Mortgage Basics
Once you decide to buy a home, the buying process begins with setting a budget.
Your home-buying budget is composed of 4 major items. In order of typical size, they are:
Mortgage—How much money a lender will give you to help with the purchase.
Down Payment—How much money will you put into purchasing the home?
Closing Costs—What are the Property Inspection Fees, Property Valuation Fees (for the lender), Legal Fees, Title Insurance, and Taxes?
Moving Costs—What might the cost be of moving, connecting utilities, buying new furniture, and minor repairs?
This page focuses on mortgage basics and explains some little-known quirks of Canadian mortgages that you can use to your advantage.
A Mortgage is a Home Loan
At its core, a mortgage is a home loan in which you offer the bank your home as collateral. It’s similar to a car loan in which you offer the car as collateral.
If you miss too many payments or significantly alter the value of the property offered as collateral (home or car), then you will have broken the loan agreement, and the lender will ask for the entire loan amount back or ask a judge to force you to sell the property to pay them back.
When a lender gives you money for a home loan, they register their name on the “title” to your home. The title is like a certificate of ownership held on record by the province where you live. Anyone can search provincial land titles and see who lent you your mortgage.
A home loan involves a lot of trust because the lender will give you a loan that typically takes 25 to 30 years to pay off. Ideally, you want a larger lender with a reputation to protect. They will generally make a greater effort to work with you if you lose your job or experience a significant unexpected expense. Not all of the big Canadian mortgage lenders are banks.
Key Features of a Mortgage
The biggest mistake that home buyers make is assuming that the interest rate is the only feature of a mortgage. Mortgages are complex loans, and lenders combine their features in different ways to differentiate themselves. Mortgage Sandbox has looked at all the different ways of combining mortgage features, and we estimate there are potentially 90,000 different feature combinations.
Since not all mortgages are the same, you’ll need help figuring out which is best for you. We recommend that you speak to a Mortgage Broker in addition to your primary bank. A mortgage broker can give you more impartial mortgage advice because they can pick from most Canadian lenders. Your primary bank may be able to offer you some concessions to reward you for your loyalty, but they will only help you choose from among their selection of mortgage products. Whether they are mobile mortgage salespeople or branch staff, mortgage advisors who work for a lender have limited knowledge of mortgages offered by competing lenders. They will never recommend mortgage features they can’t provide in-house.
Below is a diagram that depicts how a $100k mortgage gets paid off over time.
Loan Amount
In the diagram, the loan amount is in the light grey column on the far left. This is the most critical feature of a mortgage and is most often overlooked in pursuit of the lowest rate. By law, banks can only provide mortgage financing to qualified homeowners with up to 80% of the home's value (i.e., They will loan you $80k if you put in $20k). That sets the maximum loan amount without mortgage default insurance.
Most lenders will not lend as much in rural areas, hot markets, or for properties valued at more than $1 million. Each lender develops its own policies for these situations, and the policies can change at any time, so there is a lot of variation between lenders that could mean thousands of dollars to you.
Don’t settle for your second choice when house hunting simply because you didn’t know which lenders were most accommodating in your market. Consult a Mortgage Broker.
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Mortgage Non-Payment Insurance (Mortgage Default Insurance)
If you are a first-time homebuyer, you can borrow up to 95% of the home's value if you buy mortgage default insurance. Most people think of the government-owned Canada Mortgage and Housing Corporation (CMHC) as the primary insurance provider, but there are private insurers, too. They are Genworth and Canada Guarantee, and even though they compete for business with CMHC, there is no difference in the cost between them. CMHC sets the price of premiums, and the private insurers must match.
If you are not a first-time homebuyer, you are only eligible for a loan of up to 90% of the home's value.
The advantage of mortgage default insurance is that it allows you to get a bigger loan, but it does have drawbacks:
You will pay 2.8% to 4.0% of the loan's value as an insurance premium. That’s a $4,500 premium for a $100k mortgage. You can make up for a small part of the default insurance cost because insured mortgages get a slightly better interest rate.
Properties valued over $500,000 are not eligible for first-time buyer 95% financing, and insurance is unavailable for properties over $1.000,000. This is particularly significant in Vancouver and Toronto.
Borrowers must pay off insured mortgages within 25 years (30 years for first-time buyers). Non-insured mortgages can have lifespans of 30 and even 35 years.
Rental properties, recreational properties, and refinancing a primary residence are not eligible for insurance.
Mortgage Interest Rate
Rates are either locked or floating. Locked rates are called “fixed rates”. Floating rates come in two flavours: “variable” and “adjustable”.
Locked-in Rate
Locked-in or Fixed rates are unchanged over a contract duration. They fluctuate in tandem with bond rates that are set by financial markets. Many people mistakenly believe that the government sets bond rates, but this isn’t true.
