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How do mortgages work in Canada?

30 May 2018

Before you execute your plans to buy a new home, you must take the time to ask and learn the answer to this question: How do mortgages work?

Not all aspiring homeowners in Canada have the extra money to pay up front the full purchase price of their dream home. And so, to be able to afford the cost of buying a new property, they take out loans, or more particularly, mortgages.

This entails borrowing money from banks and other financial institutions and slowly paying off the amount loaned with interest. This sounds simple enough, but there are many considerations to think about before a potential homebuyer should apply for a mortgage.

There different types of mortgages and each has key features which may or may not suit you. Moreover, although mortgages are common across the globe, the rules which govern them have key differences in every country.

To help you navigate this aspect of the real estate world, here is a guide to understanding how mortgages work in Canada.

1. You need to prepare your down payment

In Canada, you won’t be able to purchase a house unless you have enough money saved up to cover your down payment, which must be paid up front. The down payment is a percentage of the total purchase price of the property.

Generally, homebuyers are required to pay 20% of the purchase price as down payment. However, it is also possible for you to secure a mortgage even if you only have enough money to pay less than 20% of the property’s price (e.g., 5% or 10%).

In cases like these, having mortgage loan insurance is a must. This protects the lender in the event that you default on your payments since it is the insurer who will then be accountable to pay for what you owe.

2. You need to get pre-approved before applying for an actual mortgage

Getting pre-approved is a very important step of the homebuying process because it gives you a clearer picture of your preparedness to take on the responsibilities of homeownership and helps you set a more realistic budget that you can afford for the long term.

Once you’re pre-approved, you may also lock in a specific interest rate for a limited period of time while you’re still house-hunting.

When you approach a lender to seek pre-approval, the bank or lending institution will require you to submit:

  • Proof of identity (IDs) issued by the government
  • Proof of address
  • Employer’s contact information and employment history
  • Proof of income
  • List of debts and assets

Lenders will pay particular attention to your credit history as it sheds light on how financially responsible you are (i.e., whether you pay bills and debts on time).

3. You must determine what type of mortgage (open or closed) suits you best

Do you plan on making extra payments to completely pay off your mortgage as soon as possible? Then, you should try to get an open mortgage since it’s more flexible in letting you make prepayments. However, the interest rate for this type of mortgage is usually higher.

A closed mortgage, on the other hand, offers a lower interest rate but limits how much extra money you can add to pay your mortgage faster. This type of mortgage usually charges penalty fees if you try to make prepayments which are more than the limit set by your lender and if you choose to break the mortgage agreement.

4. How long will it take for you to completely pay off your mortgage?

The time it takes for you to pay the principal amount of the loan (plus interest) is called the amortization period. It is usually between 10 and 25 years, and your monthly payment will vary depending on the amortization period you chose.

A longer amortization period may mean smaller monthly payments, but it also means you’ll be paying more in interest. Within the first five years, you will barely shave off the principal amount you owe your lender, as most of what your payments covered was the interest of the loan.

5. You will need to renew your mortgage once the mortgage contract expires

The Financial Consumer Agency of Canada defines mortgage term as “the length of time your mortgage contract will be in effect.” The duration ranges from several months to five years, sometimes even longer.

This means the terms and conditions of your mortgage agreement with the lender, including the established interest rates, will only remain valid before the end of the mortgage term. After that, you must renew or renegotiate your mortgage under new terms.

You should opt for a short-term mortgage if you intend to secure a lower interest rate for your mortgage in the next few years, or if you have plans to move into a different home eventually. However, interest rate fluctuations may not be favorable to you when the mortgage term ends, which means you might end up with a mortgage that has a higher interest rate.

In a long-term mortgage, you get to lock in the current interest rate so that you won’t be affected by the fluctuations in market rates. However, should you decide to change any part of your mortgage agreement, you may be liable to pay prepayment penalties.

There are also mortgages with a convertible term. It may initially be a short-term mortgage, but you have the option to convert it to a long-term one later on. However, once you request the conversion, the interest rate will adjust according to the lender’s rates for long-term mortgages.

6. You must choose between a fixed interest rate mortgage or a variable interest rate mortgage

Lenders like banks don’t give you money to buy a house unless they are guaranteed financial gains in doing so. Therefore, in exchange for lending you the money you needed, you must also pay for their services in the form of interest.

These lenders usually give borrowers the option to choose either a mortgage with a fixed interest rate or one with a variable rate.

Fixed interest rates, in general, are higher than variable interest rates, but they are guaranteed to stay the same throughout the mortgage term.

A mortgage with a variable interest rate means the interest you owe your lender will vary depending on the rise and fall of market rates. You may be paying a low interest rate now, but that can change in the future. Given the unpredictability of the market, variable mortgages offer lower interest rates than fixed mortgages.

Some lenders, however, offer hybrid or combination mortgages. In these types of mortgages, a part of your mortgage is protected from market rate fluctuations (like in fixed rate mortgages). The rest won’t be. Hence, if interest rates drop, you still stand to gain some benefit though not as much as a variable rate mortgages usually do.

7. How frequent will you make your mortgage payments?

In Canada, you may choose how often you pay your mortgage, and so, you must make sure that your chosen payment schedule suits you and your lifestyle best. You may decide to pay on a monthly, semi-monthly (twice a month), biweekly, or weekly basis.

As you can see, mortgages in Canada can get complicated. This is why it is best that you consult with a trusted mortgage professional who can guide you in securing a loan so that you can buy a new home.

8. Conventional vs. high ratio mortgages?

Mortgages that require at least a 20% down payment are referred to as conventional mortgages in the industry while anything less than a 20% down payment would be known as a high ratio mortgage. Uninsured mortgages require the borrower to undergo a stress test where borrowers have to qualify at the contractual mortgage rate + 2%.

The qualification criteria becomes less imposing with the more money you put down. With a higher down payment comes higher leverage against the banks qualification criteria imposed to hedge their risk in case of mortgage default. The more security you have to offer (collateral), the less stringent the qualification criteria becomes.

Another alternative option that comes with far less hoops to jump through and less bureaucracy involves borrowing from private or alternative lenders. They are more flexible to accommodate many borrowers’ situations that wouldn’t typically fit the rigid system of major banks.

9. Understanding the different lender tier options?

With the newly imposed mortgage regulations taking a toll on Canadian mortgage borrowers, many have started looking towards alternative lenders. Following regulatory changes, mortgage brokers claim as much as a 20% uptick in rejection rates. This has created an opportunity for mortgage investment corporations, private lending options and credit unions to fill the gap that the primary lenders have left wide open.

It is unfortunate that some would be qualified borrowers prior to the regulatory measures have been shunned by the institutional banks. However, the stress test with alternative lenders is more lax and does not come with all the newly imposed stringent qualification procedures looking to cool the housing market.

Institutional lenders including the likes of CIBC, RBC, BMO, TD and Scotiabank are oftentimes referred to as “A lenders.” These are lenders that offer the lowest interest rates but with the most strings and qualification criteria attached including the newly imposed mortgage stress test.

Lending institutions that fall directly below these A lenders are known as “B lenders.” The barrier of entry for acquiring a mortgage through this channel is slightly lower. Meaning, the qualification procedure is not as stringent. If you have a lacking credit history for example, this is where a B lender would have some flexibility to accommodate your case.

Alternative or private lenders are increasingly popular mainly due to their flexibility. There is of course oversight and regulation of these lenders but they are not on such a tight leash compared to A lenders. If you happen to be self-employed for instance, this would be a great option for you to start shopping.

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