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WHAT IS A MORTGAGE? -HOW MORTGAGES WORK

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Most people would consider buying a home is a very exciting prospect.

Homeownership can provide a feeling of pride as it is often considered a significant life accomplishment. And in many cases, owning a home can also boost your long-term financial outlook.

However, homeownership is a serious commitment that requires careful consideration. Before receiving the keys to your new home, there are a few key factors to ponder upon and determine whether homeownership is right for you.

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How to pay for your home is an essential factor to consider.

First, most people will require financing to make their homeownership dreams come true, and securing a mortgage is not exactly a walk in the park.

Second, the financing aspect of house hunting can feel a bit overwhelming. You may have encountered confusing terms such as “amortization,” “pre-approval,” and “escrow accounts.” 

Chin up, though: The right information and an understanding of the lingo will significantly simplify the process for you. This article will discuss what a mortgage is and everything you need to know before securing one.

What is a Mortgage?

A mortgage is a type of loan from a lender (bank or other financial institution) used to purchase real estate. This kind of loan allows the lender to take possession of the property if a borrower defaults.

Let’s consider Suzy, who is looking to buy a condo selling for $350,000.

Suzy has been diligently saving over the past few years and has accumulated $50,000.

Through the Home Buyers Plan, Suzy can also access an additional $15,000 from her RRSP. In addition to her savings, Suzy has $65,000 to put towards her first home purchase.

To buy the condo, Suzy will require a mortgage of $285,000 (i.e., the selling price of $350,000 less her available cash amount of $65,000).

Suzy’s lender will take her $65,000 deposit and add $285,000 to add up to the condo’s $350,000 selling price.

  • The lender will then give this amount to the seller’s bank in exchange for the condo’s ownership (title).
  • Suzy will receive keys to her brand new home. She will also now have a loan of $285,000, of which she is obliged to make regular monthly payments to her lender.

Important Mortgage Terminology

Mortgage Amortization vs. Mortgage Term

The Mortgage Amortization is the length of time you would require to pay off your mortgage in full. The typical amortization period is 15, 20, 25, or 30 years.

In Canada, if you make a deposit of less than 20% and therefore require mortgage insurance, the maximum amortization is 25 years.

Mortgage Term is the length of time you commit to a rate, a lender, and the related terms and conditions. It can range from 6 months to 10 years. In Canada, the average mortgage term is 5 years.

At the end of a mortgage term, you may need to renegotiate your rate to extend to a new term and continue making payments.

Down Payment

A down payment is the amount of money you put towards purchasing an expensive item or service. It is usually a percentage of the total purchase price.

In Suzy’s example, she put a down payment of $65,000 towards her condo purchase. This  amount is about 18% of her condo’s purchase price.

If you put a down payment of less than 20% in Canada, you must purchase mortgage loan insurance.

A larger down payment lowers your monthly payments and the amount of interest paid over the life of the loan.

The table below gives the minimum down payment requirements in Canada.

Purchase Price Minimum Down Payment
$500,000 or less 5% of Purchase Price
$500,000 to $999,999 5% of the 1st $500,000 10% of portion above $500,000
$1,000,000 and above 20% of Purchase Price

Mortgage Default Insurance

Mortgage Default Insurance protects lenders in case a borrower defaults on their loan. It does not cover the borrower.

You can pay the related insurance premium in a lump sum or add it to your mortgage and include it in your monthly payments.

If you make a down payment of less than 20% in Canada, you must have mortgage default insurance. The three mortgage loan insurance providers in Canada are CMHC, Sagen and Canada Guaranty.

Mortgage Default Insurance costs 2.8% to 4.0% of your loan amount. However, it may be beneficial for the following reasons:

  • Makes homeownership accessible with a lower down payment
    • Lenders can offer lower interest rates as the insurer bears the default risk

Breaking Down A Mortgage Payment

Financial independence involves keeping debt at a minimum. And as such, understanding your mortgage payment will help you to plan your cashflows and manage your debt repayment horizon.

Typically, your mortgage payment includes principal and interest. You could pay taxes and insurance separately, or you may have them included in your monthly payments.

Mortgage Principal

Principal is the amount borrowed from a lender. In Suzy’s example, she starts with a principal balance of $285,000.

A portion of the monthly mortgage payments reduce the principal amount owing to the lender. Early on, only a small part of the monthly payment goes toward principal, and most of it is interest.

As a borrower makes pays down the loan, an increasing share of the payment is applied to decrease the principal.

Mortgage Interest

Mortgage interest is the fee lenders charge for extending real estate loans. It is the cost of borrowing money and is also known as the cost of debt.

Interest compensates the lender for four main things:

  • Risk of loss, in case of borrower defaults
    • Cost of inflation
    • Administration cost for servicing the loan
    • Profit margin for providing financial service

Taxes

Taxes are the property assessments collected by your local government.