Floating Rate
Floating mortgage rates are calculated monthly using the Prime Rate. The industry term for these is Variable-Rate Mortgages (VRM) or adjustable-rate mortgages (ARM). The Prime Rate is a floating rate set by each bank that can change monthly, so the interest charged on a floating-rate mortgage can vary from month to month even though the monthly payment stays the same.
The mortgage payment on a VRM is set at the beginning of the contract term based on the beginning contract rate and then stays fixed for the duration of the contract term.
When a floating interest rate increases (or decreases) with the Prime Rate, the amount of your mortgage paid down changes downward (or upward). Below is an example using a $500,000 mortgage to illustrate the impact of a rate change.
In a rising interest rate environment, this might result in a borrower falling behind on their loan repayment during a contract term and then having to make up the difference in the subsequent term by increasing their payments.
With an adjustable-rate mortgage (ARM), your mortgage payment fluctuates with the interest rate to keep your repayment schedule on track.
Benefits of Locked-in vs. Floating
Contract Duration (Term)
The contract duration, also referred to as the “term,” is the number of months that you and the lender have agreed to with a specific interest rate and loan repayment schedule. At the end of the timeframe, the contract ends or “matures,” and you are given the option to commit to another period of time or “renew.”
There are open contracts and closed contracts. Open contracts can be repaid at any time with no penalties but charge a higher interest rate, and closed contracts have limitations on early repayment. Whether you have a fixed rate or a floating rate, you will agree to a contract duration with the lender. Keep in mind that some contracts are more flexible than others, and usually, more flexible contracts carry higher borrowing costs.
Lender Commitments
When you get approved for a mortgage, the lender will issue a commitment letter. In it, they commit to the various features of the mortgage, including the interest rate. Usually, you can take the lower of the committed rate and the market rate at the time of taking possession of the home. Rates can change at any moment, and knowing there is a limit to how much interest you can be charged is comforting.
The commitment letter eventually expires, and this is where knowledge of lenders is critical. Commitments vary from 30 to 120 days, and if you get a pre-approval, your commitment may expire before you find the home you want! Likewise, you may make an offer in February to close in June (when the kids are out of school) and find that your commitment expires before the purchase closing date.
Loan Life Span (Amortization)
Loan Life Span is the number of years it takes to pay off the loan (see diagram above). Bankers call this “amortization.” Why is the lifespan important?
|
Shorter Lifespan |
Longer Lifespan |
|---|---|
|
|
So yes, you will pay more interest over the life of the loan with a longer lifespan if you don’t prepay your mortgage at any point. Still, mortgage interest is the lowest interest rate available to consumers. If you need to choose between taking a few more years to pay off your mortgage and holding balances on credit cards or car loans, you should take a long-lived mortgage and not take on other, more expensive debt.
Also, long mortgages provide flexibility. You can always pay them down more quickly. To extend the life of a short-lived mortgage, you would have to re-apply.
Are you house-rich but cash-poor? Long-lived mortgages leave you less cash-poor. Yes, they may cost you in interest, but it’s worth it if you have money today for a romantic getaway or special programs for your kids.
Scheduled Repayment
The most common repayment option for mortgages is monthly, but you can split your monthly payments into smaller amounts paid more frequently and time them to come out of your account the day after your pay is deposited. This is a great way to make sure there will be enough money in your account to cover your mortgage payments.
See illustration below for a $100,000 mortgage with a 5% interest rate:
|
Frequency |
Example |
# payments per year |
Longer Lifespan |
|---|---|---|---|
| Monthly | 1st of every month | 12 | $582 |
| Semi-monthly | On the 1st and 15th, every month | 24 | $291 |
| Bi-weekly | Monday every 2nd week | 26 | $268 |
| Weekly | Every Monday | 52 | $134 |
Many lenders will allow you to pay “accelerated bi-weekly” or “accelerated weekly” payments. This means they increase each of your bi-weekly or weekly payments a little, and this pays down your mortgage balance faster.
Another option is to increase your payments up to double the amount required by your mortgage lifespan. This also pays down your mortgage faster and can be applied to monthly payments as well as other frequency options.
A strategy we recommend at Mortgage Sandbox is to take a longer mortgage lifespan. Hence, you have the flexibility of lower payments if you want them but then set them higher as if the mortgage had a shorter lifespan.
Allowed Early Repayment (Prepayment)
If you choose to repay your closed-term mortgage prior to the contract maturity date, you may be charged penalties. However, every lender has a different approach. First, even though some lenders will charge a penalty on any early payment, most offer annual early repayment privileges of 10%, 15%, and even 20%.
Early repayment privileges are usually calculated as a percentage of the original loan amount. So, a 10% prepayment privilege on a $100,000 mortgage would allow you to repay an extra $10,000 annually. For most people, 10% is plenty.
