Tackling debt

What is a mortgage?

11 min read

Barry Choi

If you’re thinking about buying a home, there’s a good chance you’ve asked what a mortgage is. Simply put, a mortgage is a loan from a lender that can be used to buy a home. For most people, a mortgage will be the biggest loan they get in their lives, and it’ll take decades to repay. Since it’s a significant commitment, you’ll want to ensure you understand how mortgages work, so you know exactly what you’re getting.

How do you qualify for a mortgage?

Generally speaking, there are three major factors that will help you prepare to get a mortgage. You’ll likely be able to secure a mortgage if you have the following in place:

How much you’ll qualify for and the rates you’re given are also determined by the above, which is why you want to have all three in good standing.

Improve your credit score

If you didn’t know, your credit score is a number that ranges between 300 and 900. The higher your credit score, the more creditworthy you are. When applying for a mortgage, lenders will see where you stand. If you’re in the “good” to “excellent” range, you likely won’t have a problem getting approved for the best interest rates. However, if your score is lower, you may find it tough to qualify, or you may only be approved for a mortgage with a higher interest rate.

Before you apply for a mortgage, you want to take the steps to improve your credit score. Reducing your debt and using KOHO’s Credit Building tool are just some of the ways you can boost your score.

Save for a down payment

To purchase a home in Canada, you need a down payment of at least 5%. For example, if you’re looking to buy a home that costs $500,000, you need to have saved at least $25,000 to qualify for a mortgage. While 5% is the minimum, it’d be advantageous to provide a 20% down payment, as you would not need to get Canada Mortgage and Housing Corporation (CMHC) insurance.

CMHC insurance is mandatory for anyone with a high ratio mortgage, which is anything less than 20% down. This insurance protects the lender in case you default on your loan. You would need to pay a small premium for this insurance that’s based on the purchase price. The payments are rolled right into your mortgage, which makes managing your finances easier.

Have a stable income

When determining how much they’ll lend you, mortgage providers will look at the size of your down payment and your income. Someone with a higher income will typically be approved for a larger mortgage. If you’re purchasing a home with another person, both incomes count, so you could be approved for more.

While this income requirement is standard, lenders also want to see that you’ve had stable employment. Anyone who has recently changed jobs or is a freelancer may not come by automatic approval. This may seem unfair, but financial institutions typically prefer to lend to people who have secure full-time employment. That doesn’t mean a freelancer won’t get approved; you may just need to show a record of consistent yearly income.

"For most people, a mortgage will be the biggest loan they get in their lives, and it’ll take decades to repay."

How much can I afford to borrow?

Every situation is unique, but you can quickly figure out how much you can afford to borrow by looking at an online mortgage calculator or getting pre-approved. A pre-approved mortgage is highly recommended as it’s a quick way for lenders to tell you how much they’re willing to lend you. Plus, it doesn’t affect your credit score, so there’s no reason to not get one.

All you need to do is let the lender know how much you have saved for a down payment and what your annual income is. Based on that info, they’ll tell you how large of a mortgage you can get. This is handy for any potential homeowner as they’ll know what their limit is when they start house hunting.

That said, it’s not recommended that you borrow the maximum amount that you’re offered. Lenders don’t factor in additional expenses such as vacations, retirement savings, furniture, the cost of raising children, or rising interest rates. As a general reference, most experts advise borrowing no more than 5x your annual income. By leaving a buffer, you’ll give yourself some breathing room for any unforeseen costs.

How do mortgage rates work?

When people talk about mortgage rates, they’re referring to what you’ll pay. While rates do differ lender by lender, there are three main things you’ll want to look at when securing a mortgage.

  • The current interest rate

  • Fixed mortgage

  • Variable mortgage

Current mortgage rates

Although mortgage rates are typically based on the prime lending rate set by the Bank of Canada, lenders will also look at bond yields to determine their lending rates. In practical terms, all you need to know is that mortgage rates can change every day, and among lenders. One lender may offer better rates than another on any given day for a variety of reasons.

A significant factor in these changes are interest rates. When interest rates are low, banks will lend you more money. In this case, purchasing a home may appear more affordable since the cost to borrow is lower. Of course, mortgage rates can also go up, which could make buying a home less affordable

Playing it safe with fixed rates

Fixed-rate mortgages allow you to pay the same price over your term. This is an attractive option for many people since they’ll know exactly how much their mortgage will cost them each month. Currently, Canada has seen some of the lowest mortgage rates in history, so many people are locking that in by proceeding with a fixed-rate mortgage.

Potentially save more with a variable rate

Variable mortgages are quoted as Prime +/- a specific number, like “Prime - 0.25%.” As the prime rate changes, so do the payments towards your mortgage. What makes this appealing is that at any given time, variable-rate mortgages are cheaper than fixed mortgages. By going this route, you’re being rewarded for your risk.

In a stable or falling interest rate environment, variable rates will save you more money. However, if rates go up, so do your payments towards interest. That will cost you more if you have a variable rate. That said, you can often convert your variable mortgage to fixed if it’s allowed in your contract.

"As a general reference, most experts advise borrowing no more than 5x your annual income."

What’s the difference between mortgage term and amortization?

