What is a mortgage? Understanding how mortgages work in Canada
Author: Tom Drake
They say that buying a house is one of the most stressful experiences people go through. And it's no surprise, after all, there are so many things to consider. Getting a mortgage is one of the more complicated parts of the process. Perhaps you've never owned a home, and you're wondering how it all works. If so, you've come to the right place. This article will cover all of the basics of getting a mortgage in Canada.
What is a mortgage?
The basic definition of a mortgage is that it's a loan used to purchase or refinance a home. A business can take out a mortgage to buy a commercial property, but the vast majority of mortgages finance a personal property.
How do mortgages work?
Because mortgages are multi-faceted, perhaps the best way to explain how they work is to break down their main components.
Open vs. closed mortgages
A mortgage is either open or closed. A closed mortgage means that there are limits on how much of the balance owing can be paid down during the mortgage term, which we'll get into a bit later. An open mortgage has more flexibility with how extra payments can be applied.
Often, the borrower can pay off an open mortgage at any time without a penalty. The trade-off is that the interest rate on an open is higher than on a closed.
Due to their lower rates, closed mortgages are better for people who plan to stay in their house for the long term. An open mortgage is well suited for borrowers who are planning to pay off their mortgage soon, for any reason.
Most lenders have a portability feature on some closed mortgages, allowing the borrower to transfer the term and interest rate to a new property when they move. While conditions apply, mortgage portability can alleviate the worry of paying the penalty on a closed mortgage.
Mortgage down payment
When you purchase a home, you'll need to front a percentage of the purchase price using your resources. This is referred to as a down payment. A down payment is necessary because lenders will never finance 100% of the home purchase.
The standard down payment for a conventional mortgage is 20%, but homebuyers in Canada can purchase a house with as little as 5% down. The more you put down, the more money you'll save because a larger down payment means a smaller mortgage amount and less interest charged.
Mortgage default insurance
If your down payment is less than 20%, you will have to pay for mortgage default insurance, commonly referred to as CMHC insurance. This is a one-time premium, calculated as a percentage of the overall mortgage amount, paid when it's advanced.
CMHC stands for Canada Mortgage and Housing Corporation. They cover the lender on mortgages with less than 20% down payment, should the homeowner default on the mortgage. Two other companies also provide mortgage default insurance – Genworth Canada and Canada Guaranty.
Mortgage default insurance is something you will need to consider when going through the homebuying process.
Mortgage amortization period
The mortgage amortization period is the length of time it will take you to pay off the mortgage. The standard amortization length for mortgages in Canada is 25 years. However, borrowers can choose a shorter amortization period or pay off the mortgage earlier by applying additional funds to their principal balance. They do this via a lump sum payment or by increasing your regular payment.
What is a mortgage term?
When you sign up for a mortgage, you will agree to an interest rate and payment for a preset number of months. This period is known as the mortgage term. During the mortgage term, you will be subject to the various conditions you agreed to at the mortgage signing, like the interest rate and any prepayment allowances offered by the lender.
Mortgage interest rate
There are two types of interest rates to choose from when getting a mortgage, fixed and variable. Both types can be beneficial, depending on your situation and the overall market. Let's take a closer look at each.
Fixed rate mortgage
Historically in Canada, the most common mortgage loan type is a closed, 5-year fixed rate term. Because of their popularity, 5-year fixed rates are priced competitively amongst the various mortgage lenders. But most banks and credit unions offer fixed rates on terms ranging from 1 to 5 years, with some offering fixed rates up to 10 years in length.
A fixed rate mortgage is ideal for borrowers with limited budget flexibility or who simply want the peace of mind knowing that their rate (and monthly payment) won't rise unexpectedly in the middle of their term. A fixed rate can also be advantageous when interest rates are rising.
Interest rates in Canada have remained low for well over a decade now, however, which is why variable rates have become so popular.
Variable rate mortgage
Unlike fixed, variable interest rates are tied to the Bank of Canada Prime Interest rate and float up and down during the mortgage term. The most common variable rate term is five years (closed and open), but they are also available over different periods.
There is more risk involved with choosing a variable rate because they could rise with little notice at any time. A sustained rise in the mortgage rate can result in increased interest costs, even an increase in the borrower's mortgage payment.
Variable rate mortgages are well-suited for borrowers with the budget flexibility to absorb a sudden increase in interest rates.
What is a mortgage renewal?
When your mortgage term expires, you will need to meet with the lender to negotiate a new term and mortgage rate. This is known as a mortgage renewal. You will renew your mortgage several times over the life of the loan. The rate you get at renewal will depend on what the going rates are at that time. In most cases, your lender will allow you to renew the mortgage a few months early without a penalty. This can be an incentive to continue dealing with the same lender.
What is a mortgage broker?
Traditionally, Canadians have gone to their primary bank or credit union when they need a mortgage. That's no longer the case. More than ever, mortgage brokers are the initial contact for a prospective home buyer.
A mortgage broker doesn't act as the mortgage lender. Instead, they take your application and shop it to dozens of potential lenders to find you the best rate and terms for your mortgage. The home buyer doesn't pay the mortgage broker either. Instead, they are compensated by the lender as a fee for bringing them a new client.
Final thoughts on mortgages in Canada
As you can see, there's a lot to consider before getting a mortgage. In addition to the information provided above, you'll need to think about your monthly mortgage payments and mortgage insurance. Also, it's essential to make sure your credit score is in good shape before you apply. Hopefully this article has equipped you with plenty of knowledge. It's always recommended dealing with professionals when it comes to buying a home. This includes searching out a mortgage broker or bank advisor that you trust.