Anyone who’s buying a home will likely need a mortgage. First-time home buyers in particular might wonder: how does a mortgage work in Canada? It’s a straightforward financial product, but what can confuse people are the different options and interest rates available. Since purchasing a home will likely be the most significant expense of your life, you’ll want to ensure that you understand how mortgages work.
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How does a mortgage work?
A mortgage is a loan that’s specifically used to purchase a home. Since most people won’t have enough cash to pay for a home, they need a mortgage from a financial institution or private lender to help pay the balance. Once you have a mortgage secured, you make payments on an agreed schedule. Every mortgage is different, but they all have similar components that you need to be aware of and understand.
When people think about mortgages, the first thing that comes to mind is typically the interest rate. The interest rate is the cost of borrowing.
For example, let’s say the current interest rate is 2%. That means you would pay $2 for every $100 borrowed. This is a very simplified answer as other factors come into play, but you get the idea.
When interest rates are low, the cost of borrowing is cheaper. That means you could potentially borrow more. On the other hand, if rates go up, so do your monthly payments, affecting how much home you can afford. The interest rates lenders offer are based on the prime rate from the Bank of Canada. Rates can change at any time, so be sure you know what the current rates are.
Nerdy tip: A halal mortgage is a home loan for practicing Muslims. According to Sharia law, riba — or loans that charge interest — are seen as exploitative. Instead of typical mortgage interest rates, a halal lender might charge a “profit rate.”
Types of mortgages
When getting a mortgage, you have two options available: fixed and variable. With a fixed-rate mortgage, your interest rate stays the same for the length of the term. You’re essentially locking in your rate, so you’ll know exactly what you’re paying.
Variable-rate mortgages offer a discount (e.g., prime minus X%), which means you’re paying less than current fixed rates. If interest rates fall, you get even bigger savings. However, if interest rates rise, you may end up paying more than what you would have paid with a fixed-rate mortgage. That said, some lenders allow you to convert your variable-rate mortgage to a fixed rate, so you still have options.
Closed and open mortgages
Besides fixed and variable, you also need to choose between closed and open mortgages. Most homeowners will go with a closed-term mortgage since it gets them access to lower interest rates. The trade-off is that you will pay a penalty if you want to renegotiate your mortgage or pay off the balance before your term ends. That said, closed-rate mortgages can come with prepayment privileges that allow you to make additional payments without penalty.
Open rate mortgages are a good choice if you think you’ll be able to repay your mortgage in the near future. You can repay either part or all of your mortgage without having to worry about any fees. Converting your mortgage to another term without any penalties is another option. This added flexibility comes at a cost in the form of higher interest rates.
Amortization period and term
Since mortgages are typically huge, they need to be paid back over many years. This is known as the amortization period. Most new homeowners will get a mortgage with an amortization period of 25 years, but in some situations, you can get a 30-year amortization period. Having a longer amortization period will lower your monthly payments, but it’ll also increase the total amount of interest you’ll pay over the life of the mortgage. You can use a mortgage amortization calculator to see the effects of different amortization periods.
Your mortgage term is how long your mortgage contract lasts with a lender. Most people go with a five-year term, but terms can range from one to 10 years. A longer term will usually cost more, but the rate you get is locked in. A short term is appealing for the lower rates, but when your term is up you’ll need to renew at whatever the rates are at that time.
When setting up your mortgage, you have multiple payment frequency options. What you choose will determine how much you pay, and how often. The following are your mortgage payment options:
- Monthly: Payments happen once a month
- Bi-weekly: Your monthly payment is multiplied by 12 and then divided by 26. You make that payment every other week
- Accelerated bi-weekly: Your monthly payment is divided by two and then paid every other week
- Weekly: Your monthly payment is multiplied by 12 and then divided by 52. You make that payment every week
- Accelerated weekly: Your monthly payment is divided by four and then paid every week
Going with a monthly or bi-weekly payment scheduled can help many homeowners balance their budget. However, if you set an accelerated schedule, you’re making extra payments. That means you would be paying off your mortgage faster.
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Requirements for getting a mortgage
Whenever you apply for a mortgage, lenders are looking for three major things. As long as you have the following, you should be approved:
- A good credit score. Lenders want to ensure that you’re creditworthy.
- A down payment. You need to have at least 5% of the purchase price saved to qualify for a mortgage.
- Secured income. A letter of employment proves that you have a steady income and will be able to keep up with mortgage payments.
Even if you don’t meet all the criteria, you may still have options. Some lenders are willing to work with borrowers with lower credit scores, but you may have to pay a higher interest rate. Self-employed and low-income individuals can still get a mortgage, but they may need to prove their income or get a co-signer.
How much mortgage can I afford?
When it comes to how much mortgage you can afford, most lenders use two calculations to determine the maximum amount:
- Gross Debt Service (GDS) Ratio. Housing costs such as your mortgage, heat, condo fees and property taxes make up your GDS. The amount shouldn’t exceed 32% of your pre-tax income.
- Total Debt Service (TDS) Ratio. Adding any additional debt payments such as student loans and credit card debt to your GDS gives you your TDS. Lenders don’t want you to exceed 40% of your pre-tax income here.
While these debt service ratios are good estimates, it’s worth noting you need to factor in any other goals that you may have when determining how much you want to borrow. Things such as retirement savings, vacations, and even the cost of having kids need to include in your budget. If you take a bigger mortgage, you might stretch yourself thin when other expenses come up later.
Choosing a mortgage is not something that should be done quickly. You need to look at the different options and see which lenders have the best offers available to you. If you have more questions, seek the advice of a mortgage specialist at your financial institution. Alternatively, consider reaching out to a mortgage broker since they can shop around on your behalf.
If you change your mortgage contract mid-term, expect to pay for it. Your penalty could be three months’ interest or the amount determined by your lender’s interest rate differential.