A mortgage is a type of loan used to buy property. With every payment you make, you’re one step closer to owning the home outright. Buying a home starts with learning how a mortgage works, including how to qualify for a mortgage and how to get a competitive interest rate.
If you’re buying a house, chances are you’ll need a mortgage. To help you on your journey to becoming a homeowner, we’ve put together a beginner’s guide to mortgages, explaining what is a mortgage, how a mortgage works, and everything else that’s important to know before you get one.
A mortgage is a type of loan you take out when you want to buy a home or other type of property, but don’t have enough cash to pay the full purchase price. As such, nearly all prospective buyers need a mortgage to get into the housing market. Mortgages are available at banks, credit unions and other financial institutions, as well as from private lenders. All mortgage lenders have the right to take possession of your home if you don’t make your payments on time or default on the loan.
A mortgage works similarly to other loans, such as a car loan or personal loan. You must apply with a lender to get approved for a mortgage and to find out what size mortgage you qualify to borrow. To determine your eligibility and the rate of interest you’ll pay, mortgage lenders look at a variety of factors including your income, debt, credit history and score, and the size of the down payment.
Once the mortgage is finalized and you’ve purchased your home, you must make regular payments (usually monthly, but there are also options to pay more frequently) as set out by your lender until you pay off the loan in full. These payment amounts depend on the size of your mortgage, the amount of time over which you will pay back the loan (called the amortization period), and the rate of interest charged.
As explained above, your lender will expect you to pay down your mortgage in full within a given timeframe, called the “amortization period.” The longest mortgage amortization currently available in Canada is 30 years, but that is only accessible to buyers who have a down payment of at least 20%. For everyone else, the maximum amortization is 25 years, and it’s also the most popular option.
However, that doesn’t mean the mortgage contract you agree to with your lender stays in place for the full 25 years. Rather, you must choose a term for your contract—anything from one to 10 years—and at the end of the term you have an opportunity to either renegotiate your mortgage (and the rate of interest charged) with your current lender or find a new one.
Side note: you can also refinance your mortgage or switch lenders before the term is up but, depending on the type of mortgage you have, it can be quite costly as lenders generally charge penalty fees to break a mortgage mid-term.
The longer your amortization, the more interest you pay in total over the life of your mortgage. That’s why many borrowers prefer to lower their amortization by making extra payments (called prepayments) that go directly toward paying off the principal mortgage loan.
As is the case with all forms of borrowing, the lender charges you interest in exchange for fronting you the money. In other words, interest is the cost of borrowing—and every mortgage payment you make has those costs built in.
Since interest is tacked onto what you borrowed, you’ll end up paying back more than what you owe to the mortgage lender. For instance, let’s say you have a $500,000 mortgage at 2.79% repaid biweekly over 25 years. Using this mortgage interest calculator, you will have paid $500,000.00 in principal, $193,505.56 in interest, for a total of $693,505.56 by the end of 25 years.
With every mortgage payment, you reduce the amount that you owe to a mortgage lender and move one step closer to owning the property outright.
The amount of interest you’ll pay on your mortgage varies according to your payment schedule. For example, if you make an extra $5,000 annual prepayment on that same $500,000 mortgage, you’ll save $44,622.19 in interest charges over the 25-year amortization. Similarly, if you switch from a regular biweekly payment schedule to an accelerated biweekly one, the payments you make every two weeks would be slightly higher (in this case, $89.41 more per payment)—but you’d save $22,801.94 in interest over the life of the mortgage.
Why do prepayments and accelerated payments save you so much money? It’s because those extra funds go directly toward paying off the mortgage principal. Remember: the amount of interest charged on every payment is calculated as a percentage of your remaining principal. So, the faster you pay off your mortgage loan, the less you’ll be charged in interest.
The rate of interest you pay largely depends on how reliable you are as a borrower, which is reflected in your credit report and score.
If you have an established history of borrowing and making your payments on time, lenders are more likely to offer you their lowest interest rates. Even so, interest charges can vary wildly from lender to lender, which is why it’s important to shop around or consult a mortgage broker to get the best rate.
On the other hand, if you’ve never borrowed money before or you repeatedly miss payment deadlines on your credit card bills or other debts, a bank or credit union may view you as too great of a risk. In that case, a private mortgage lender may be your only option, and you’ll pay a much higher interest rate.
The rate of interest a lender offers you also depends on the type of mortgage you choose, as explained below.
An open mortgage generally gives you more flexibility in your payments. Specifically, you can pay down as much of the loan principal whenever you want without incurring prepayment charges, and you can even break your mortgage contract before the term is over without paying penalty fees. However, in exchange for that freedom, you’ll usually pay a greater rate of interest than you would on a closed mortgage, resulting in higher monthly payments.
Conversely, a closed mortgage may allow you to make some prepayments towards the loan principal without extra fees—say, 10% of the outstanding mortgage annually—but if you exceed those limits, you’ll be charged a penalty.
With a fixed-rate mortgage, the rate of interest you pay remains the same for your entire mortgage term. So, for example, if you get a five-year fixed-rate mortgage at 2.5%, you’ll continue to pay 2.5% interest until the term is up. Generally, you pay more for the security of having a guaranteed rate, and the longer the term the higher the rate.
The rates offered on variable mortgages are usually lower than on fixed-rate ones, but there’s a catch—that rate can fluctuate throughout the mortgage term. For instance, if you have a five-year variable-rate mortgage of 1.75%, you’ll start out paying 1.75% interest, but that rate could go up or down at any time depending on the economy and the Bank of Canada’s benchmark lending rates. If rates go up, so will your monthly payments.
Aside from the interest rate itself, there’s another major difference between fixed- and variable-rate mortgages: how the penalty fees are calculated if you want to refinance before the term is up. In most cases, it’s much cheaper to break a variable-rate mortgage than a fixed-rate one.
If you buy a home with a down payment that’s less than 20% of the purchase price, it’s referred to as a high-ratio mortgage. In that case, you’ll need mortgage default insurance. This type of insurance protects your lender in case you are unable to make your payments.
Technically, your lender is the one that takes out the insurance from the Canada Mortgage Housing Corporation (CMHC) or another provider, but the lender passes on the cost to you. The premium is calculated as a percentage (up to 4%) of your mortgage, which you can either pay as a lump sum or add to your mortgage loan (in which case you make interest payments on the premium).
Homes that cost $1 million or more are currently not eligible for mortgage default insurance, which is why they require a down payment of at least 20%. (The federal Liberal government said in the last election campaign it would raise that threshold to $1.25 million, but it’s unclear as to whether or when this will take place.)
There are a few things you need to qualify for a mortgage:
For homes that cost $1 million or more, a minimum 20% down payment is required.
There are government programs designed to help first-time buyers in Canada boost their down payment. It might make it easier for you to qualify for a mortgage on your first home:
Borrowing hundreds of thousands of dollars in the form of a mortgage can be stressful but understanding the basics – such as what is a mortgage and how a mortgage works – shouldn’t be. Now that you know the difference between a mortgage amortization and term, open and closed mortgages, fixed- and variable-rate mortgages, and high- and low-ratio mortgages, you should feel prepared to approach your lender or mortgage broker with confidence and get one step closer to becoming a homeowner.
The content provided on Myfinancesguru.com is information to help users become financially literate. It is neither tax nor legal advice, is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Tax, investment and all other decisions should be made, as appropriate, only with guidance from a qualified professional. We make no representation or warranty of any kind, either express or implied, with respect to the data provided, the timeliness thereof, the results to be obtained by the use thereof or any other matter.