower the better; however, the lender has to assess the risk of repayment when setting a rate. Having solid finances and good credit history will help you obtain a lower interest rate.
So, what affects mortgage rates? Inflation, housing market conditions and the Bank of Canada are three key factors affecting mortgage interest rates.
Inflation decreases the purchasing power of dollars over time, so lenders have to maintain an interest rate at a level that counters this erosion in order to ensure that their interest returns represent a net profit.
Housing market conditions also affect the interest rate. With less houses being built, less homes being bought, and more consumers opting to rent, mortgage lenders are forced to lower their interest rates to make purchasing a home more attractive.
Lastly, the Bank of Canada also has a large impact on the interest rate, as they are responsible for setting the prime rate, which directly affects mortgage rates.
As you can see, interest rates are a key aspect to any mortgage. Having great credit history will help you obtain a lower rate. Keeping an eye on housing market conditions and the Bank of Canada interest rate prediction will help you stay on top of what interest rates are currently looking like. This long-term outlook may help you make wiser decisions when the time comes for you mortgage to be up for renewal!
Paying your mortgage
Payments on mortgages vary based on the amount owed, the amortization period and interest rates. The graphs below will help give you an idea of how these factors influence your mortgage payments and total interest paid.
The two graphs below show the impact that interest rates have on a mortgage. All of these mortgages owe $250,000 and have an amortization period of 25 years.
The next two graphs show the effect amortization rates have on a mortgage. All of these mortgages owe $250,000 and have an interest rate of 4%
How to qualify for a mortgage
Whether you decide to build or buy a home, it is a good idea to visit a mortgage specialist to get pre-approved for a mortgage. During this pre-approval, the lender will check your income, expenses, debts, credit score, and look at the amortization period to formulate what you may borrow. This pre-approval can be guaranteed for up to 120 days.
According to the Financial Consumer Agency of Canada, your total debt load shouldn’t be more than 40% of your gross income. This includes your total monthly housing costs, plus all your other debts. Other debts include credit card payments, car payments, student loans, lines of credit, and more.
What happens if you do not get approved? Don’t worry, it is not the end of the world! Chat with your mortgage specialist and assess other options. The lender may still be able to approve you, but for a lesser amount than what you initially requested. They may require a larger down payment in order to give you the amount you are looking for. In some cases, the lender may ask to have someone co-sign the mortgage.
Negotiating your mortgage
Once an opportunity arises to purchase or build, you will need to get your financing finalized. The total mortgage amount – which will include the purchase price plus legal fees and taxes – will need to be within your approved parameters.
Other items that need to be finalized are the amortization period, term, payment intervals, mortgage type, and interest rate. All of these finances will have to be in order come closing day!
Yup, there sure is a lot to consider when seeking financing for a home. Hopefully, this blog post helped demystify the process a little and gave you a solid base to move forward into the rewarding world of home ownership.
If you enjoyed this blog post, we have lots more you may find interesting. Why not start with this one: 12 Ideas to Save for a Downpayment
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