Remember, pay off all your other debts before paying off your mortgage. Your mortgage has the lowest interest cost of any debt.
Penalties for Early Repayment (Prepayment)
If you pay off a closed-term mortgage early (i.e., exceed the limits of your early repayment privileges), you will get charged a penalty. The penalty will be laid out in the mortgage agreement.
There are two ways of calculating the penalty, and the borrower is always charged the bigger of the two.
3 months of interest
Interest rate spread (interest rate differential)
3 months of interest is relatively straightforward math. The only tricky part is converting the mortgage interest rate from compound semi-annual to annual when doing the calculation for a fixed-rate mortgage.
The Interest Rate Spread, also known as IRD, is much more complicated and only applies to fixed-rate mortgages. On the day that you pay down the mortgage, the IRD is the difference between the interest rate on your mortgage with the lender and their latest posted rate for a mortgage with a term similar to the time remaining on your contractual term.
For example, if you have a mortgage of $525,000 at a rate of 5% and pay it off one year into a 5-year term, they will compare your 5% 5-year rate to the current 4-year rate to determine the penalty. If the current 4-year rate is 4% and the balance remaining on your mortgage is $500,000, then the IRD is 1% of the mortgage balance for four years, roughly $20,000.
Note: Interest rates for Fixed-Rate mortgages are compounded semi-annually, so the actual simple annual interest rate is slightly higher. If you attempt to replicate any bank interest calculations using the contract rate without converting it from compound semi-annual to compound annual, you will get a lower number than the actual interest cost.
Set-up Costs
Mortgage set-up costs are:
Property Valuation
Legal Fees
Title Insurance
Home Insurance Binder
Legal fees and title insurance are pretty standard regardless of lender, but property valuation can be an opportunity to save time and money.
Property Valuation
You may ask why the lender wants to confirm the property’s value. Wouldn’t it make sense to use the purchase price?
Truthfully, the lender wants to know what a likely buyer would pay for the home if the lender ever had to force a sale. You might have fallen in love with the property and offered to buy it for more than the average buyer would pay. The lender will always use the lower of the purchase price and the property valuation.
Lenders value properties using real estate price databases (Automated Valuation Model) and old-fashioned appraisals. If you are buying in a very active area, they may use the database to value your property, which may cost around $150. An appraisal typically costs between $250 and $500.
Property Valuation is an area where lenders set themselves apart. A lender who uses automated valuation can save you a couple of hundred dollars, and it is instantaneous. A proper appraisal requires scheduling an appraiser to visit the home and then write a report. Your mortgage broker can find out which lenders use auto-valuation in your area.
Title Insurance
Almost all Canadian lenders require that you buy title insurance to protect the lender, but many people don’t know that you can also purchase title insurance for your benefit.
Lender Title Insurance Policy
A one-time premium protects the lenders against losses associated with a host of potential issues that may impair the value of their collateral.
Home Owner Title Insurance Policy
Below are the main areas of coverage contained in the Homeowner Policy:
Fraud—a person fraudulently transfers your property without your knowledge or consent.
Forgery—someone forges your signature on a registered document, enabling them to sell or mortgage your property.
Encroachments—if a structure built by a previous owner sits outside the property’s boundaries or if a neighbour builds a structure that is partially on your property after you purchase your policy.
Lack of building permits—If a previous owner completed work on your property without the required building permits, such as an addition or improvement, your municipality could force you to remove or remedy the structure.
Duty to defend—The insurer will pay for the legal fees and costs associated with protecting and restoring your title due to a covered title risk.
Home Insurance Binder Fee
All homes other than condominiums must have Fire Insurance to protect you and the lender if your home burns down. Your lawyer or notary must obtain proof of Fire Insurance, called a binder, from the insurer before the Closing Date. You can have your insurance agent forward the fire insurance binder to the law office, or the law office can request it from the insurance company on your behalf.
For a detailed description of all of the costs of home buying. Click on the "learn more" button.
Cancellation (Discharge) Costs
When you cancel or discharge your mortgage, there are real costs to the lender (government, legal, etc.) involved in removing the lender’s name from the land government registry. The lender has to prepare some legal documents, and a lawyer will need to execute them to remove the mortgage. It isn’t as simple as paying the mortgage down to a zero balance.
Cancellation fees have various names, such as Discharge Fee, Discharge Statement Fee, Discharge Registration fee, Reinvestment Fee, or Government Charge for Discharge.
Combined, they can range from $75 to $370.
While you’re at it, you should also check on fees for bounced payments (also known as non-sufficient funds or NSF) and renewal fees.
Lender Policies
Every lender has different policies on income ratios, loan-to-value ratios, income confirmation, and other supporting documentation. Choosing the most favourable lender can save you thousands of dollars in additional borrowing power and rates and fees.
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