How do Mortgages Work in Canada?

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Have you ever wondered how do mortgages work in Canada? To simply put it, a mortgage is a loan that you get to help you purchase a home. That said, there are different types of mortgages and options available. Understanding the ins and outs of mortgages is vital since they’ll significantly impact your purchasing decision and monthly budget.

How do mortgages work in Canada?

Most people who buy a home will only have a down payment saved. So to cover the remaining balance, they need to get a loan from a lender. This is known as a mortgage

Your mortgage is a legal contract between you and your lender that outlines your loan details. If you fail to meet the conditions of your loan, the lender could take possession of your home. Mortgages are basically a secured loan, with your property being the item that’s been secured loan.

Obviously, you don’t ever want your home to be taken away. That’s why you need to stick to the conditions of your mortgage. Fortunately, if you ever find yourself in a difficult financial situation, you might be able to renegotiate the terms of your mortgage.

Generally speaking, as long as you’re making your monthly payments, you won’t default on your mortgage, and you’ll be able to stay in your home. Once you pay off your mortgage, the title is updated to remove the lender. You would then own your home outright.

What is a down payment?

To answer the question about how do mortgages work, you need to start with saving a down payment. That’s because the amount you save will affect how much you can borrow. In addition, if your down payment is less than 20% of the purchase price, you need to purchase mortgage loan insurance. That will increase your overall carrying costs.

The minimum down payment in Canada is as follows:

  • $500,000 or less – 5% of the purchase price
  • $500,000-$999,999 – 5% of the first $500,000 of the purchase price, 10% for the portion above $500,000
  • $1,000,000+ – 20% of the purchase price

Your down payment can come from anywhere. Most people will save up their money, while others may get their down payment as a gift from their family. Obviously, the larger your down payment, the lower your monthly carrying costs.

Anyone self-employed or has a questionable credit history may require a larger down payment or a co-signer. That said, some lenders have easier lending requirements. When getting a mortgage, it’s always best to shop around.

If part of your down payment is being gifted to you, then you’ll need to get a mortgage gift letter.

What is mortgage loan insurance?

As mentioned, if you have a down payment of less than 20%, you need to get mortgage loan insurance. That’s because you have a high ratio mortgage, and lenders are taking a chance when approving your mortgage. So to protect lenders, you’re required to get mortgage loan insurance.

Often known as mortgage default insurance, this insurance will pay the lender back what you owe if you were ever to default on your mortgage. Note that this insurance won’t cover you if you stop paying your mortgage. This is because you still have a binding contract with your lender.

The cost of mortgage loan insurance ranges from 0.6%-4.5% of your mortgage. The lower your down payment, the bigger your insurance premiums. This additional fee can be paid as a lump sum before you close on your home or added to your monthly mortgage payments.

Mortgage loan insurance can be purchased from one of the following companies:

  • Canada Mortgage and Housing Corporation (CMHC)
  • Sagen
  • Canada Guaranty Mortgage Insurance Company

What is the mortgage term and amortization?

Understanding your mortgage term and amortization is vital as they’ll affect your overall costs. Your term is the length of time your mortgage contract is in effect. Most people choose a 5-year term, but you can do it for as little as a few months to 10-years. 

You would renew your mortgage under a new term when your mortgage term is up. At that renewal period, you could also switch lenders without having to pay a penalty (if your mortgage contract allows it). You would also renew at the current interest rates available. Most people will require multiple terms before their mortgage is fully paid off.

Shorter terms typically give you better rates. For example, a 5-year mortgage might have a fixed rate of 2.49%, while a 10-year term could be 3.99%. The longer term buys you security. That’s why you’d have to pay a premium for it. Most people choose 5-year terms as it gives them flexibility while paying current rates.

Your amortization period is the total length of time it takes to pay off your mortgage. If your down payment is less than 20% of the purchase price, the maximum amortization you can get is 25 years. If you don’t have a high ratio mortgage, you can go up to 30 years, possibly more.

As you pay down your mortgage, your amortization period would also reduce. For example, let’s say you start off with a 5-year term with a 25 year amortization period. After the 5 years, you would get a new mortgage with an amortization period of 20 years. 

Having a longer term appeals to many people since it lowers your monthly payments. That said, you’ll also be paying more interest. As long as you keep reducing your amortization when your term is up, you’ll own your home outright eventually.

How do interest rates work?

Since mortgages are loans, you need to pay a fee to borrow that money. That’s known as interest and is calculated as a percentage of your loan. How much interest you’ll pay depends on a variety of factors including:

  • The current prime rate set by the Bank of Canada
  • Your mortgage term
  • The type of mortgage you choose (fixed or variable)
  • Your credit history

Generally speaking, the prime rate set by the Bank of Canada (BoC) will have the most significant impact on your interest rate. That’s because the prime rate is what the BoC charges financial institutions to borrow money. That money is then lent to consumers at a higher interest rate. In other words, when the prime rate is low, so are interest rates.

