Mortgage Basics
Your home buying budget is composed of 4 major line 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 you will put into the purchase of the home.
- Closing Costs – Property Inspection Fees, Property Valuation Fees (for the lender), Legal Fees, Title Insurance, and Taxes.
- Moving Costs – The cost of movers, moving trucks, 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 where you offer the bank your home a collateral for the loan. It’s like a car loan where you offer the car as collateral for the loan but different from an unsecured loan in which you don’t offer the lender anything you own 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 full 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 that is held on record by the province where you live. Anyone can search provincial land titles and see who lent you your mortgage.
There is a lot of trust involved in a home loan because the lender will give you a loan that typically takes 25 to 30 years to pay off. Ideally, you want a lender who is larger and has a reputation to protect. They will generally make a bigger effort to work with you if you lose your job or get hit by a big 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 in an effort 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 to figure out which mortgage 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 true mortgage advice and they can pick from most Canadian lenders. Your primary bank, may be able to offer you something special 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 very little knowledge of mortgages offered by competing lenders and they will never recommend mortgage features that they don’t offer 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 the light grey column on the far left. This is the most critical feature of a mortgage and 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 value of the home (i.e., They will loan you $80k if you put in $20k). That sets the maximum loan amount without mortgage default insurance.
In rural areas, hot markets, and for properties valued at more than $1 million, most lenders won’t lend as much. Each lender develops their 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.
When house hunting, don’t settle for your second choice simply because you didn’t know which lenders were most accommodating in your market. Consult a Mortgage Broker.
Mortgage Non-Payment Insurance (Mortgage Default Insurance)
If you are a first-time homebuyer, you can borrow up to 95% of the value of the home if you buy mortgage default insurance. Most people think of government owned Canada Mortgage and Housing Corporation (CMHC) as the primary provider of insurance 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. The price of premiums is set by CMHC and the private insurers are required to match.
If you are not a first-time homebuyer you are only eligible for a loan of up to 90% of the value of the home.
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 4.5% of the value of the loan as an insurance premium. That’s a $4,500 premium for a $100k mortgage. A small part of the cost is mitigated 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 not available for properties over $1.000,000. This is particularly significant in Vancouver and Toronto.
- Insured mortgages must be paid off within 25 years. 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 referred to as “fixed rates”. Floating rates come in two flavours: “variable” and “adjustable”.
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 the case.
Floating mortgages rates are calculated monthly using the Prime Rate, the industry term for these are Variable Rate Mortgages (VRM) or an Adjustable Rate Mortgage (ARM). The Prime Rate is a floating rate set by each bank that can change monthly so that 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 mortgage repayment schedule on track.
Pay close attention to the floating rate quoted by lenders because not all lenders use the same “Prime Rate” rate. Some lenders have a higher prime rate specifically for mortgages. For example, at the time of writing this article TD Mortgage Prime Rate was 0.15% higher than the regular TD Prime Rate used for other floating loans. The difference between the two is small but significant. Over the course of a year the difference in rates could save you hundreds of dollars.
Note: Interest rates for Fixed Rate mortgages are compounded semi-annually so the actual simple annual interest rate is slightly higher. If you are going to attempt to replicate any bank interest calculations using the contract rate without converting it from compound semi-annual to compound annual it will give you a lower number than the actual interest cost.
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 an option to commit for another period of time or “renew”.
There are open contracts and closed contracts. Open contracts can be repaid any time with no penalties but charge a higher interest rate and closed contract have limitations on early repayment. Whether you have a fixed rate or a floating rate, you will be agreeing 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 will 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 its is comforting to know there is a limit to how much interest you can be charged.
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 a 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 Lifespan (Amortization)
Loan Lifespan is the number of years it takes to pay off the loan (see diagram above). Banker types call is “amortization”. Why is the lifespan important?
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 in time, but 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, then 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.
House rich and cash poor? Long lived mortgages leave you less cash poor. Yes, it 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:
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 so you have the flexibility of lower payments if you want them, but then set the payments 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 of all, 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 percent 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 first before you pay off your mortgage. You 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 2 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 interest is relatively straightforward math. The only tricky party is converting the mortgage interest rate from compound semi-annual to annual when doing the calculation for a fixed rate mortgage.
Interest Rate Spread, also known as IRD, only applies to fixed rate mortgages and is much more complicated. 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 1 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 4 years which is 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 are going to attempt to replicate any bank interest calculations using the contract rate without converting it from compound semi-annual to compound annual will give you lower number than the actual interest cost.
Set-up Costs
Mortgage set-up costs are:
- Property Valuation
- Legal Fees
- Title Insurance
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 value of the property, wouldn’t it make sense to simply 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 of the home. It is possible that you fell in love with the property and offered to buy it for more than what 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 with old fashioned appraisals. If you are buying in a very active area then they may use the database to value your property and that 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 to have an appraiser visit the home and then write up 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 buy title insurance to your own 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, which enables 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 to your property without the required building permits, such as an addition or improvement, you could be forced by your municipality 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 as a result of a covered title risk.
Fire Insurance Binder Fee (excludes Condos)
All homes other than condominiums are required to have Fire Insurance to protect you and the lender in the event your home burns down. Your lawyer or notary will need to obtain a proof of Fire Insurance, called a binder, from the insurer prior to 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.
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 the documents to remove the mortgage. It isn’t as simple as paying the mortgage down to a zero balance.
Cancellation fees have various names like Discharge Fee, Discharge Statement Fee, Discharge Registration, Reinvestment Fee, Government Charge for Discharge.
Combined, they can range from $75 to $370.
While you’re at it, you should also check on Fees for a bounced payment (also know 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 get you thousands of dollars in additional borrowing power and save you on rates and fees.
