When you take out a mortgage to buy a home, a lender agrees to finance the difference between your down payment and the sale price, and you agree to repay the loan, plus interest, over time.
What Is a Mortgage?
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.
A mortgage typically provides the bulk of the funds needed to buy a home or commercial property, but you’ll still 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% or as high as 20%. Your mortgage — the amount you owe to the lender — is the difference between the sale price and your down payment.
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.
- Had a down payment of 20% (resulting in a mortgage of $320,000).
- Has a mortgage with an interest rate of 5%.
|20-year amortization period||25-year amortization period|
|Monthly mortgage payment||$2,103||$1,861|
|Total interest paid over life of the mortgage||$184,672.02||$238,340.79|
The mortgage term is the length of your repayment agreement with your lender. While the amortization period projects all future payments until your mortgage is repaid — 25 years, for example — your mortgage contract is more likely to be shorter. Five-year terms have historically been the most prevalent length, but Canadian lenders also offer longer and shorter options.
Lenders make money by charging interest on the amount you owe. Higher interest rates result in higher monthly payments for the same size loan. In general, interest rates track the Bank of Canada’s overnight rate — mortgage rates rise when the overnight rate increases and vice versa. 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.
- Had 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|
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Paying off your mortgage
Mortgage payments are equal amounts you’re required to pay on a pre-defined, legally binding schedule (however, if you have a variable-rate mortgage, payment amounts can change over time). 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 and could also include fees and insurance charges.
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 is calculated by applying your interest rate to your current principal. As your principal gradually decreases over time, the amount of each mortgage payment that goes toward interest also decreases, so the amount going toward paying off your principal increases (variable-rate mortgages can be an exception to this general rule).
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.
Depending on which mortgage lender you choose, you may be paying 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.
If you buy a home worth up to $1 million with less than a 20% down payment, you’re required to pay mortgage default insurance, a monthly payment that protects lenders against additional risk. If you’re looking at homes above $1 million, you won’t pay mortgage default insurance because you don’t have the option to buy those homes with less than 20% down.
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, you’re charged interest.
How to find 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-rate mortgages can rise and fall during your term. The Bank of Canada’s overnight rate is the primary driver.
- Fixed-rate mortgages keep the same interest rate for the length of the contract, even if mortgage rates in general change.
Do you plan to pay off your home ahead of schedule?
- Open mortgages give you greater flexibility to make prepayments.
- Closed mortgages don’t allow as much prepayment activity. You will likely face penalties if you prepay.
Do you have a down payment of at least 20%?
- Insured mortgages, also called high-ratio mortgages, involve borrowing more than 80% of a home’s price. They’re called insured mortgages because they require buyers to purchase mortgage default insurance. This insurance adds to your monthly payment but doesn’t go toward paying off your loan.
- Uninsured mortgages don’t require mortgage default insurance. You can avoid this insurance if your down payment is 20% or more.
How the mortgage process works
No matter where you eventually apply for a mortgage, you’ll generally go through the same process.
1. Get pre-qualified
Getting pre-qualified for a mortgage is generally a quick and simple process you can do online. You send your basic financial information (your assets, income and debt) to a lender, and they give 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.
But pre-qualification is still a valuable first step: Having an informed sense of what your home-buying budget might be can help you establish expectations around the kind of property you can afford.
2. Get pre-approved
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 check your credit score and credit report to assess your ability to pay back debt and discover whether you have any red flags in your credit history.
Income information. A lender wants to be confident that you can afford your mortgage and keep up with payments. They’ll verify the information you provide by asking to see a letter of employment and pay stubs.
Other outstanding debts. Lenders will examine your debt service ratios, including:
- Your gross debt service ratio (GDS), which is the percentage of your pre-tax income that goes toward housing costs. Most lenders won’t offer you a mortgage if it results in a GDS higher than 39%.
- Your total debt service ratio (TDS), which is the percentage of your pre-tax income that goes toward all outstanding debt payments, including credit card debt. Lenders typically don’t approve mortgages if it leads to a TDS above 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. In other words, if you’re offered a rate of 5.75%, lenders will want to know whether you could still make mortgage payments if the rate were actually 7.75%.
Once the pre-approval process is complete, your lender will give you a mortgage pre-approval that sets out how much you can borrow and what interest rate you’ll be charged. Like a pre-qualification, 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. And, if your financial situation doesn’t change before you 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. So make sure you understand which documents your lender is asking for and make sure they’re easily available by the time 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, which tells your lender whether the loan 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.
Frequently asked questions about what a mortgage is
A mortgage is a loan people use to buy property. A lender provides the amount required and is paid back, with interest, over a period of months or years.
The property being purchased is also the collateral, which means the lender can repossess it if the borrower fails to make the required payments.
A mortgage is a common type of home loan, but there are other types. A home equity line of credit, for example, also uses a home as collateral to secure additional financing.
Knowing how much house you can afford sets realistic home buying expectations — and can show you where your finances might need a little help.
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