Your credit score also plays a significant factor. If you have a low credit score, lenders may not see you as creditworthy compared to someone with an excellent credit score. As a result, they may not offer you the lowest rates. They may not even lend anything to you.

How do fixed vs. variable interest rates work?

When people research how do mortgages work in Canada, they usually want to know the difference between fixed and variable mortgages. The differences are pretty simple, but they can have a significant impact on your finances.

With fixed rate mortgages, your interest rate stays the same for the length of your term. If the prime rate increases, your mortgage won’t since you’re on a fixed rate. In addition, you’ll know in advance how much of your payments are going towards your principal. Of course, since you’re getting security with a fixed rate mortgage, they’ll be more expensive than variable rate mortgages.

As for variable rate mortgages, they can increase and decrease during the term of your mortgage. For example, if the prime rate goes up or down, so would the interest rate on your mortgage. In addition, some variable mortgages are set, so the amount you’re paying actually changes with the interest rate. However, you can also get a fixed payment variable interest rate where your monthly payment is the same. The principal payment changes if the prime rate increases or decreases.

Traditionally, variable rate mortgages have been cheaper than fixed rate mortgages in the long run, but getting a fixed rate is highly appealing in a low interest rate environment.

What’s the difference between closed and open mortgages?

Regardless of what type of mortgage you get, you’re required to choose between open and closed mortgages. At first glance, open mortgages sound like a good choice since it allows you to pay off your mortgage at any time without having to pay a fee. However, for this privilege, you typically have to pay a fee that comes in the form of a higher interest rate.

Most homeowners choose to get a closed mortgage since it lowers their interest rates. However, if you want to change lenders or pay off your mortgage early, you’d have to pay a fee to do so. That’s not to say you can’t make additional payments without a cost. It’s just that you can only make extra payments that are outlined in your mortgage contract.

How do mortgage payments work?

Mortgage payments are made directly from a chequing or savings account. You can not make mortgage payments with your credit card. As for your payment frequency, that’s determined by you when you set up your mortgage. The options you have include:

  • Monthly – You’ll make one payment a month.
  • Bi-Weekly – Your payment is every other week. The amount you’ll pay is your monthly payment is multiplied by 12 and then divided by 26.
  • Accelerated bi-weekly – Your payment is every other week. The amount you’ll pay is your monthly payment divided by 2.
  • Weekly – Payments are made every week based on your monthly payment multiplied by 12 and then divided by 52.
  • Accelerated weekly – Your payment is every week. The amount you’ll pay is your monthly payment divided by 4.

If you choose an accelerated payment schedule, you’re making additional payments. These payments go 100% towards your principal. That means you could shave years off your mortgage.

How much mortgage can I afford? 

The amount of mortgage you can get will depend on multiple factors such as your down payment, income, and debt load. Since every person has a different situation, lenders typically use two quick calculations to determine how much mortgage you can afford: Gross Debt Service (GDS) and Total Debt Service (TDS).

Your total housing costs can’t exceed 32% of your pre-tax income with your GDS ratio. To qualify under the TDS ratio, your housing costs, plus any outstanding debt, can’t exceed 40% of your pre-tax income. Note that some lenders may have higher GDS and TDS requirements if you require mortgage loan insurance. 

Keep in mind that these ratios are used by financial institutions to quickly figure out how much you can reasonably afford. They don’t include your lifestyle costs such as travel, hobbies, raising kids, and retirement savings. They also use pre-tax dollars, which makes no sense since we get paid with after-tax dollars. In other words, you should never stretch out your budget when buying a home, or you’ll just be house poor.

What is the mortgage stress test? 

To ensure that people can afford their monthly payments, there’s also a mortgage stress test requirement. Basically, for all types of mortgages, you must qualify for a rate that’s the higher of 5.25% or the rate offered by your lender +2%.

For example, let’s say you’re offered a 5-year fixed interest rate of 2.99%. You’ll need to use the 5.25% interest rate when calculating affordability. If your rate is 3.49%, the stress test would be 5.49%.

The higher interest rate would need to fall under your GDS and TDS ratios. If it exceeds those ratios, you’d have to increase your down payment or find a home that has a lower cost.

How to get a mortgage?

Getting a mortgage is easy, but you do need to line up a few things first. In most cases, you’ll need at least the following:

  • A good credit score
  • A down payment of at least 5% 
  • Consistent income

With all of that in place, you could get pre-approved for a mortgage. This can be done at a financial institution or via a mortgage broker. The advantage of getting pre-approved is that you’ll know precisely how large of a mortgage you’ll qualify for, so you can shop accordingly.

Once an offer to purchase a home you’ve put in has been accepted, you would go through the formal process of getting a mortgage. Your real estate lawyer would ensure that the funds get to the appropriate parties and the mortgage is registered with your name and property.

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About Barry Choi

Barry Choi is a Toronto-based personal finance and travel expert who frequently makes media appearances. His blog Money We Have is one of Canada’s most trusted sources when it comes to money and travel. You can find him on Twitter:@barrychoi

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