The local government may send a property tax bill to you directly, and you are responsible for making the payments yourself.

In other instances, lenders may collect a portion of your property taxes in every monthly payment and hold the funds in an account known as an escrow account.

When your property tax payment becomes due, the lender will remit payment to the local government on your behalf.

Insurance

Like property taxes, a lender may collect a portion of your insurance premiums in every monthly payment and keep the funds in an escrow account. The lender will make the insurance payments on your behalf as they come due.

Two types of insurance payments could apply to you:

  1. Homeowner’s Insurance: Financial protection covering losses and damages to your property due to fire, wind, theft, flooding, and other hazards. It is typically mandatory (and highly advisable) to maintain homeowner’s insurance.
  • Mortgage Default Insurance: Financial protection for the lender if you fail to make your monthly payments. Borrowers who make a down payment of less than 20% of the property price must obtain this insurance.

What is a Mortgage? How Mortgages Work

Types of Mortgages

As a homebuyer, you have various options for mortgages. The most suitable type of mortgage depends on your budget, risk tolerance, and unique circumstances.

Here is an overview of the common types of mortgages to consider:

Fixed-Rate vs. Variable Rate Mortgages

Fixed-Rate Mortgage: The interest rate is determined and fixed for the term of the loan. It is best if you are risk-averse, your budget is tight, or think interest rates are likely to increase.

Variable-Rate Mortgages (aka Adjustable Rate Mortgages): The interest rate fluctuates with the market interest rate. The variable rates are often lower than fixed rates but carry more risk as the market interest rate always has the potential to increase.

Closed vs. Open Mortgages

Closed Mortgages: Loan agreements that cannot be prepaid, renegotiated, or refinanced before maturity, except according to the terms of the mortgage.

Open Mortgages: Mortgage agreements that provide you with the flexibility to repay the loan at any time without penalty. Open mortgages typically have higher interest rates than closed mortgages.

Low Ratio vs. High Ratio Mortgages

Low Ratio Mortgages: A type of loan where the down payment is more than 20% of the purchase price. A low ratio mortgage does not require mortgage default insurance.

High Ratio Mortgages: A type loan where the down payment is less than 20% of the purchase price and requires mortgage default insurance.

Home Equity Lines of Credit (HELOC)

HELOC: Provides an option to borrow on your home’s equity (the difference between your home’s value and the outstanding loan balance).

Types of Mortgage Lenders

Today, banks are not the only mortgage providers in the market. As a prospective buyer, you may compare mortgages from both banks and mortgage brokers for the most competitive rates.

  • Banks: Typically offer their own financial products. A homeowner may find comfort in that banks are large financial institutions that can weather economic instability better.
  • Mortgage Brokers: Intermediaries with access to various lenders and interest rates and thus provide a wider variety of options.

Mortgage Pre-approval

Let’s clear the record; a pre-approval is not a guarantee that a lender will give you a loan.

A pre-approval simply means that a loan officer has assessed your finances (income, debt, assets, credit history) to determine how much money you could borrow and at what interest rate.

Pre-approvals typically last for 60 to 90 days, as many things could change after you get pre-approved. For instance, your income, credit score, or market interest rates could change.

Obtaining a mortgage pre-approval is useful for the following reasons:

  • A pre-approval letter shows lenders and sellers that you are a serious buyer
  • It helps you know how much you can afford and thus guides your house search
  • Accelerates your loan closing process as most of your information is in the lender’s system

Mortgage Payment Calculator

Getting a pre-approval lets you know how much your potential monthly payments will be.

Many online mortgage payment calculators can give you an idea of your monthly payments.

Feel free to check out our excel mortgage payment calculator that allows you to assess various scenarios by adjusting the amortization period, interest rate, and principal amounts.

Conclusion

What is a mortgage? A mortgage is simply a loan secured by real estate. Lenders require a down payment before extending a loan.

There are various types of mortgages with different aspects, and there is no one size fits all. The best kind of mortgage for you depends on your budget, risk appetite, and individual circumstances.

Making sense of all the mortgage jargon may feel a bit daunting at first, but that is entirely normal! This article will demystify mortgages and help you to feel confident before applying for your next mortgage.  

PIN IT FOR LATER!

What is a Mortgage?

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TAKE CONTROL OF YOUR PERSONAL FINANCES

download-750x952

Ever feel like money just seems to slip through your fingers month after month? Our Monthly Budget Tracker will guide you to start making the most of every dollar. It’s a game changer—get it free for a limited time!

Nikki Kirimi

Nikki Kirimi is a finance professional (MBA, CPA, CMA) and the creator of Money World Basics. She is passionate about acquiring and teaching personal finance knowledge to help women achieve their financial goals.