Buying a home is one of the most expensive purchases you can make. And, while it’s possible to buy a house with cash, most prospective buyers take out a mortgage to finance their new home.
More goes into a mortgage than simply borrowing money, but don’t worry. We’ll go through everything a beginner needs to know about a mortgage, how they work, what types you can get and how the application process works.
What Is A Mortgage?
A mortgage is a loan used to purchase real estate, typically a house. The mortgage holder agrees to repay the loan, plus interest, to the lender within a set period of time.
Mortgages are secured by the home being purchased. This means the house acts as collateral. The lender can claim it to recover their investment should the borrower fail to repay the loan.
How Does A Mortgage Work?
As mentioned, a mortgage involves more than lending and repayment of the loan. Let’s have a look at some of the basic components of a mortgage and what they mean to borrowers.
Mortgage Payments
Most homeowners make mortgage payments on a monthly basis, but payment frequencies can differ depending on your contract. The mortgage payment itself consists of four main items:
- Principal: Simply put, the principal on your mortgage is the total amount you’ve borrowed to finance the home. Every month, you’ll repay a portion of your principal.
- Interest: Your monthly payment also includes interest on the loan. Your specific interest rate is part of your mortgage contract.
- Taxes: Municipalities collect taxes from homeowners to help fund the services they provide. Unless you elect to pay the municipality directly, a portion of your mortgage payment will go toward property taxes.
- Insurance: Your monthly payment will also include premiums for any home insurance you may have. Your monthly payment could also include default insurance premiums, if you purchased a home with a down payment of less than 20% of your purchase price.
Early on in the repayment process, more of your mortgage payment will go toward interest than your principal amount. If your situation changes and your mortgage payment becomes unsustainable, you can take steps to lower your monthly payment.
Interest Rates
Mortgage lenders charge interest on home loans as a kind of borrowing fee. The interest rate you get will depend on your credit score, income and other financial factors – as well as market trends and rates set by the Bank of Canada. Generally speaking, lenders will offer more favourable rates to borrowers with stronger financial profiles.
Some lenders may offer more competitive rates in general than others. When choosing among lenders, it’s important to compare their interest rates.
Down Payments
You pay an upfront down payment on a property when securing a mortgage. A common down payment is 5% – 20% of a home’s purchase price. The minimum down payment standards are typically:
- 5% for homes up to $500,000
- 20% for homes $1,000,000 or more
For homes between $500,000 and $999,999, you’ll be required to put down 5% on the first $500,000, and 10% on the remaining balance. Let’s say you’re buying a home for $800,000. You’ll first make a down payment of $25,000, and then pay $30,000 for the remaining $300,000. In total, your down payment for the mortgage must be at least $55,000.
Closing Costs
When closing on your new home, you’ll be responsible for paying various legal and administrative fees. These are called closing costs and typically make up 1.5% – 4% of the home’s purchase price.
For budgeting reasons, it’s important to note that closing costs don’t include your down payment.
Loan Terms
Your loan term represents the length of your current mortgage contract with your lender. Mortgage terms in Canada usually last 5 years, though you may see other options. At the end of a given term, the borrower must renew their mortgage with their current lender (or switch to a new one) unless they’re able to repay the remaining principal balance. Most borrowers take multiple terms to fully pay off their mortgage.
Amortization Periods
The mortgage amortization period represents how long it’ll take a borrower to repay their mortgage in full. A typical amortization period lasts 25 years. Again, borrowers commonly renew their mortgage term multiple times before they’ve fully repaid the loan.
Types Of Mortgage Loans
Your mortgage may work differently depending on the type you choose. Here are some different types of mortgages you’re likely to encounter as you research your options.
Open And Closed Mortgages
The main difference between open and closed mortgages is that an open mortgage gives you more flexibility to make larger and extra payments on your mortgage to pay it off early without any prepayment penalties. Open mortgages tend to come with higher interest rates than closed mortgages, but the added flexibility may be worth it if you plan to sell your home or pay off your loan entirely before the end of a term.
Closed mortgages are much more common, in part because they tend to offer lower interest rates than open mortgages. With a closed mortgage, the terms and conditions set by the lender are “closed” for the duration of the term. Closed mortgages offer less flexibility with regard to making extra payments and paying your loan off early. However, some lenders will allow you to make lump sum payments of between 10 – 20% of your original principal balance per year without incurring a prepayment penalty. A closed mortgage can be a good choice for borrowers who want a lower interest rate and plan to stay in their home for at least the duration of their current term.
Fixed- And Variable-Rate Mortgages
Whether your mortgage is fixed- or variable-rate can affect how much you pay for your loan. A fixed-rate mortgage retains the same interest rate for a given term, meaning you’ll pay the same rate every month even if market rates go up or down during that term.
Variable-rate or adjustable-rate mortgages can change depending on the Bank of Canada’s overnight rate. You may end up with higher mortgage payments as market rates rise. However, you could also pay less if rates go down.
Convertible Mortgages
A convertible mortgage gives you the option to change your mortgage type during a given term. For example, you could convert an open mortgage into a closed mortgage. Many lenders will also allow you to switch from a variable-rate to a fixed-rate mortgage before the end of a term.