Two other major aspects of your mortgage are the term and amortization. If you’re new to mortgages, these options can be confusing as they’re both dealing with time but have very different meanings. However, they both affect your payments, so you’ll want to understand how they work.

Mortgage term

When you choose a mortgage rate, you need to select a term. This mortgage term is the amount of time that you’re committing to your mortgage rate. For example, if you get a 5-year fixed-rate mortgage at 2.5% interest, then that’s how much you would pay over the next five years.

While terms typically range between 1-10 years, most people choose five years. When your term is up, you will renew your mortgage at the current rates.

Mortgage amortization

The mortgage amortization period refers to the length of time during which you will pay your entire mortgage. Although you may have chosen a 5-year mortgage term, it’s unlikely you’d be able to pay off the total balance during that time. The amortization period is a way to make the payments more manageable. Most new homeowners get a mortgage amortization of 25 years. If you have more than a 20% down payment, some lenders will even let you go as long as 30 years.

When it comes time to renew your mortgage, you would usually reduce your amortization period at the same time. For example, let’s say you started with a 5-year term amortized over 25 years. When it’s time to renew, you would pick a new term, but change your amortization schedule to 20 years since you’ve already made five years of payments.

What are the mortgage payment options?

The other factor that will decide your monthly mortgage cost is your payment frequency. This will determine how much and often the lender will withdraw from your bank account. Your mortgage payment options are as follows:

  • Monthly: You make one payment a month.

  • Bi-weekly: You make a payment every other week. The amount is calculated by multiplying your monthly payment by 12 and then dividing it by 26.

  • Accelerated bi-weekly: Your monthly mortgage payment is divided by two. This amount is then withdrawn every other week.

  • Weekly: You make a payment every week. The amount is calculated by multiplying your monthly payment by 12 and then dividing it by 52.

  • Accelerated weekly: Your monthly mortgage payment is divided by four. This amount is then withdrawn every week.

Monthly and bi-weekly are the most popular choices. First-time homebuyers will often gravitate towards the monthly option since it makes budgeting easier. That said, it can be highly beneficial to go for one of the accelerated options.

Take a look at how accelerated bi-weekly payments are made. Your monthly payment is multiplied by 12 and divided by 26 since there are 52 weeks in the year. You’d be paying a little more every withdrawal, but you’re also making one extra monthly payment during the year. This would reduce the amount of interest you would pay and shave years off your mortgage.

What else should I consider when getting a mortgage?

Understandably, most people who buy a home will only look at what a mortgage will cost them each month. Going for the lowest rate possible is a good strategy, but it shouldn’t be your only concern. There are two other things you’ll want to consider when looking at your mortgage options.

Prepayments

Some lenders will allow you to make additional prepayments. For example, they may allow you to increase your payment options by up to another 25%. Additionally, they may also allow you to make a lump sum payment once a year of up to 25% of the total balance.

This may not seem like a big deal for people on a strict budget, but any additional payments go 100% towards the principal amount. This is relevant since every mortgage payment consists of two parts: interest payments and the principal. The interest payments go to your bank, while principal payments go towards equity. With a 25 year amortization, most of your payments are going towards interest so any additional prepayments you can make will only benefit you.

Fees if you break your mortgage

Many people don’t think they’ll ever need to break their mortgage, but a lot can happen during your five-year term. You might need to upsize or downsize due to a life event, you could relocate for work, or interest rates may have fallen.

Since your mortgage is a contract, there are going to be fees that you need to pay for breaking it. Your fees will depend on a few different variables, but most penalties are calculated with one of the following:

  • Three months of interest

  • Interest rate differential (IRD)

At first glance, this may not seem like a big deal, but it could amount to thousands of dollars. However, breaking your mortgage and paying the penalty could be the right decision if it can get you access to current lower rates, saving you more in the long run.

Mortgages with the lowest rates often have limited prepayment options and high fees, and are often referred to as closed mortgages. Their higher restrictions are why it’s not wise to jump straight to the mortgages with lowest rates. In contrast, open mortgages give you a bit more flexibility.

Should I use a mortgage broker?

You can’t talk about mortgages without mentioning mortgage brokers. Many people will go to their bank to inquire about mortgages, but those in-house mortgage specialists can only offer you what’s available from their employer.

Mortgage brokers aren’t restricted to a single lender, so they can shop the market for you to get you the best rate. This is clearly beneficial for you since they may have access to lenders that you may have never even considered. Since mortgage brokers are paid by the lender, there’s no harm in working with one.

In most cases, mortgage brokers can get you better rates. That said, you should still do your due diligence and see what various banks can offer you. Compare that to what your broker can secure and then decide what’s best for you.

How to choose the right mortgage

There’s no need to rush things. Take the time to educate yourself. If you’re actively on the hunt for a new home, start by getting pre-approved, so you know for what amount you’ll qualify.

By now, you should have a good understanding of how mortgages work, but you won’t know what’s the right fit until you’re ready to buy. Low rates are always appealing, but be smart about your purchase price and don’t stretch out your budget. Use an online mortgage calculator so you can see how different rates, terms, and payment options will affect your monthly budget. By doing this, you can keep your options open.

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