What Is a Mortgage?
A mortgage is a long-term loan used to pay for real estate. When you pay it back, your mortgage payments include a portion that goes toward interest and one that goes toward the principal.
Every mortgage in Canada is made up of the same components, though the details of each component can differ from one mortgage to the next.
For example, one homeowner might prefer to take on higher monthly payments in order to pay off their loan more quickly and pay less in total interest, while another might prefer paying their mortgage off over a longer period of time — which means lower monthly payments but a higher total amount paid in interest.
Parts of a mortgage
Down payment
A mortgage typically provides the bulk of the funds needed to buy a home or commercial property, but you need to provide some money upfront. The money you bring to the table is called the down payment.
Depending on the cost of the home, the down payment can be as little as 5%. Your mortgage — the amount you owe to the lender — is the difference between the sale price and your down payment.
Amortization period
The amortization period is the amount of time it will take to pay off your mortgage in full. The length of time is typically negotiable. With Canadian mortgages, the most common amortization period is 25 years.
All else being equal, the longer the mortgage, the lower the monthly mortgage payment. But, you’ll pay more overall due to interest charges.
For example, here’s how a five-year difference in amortization period affects the interest charges for a house that:
Costs $400,000.
Used a down payment of 20% (resulting in a mortgage of $320,000).
Has a mortgage with an interest rate of 5%.
20-year amortization | 25-year amortization | |
|---|---|---|
Monthly mortgage payment | $2,103 | $1,861 |
Total interest paid over life of the mortgage | $184,672.02 | $238,340.79 |
Mortgage term
The mortgage term is the length of your mortgage contract. At the end of each term, you'll have to pay off your mortgage in full or renew it.
Five-year terms have historically been the most prevalent length, but Canadian lenders also offer longer and shorter options.
Interest rate
Lenders make money by charging interest on the amount you borrow. Higher interest rates result in higher monthly payments for the same size loan.
On an individual level, factors like your credit score and the term length of your mortgage can result in a rate that’s higher or lower than average rate.
Interest can significantly affect monthly mortgage costs. Here’s how different interest rates can affect the mortgage for a house that:
Costs $400,000.
Used a down payment of 20% (resulting in a mortgage of $320,000).
Has an amortization period of 25 years.
4% interest rate | 6% interest rate | |
|---|---|---|
Monthly mortgage payment | $1,683 | $2,047 |
Total interest paid over life of the mortgage | $184,979.40 | $294,214.36 |
Paying off a mortgage
Mortgage payments are due on a pre-defined, legally binding schedule. How often you make mortgage payments — monthly, semi-monthly or bi-weekly, for example — will be up to you.
Your mortgage payment includes amounts that go toward the mortgage principal and interest, but they may also include fees and insurance charges.
Mortgage principal
The principal is the original amount of money you borrow. A portion of every mortgage payment goes toward reducing the amount of outstanding principal you owe. When you’ve paid off the principal, you’ve paid off your mortgage.
Mortgage interest
Mortgage interest is calculated by applying your interest rate to your current principal. As you make payments over time, the portion of each one that goes toward interest decreases, so the amount going toward paying off your principal increases.
Mortgage interest comes in two types: fixed and variable. With fixed interest rates, your interest rate and mortgage payments will stay the same for the length of your mortgage term. With a variable rate, your interest rate can rise or fall depending on movements in the lender’s prime rate.
Fees
Depending on which mortgage lender you choose, you may pay certain fees when you pay your mortgage. If you visit a lender’s website and see a mortgage rate that features a higher annual percentage rate (APR) it’s likely the result of these fees.
Nontraditional mortgages, like halal mortgages for example, might have a fee structure that makes it tough to compare directly to traditional mortgages.
Mortgage insurance
If you buy a home worth up to $1.5 million with less than a 20% down payment, you’re required to buy mortgage default insurance. Mortgage insurance is a monthly payment that protects lenders against the risk of default.
If you’re looking at homes above $1.5 million, you won’t have to buy mortgage default insurance. Homes worth that much aren't eligible to be insured and require a minimum down payment of 20%.
You can pay the insurance premium, which is typically between 0.6% and 5.6% of your mortgage, upfront, or you can pay it over time as part of your routine mortgage payments. If you pay over time, your mortgage premiums will be added to your mortgage principal.
Finding the mortgage that works best for you
In Canada, home buyers have access to several types of mortgages to choose from. To find the one that best fits your situation, you’ll need to answer the following questions:
How long will your mortgage last? Short-term mortgages last two years or less. Long-term mortgages include the popular five-year, fixed-rate mortgage.
Are you comfortable with your interest rate changing? Variable mortgage rates rise and fall, and can save or cost you money. Fixed rates remain the same for an entire mortgage term.
Do you plan to pay off your home ahead of schedule? Open mortgages give you more prepayment flexibility than closed mortgages, but their interest rates are higher.
Do you have a down payment of at least 20%? If so, you can avoid buying mortgage insurance. A down payment of at least 5% is required for homes worth $500,000 or less.
The mortgage process
In Canada, you can get mortgages from many different financial institutions, including Canada’s Big Six banks, credit unions, alternative lenders and private mortgage lenders.
No matter where you eventually apply for a mortgage, you’ll generally go through the same process.
1. Pre-qualification
Getting pre-qualified for a mortgage is generally a quick and simple process you can do online. You provide your basic financial information and a lender gives you a general estimate of what they may lend you.
Pre-qualification is not legally binding. A lender may offer different terms after thoroughly examining your finances if you later submit a more formal mortgage application.
2. Pre-approval
The mortgage pre-approval process is more involved. This is when lenders take a much closer look at you and your finances. They’ll consider the following:
Credit score. Lenders will assess your ability to pay back debt and see whether you have any red flags in your credit history.
Income. A lender wants to see that you can afford your mortgage. They’ll verify the information you provide by asking to see a letter of employment and pay stubs.
Debt levels. Lenders will examine your debt service ratios, including your gross debt service ratio and your total debt service ratio, to see if you can manage a mortgage on top of your current debt obligations. GDS should be below 39%, TDS should be below 44%.
Stress test. The mortgage stress test shows what would happen if you were to face higher interest rates. For the test, your bank will use an interest rate of either 5.25% or your negotiated interest rate plus 2%, whichever is higher.
Once the process is complete, your lender will give you a mortgage pre-approval letter that sets out how much you can borrow and what interest rate you’ll be charged.
A pre-approval doesn’t equate to a legally binding contract, but it does give you a much closer estimate of how much house you can afford. If your financial situation doesn’t change before you formally apply, the terms in your pre-approval should remain available.
3. Apply for a mortgage
Once you’ve made a successful offer on a home, you’ll need to formally apply for your mortgage. Your lender will look at your finances again to ensure you’re still able to afford the mortgage you’ve been pre-approved for.
If you haven’t been pre-approved, or if you decide to apply with a different lender, you’ll have to provide the financial information mentioned above. Make sure you understand which documents your lender asks for and that they’re all available when you’re ready to apply.
At this stage in the process, you’ll also have to provide information about the property you’re purchasing in the form of an appraisal. An appraisal tells your lender whether the home they’re funding is overvalued. If your lender is satisfied with the home’s valuation, your down payment and your overall ability to pay back your mortgage, you should be approved.
DIVE EVEN DEEPER
Clay Jarvis