Conventional Mortgages
A conventional loan, or low-ratio mortgage, requires that you put 20% or more down on a home. In exchange for such a sizable down payment, conventional mortgages don’t require mortgage default insurance. Because of this, conventional loans are also sometimes referred to as uninsured mortgages.
High-Ratio Mortgages
A high-ratio mortgage is where your down payment equals less than 20% of a home’s purchase price. This situation creates more risk for lenders, so you’ll be required to purchase mortgage default insurance. For this reason, high-ratio mortgages are also called insured mortgages.
Portable Mortgages
A portable mortgage allows you to transfer your existing home loan to a new property, if you decide to sell your current home and buy another. This can be ideal for home buyers who have more favourable rates and terms on their current mortgage and don’t want to get a new one, or want to avoid a prepayment penalty.
If your new home costs less than the remaining balance on your current mortgage, though, you may end up paying the prepayment penalty anyway.
Assumable Mortgages
Conversely, an assumable mortgage allows a home buyer to take over the previous owner’s mortgage. If interest rates are currently high, the buyer may want to assume an existing mortgage with lower rates.
Sellers with years left on their term can also avoid prepayment penalties by transferring their current mortgage to a new buyer. The buyer then becomes responsible for all terms and conditions of the assumed mortgage.
While fixed-rate mortgages can often be assumed, variable-rate mortgages usually won’t qualify.
Standard Charge and Collateral Charge Mortgages
A standard charge mortgage only secures the primary mortgage loan amount. In other words, the lender agrees to lend only as much it costs to finance the home purchase itself.
By contrast, a collateral mortgage gives you the option to borrow additional funds after closing without refinancing or going through another approval process.
Mortgage Application Process
Canadian first-time home buyers ready for the mortgage process can follow the steps below:
- Check your credit score. First, look over your credit report and determine if your credit score qualifies for a mortgage. Knowing this early can also help you figure out what type of mortgage you may want to choose.
- Determine your house budget. Review your financial situation and determine how much money you’ll need to buy a house. Be sure to budget so that you’re still able to afford your various homeowner expenses after you’ve bought the house.
- Decide what type of mortgage you need. At this stage, you’ll want to research which type of mortgage might be best suited to your situation. Some factors include whether you’re looking for a fixed or variable rate, if you’d like the ability to make additional payments without penalty and the size of the down payment you’re able to make.
- Shop for and compare lenders. Look at multiple lenders before applying for a mortgage. Individual lenders may offer different products, higher or lower interest rates and can vary in the fees they charge. You may choose to enlist a mortgage broker to help you find the right lender.
- Apply for mortgage preapproval. If you want a close estimation of how much house you can afford, apply for a mortgage preapproval with a lender and see what your rates and loan amount might look like. Applying requires you to take a mortgage stress test, which determines whether you can still afford a mortgage if rates go up.
- Make an offer on a house. With preapproval in hand, you can find a home that you’re confident you can afford. This can be the fun part, but make sure you’re not only focused on the listing price. Maintenance costs, property taxes and other homeowner costs should be factored into your budget before you put in an offer. Once you have an offer accepted, it’s time to go back to your lender.
- Submit a full mortgage application. After you’ve chosen your lender and understand all of the requirements for a mortgage, submit a full application and all of the necessary documents. Mortgage approval (or denial) typically takes 2 – 10 business days.
- Close on the loan and begin repayment. If approved, you’ll proceed to the closing process, where you’ll sign various closing documents and pay for any closing costs that aren’t getting rolled into the mortgage. Once closing is complete, you’re officially a homeowner. Your first mortgage payment will typically be due 30 days after closing.
It can be helpful to work with a real estate agent throughout the home buying process. Their expertise and connections to the industry can be a great asset to new home buyers.
FAQs About How Mortgages Work
As you can see, there’s a lot to consider when getting a mortgage loan. Here are some common questions people ask to further understand how mortgages work.
What is refinancing a mortgage?
When you refinance your mortgage, you break your current mortgage and replace it with a new loan. Borrowers may refinance to extend their amortization period, take advantage of lower mortgage rates or to get a different mortgage type.
What is a mortgage broker?
If you’d rather have someone shop around and talk to mortgage lenders on your behalf, you might want to work with a mortgage broker. Unlike a bank, which can only offer its own loan products, a mortgage broker will review different types of mortgages and lenders that may suit your situation.
How long is a mortgage?
Most mortgages in Canada come with a 25-year amortization period, though some last 30 years. If you’re financially able to, you can try and pay your mortgage off early, but be aware you may be charged a prepayment penalty, depending on the conditions of your mortgage.
The Bottom Line
Getting a mortgage is one of the most important steps in the home buying process, and there’s a lot to consider when making this financial decision. You should understand exactly what you’re getting into and know what you’ll be paying, how long you’ll have the loan, what type of mortgage you need and more.
Ready to apply for your mortgage? Start the application process today with Rocket Mortgage Canada, UL (Rocket Mortgage™).