When you buy a home, you can use a mortgage to cover the amount of the purchase price not covered by your down payment. It’s important to get the right kind of mortgage for your needs. Learn more about mortgage types, terms and how mortgages work.
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What is a mortgage?
A mortgage is a type of loan used to help you buy a home. Unless you are able to pay the entire amount up front when buying a home, you will more likely pay for it using a down payment at the time you buy, and pay for the rest with a mortgage.
When you repay a mortgage, you repay the original amount — the principal — plus interest. The interest rate you pay depends on the type of mortgage you have, and the interest rates at the time you take it on. The interest rate will affect the total amount you end up repaying.
Mortgages are given by financial institutions including banks and credit unions, or by mortgage brokers who work on behalf of mortgage lenders. It’s a good idea to shop around before deciding on who to get your mortgage from, as interest rates and policies may be different from one to the other.
Buying your first home is one of the biggest purchases you may make. Find out more about determining how much you can afford, how to save for a down payment and other financial considerations on the path to home ownership.
What should you know before taking on a mortgage?
There are a few key choices to make when taking on a mortgage:
1. How long will you take to pay off the mortgage?
This is known as the amortization period. Many people choose periods between 15 and 25 years. The amount of time you take to pay off the mortgage will affect the amount you repay each month, since the shorter the amortization period, the more you will need to repay each time.
Your down payment amount can affect your amortization period. In Canada, if your down payment is less than 20% of the price of the home, your maximum amortization period is 25 years — or 30 years if you’re a first-time home buyer.
2. How long will your mortgage term be?
The mortgage term is shorter than the amortization period. The mortgage term is usually between one and five years. At the end of the term, you’ll have to renew your mortgage. Your interest rate is decided at the beginning of the term.
3. Will you choose a fixed or variable rate?
When you repay your mortgage, you also pay interest. The interest rate you pay depends on whether you have a fixed rate or a variable rate mortgage.
With a fixed rate mortgage, you pay the same interest rate for the whole term. For example, if you take on a fixed rate mortgage at 7% interest for a five-year term, you’ll pay 7% interest for the entire five years.
A variable rate mortgage means the interest rate you pay will change as the Bank of Canada changes interest rates. The overnight lending rate set by the Bank of Canada can change, as a response to changes in inflation or the markets. So, with a variable rate mortgage, if you started out with a rate of 5% interest, and the Bank of Canada raised interest rates by 0.5%, then you would owe 5.5% interest. If the Bank of Canada then lowered interest by 0.75%, you would owe 4.75% interest on your mortgage payments.
Variable rate mortgage payments can be adjustable or fixed. With adjustable payments, the payment amount changes as the interest rate changes, or fixed. Fixed payments mean you always pay the same amount, but the amount going towards interest changes as the interest does.
A fixed rate mortgage might be the right choice if:
- It’s likely interest rates will increase in the next few years.
- You prefer the predictability of knowing your interest rate and payment amounts will be the same for your next mortgage term.
A variable rate mortgage might be the right choice if:
- It’s likely interest rates will decrease in the next few years.
- You are comfortable letting your mortgage rate float with changes in interest rates.
It’s a good idea to keep track of changes in interest rates, even before you buy a home. Some lenders will let you switch from a variable to a fixed rate mortgage as interest rates start to rise.
Caution
When interest rates rise, more of the variable rate payment goes towards interest than towards the principal. If you have a variable rate mortgage with fixed payment amounts, it is possible to end up in a situation where most or all of your mortgage payment goes towards the interest, and none towards the principal.
4. Will your mortgage be open or closed?
Open or closed mortgages have different flexibility in whether you can pay it off in full at any time.
With an open mortgage, you have the option of paying off the entire mortgage any time. However, open mortgages also tend to have higher interest rates. This may be a good choice if you are expecting to have extra money to be able to pay down your mortgage faster.
Closed mortgages have less flexibility. You might be able to pay off only part of the principal at a specific time. For example, being allowed to repay up to 10% of the mortgage within a one-year period. This may be a good choice if you want the predictability of being able to make regular payments, or don’t expect to have a lot of extra money to pay off your mortgage very quickly.
There are also risks for leaving a closed mortgage early. You will likely incur a penalty, which will be calculated in one of two ways:
- Three months’ interest – This penalty is calculated as the interest you would pay in three months at your current mortgage rate.
- Interest rate differential (IRD) – The calculation for an IRD penalty can vary from lender to lender. Generally, it estimates the difference in the amount of interest the lender would receive on your remaining principle, based on current interest rates. The rate used depends on the lender, but, for example, if you have two years left in your term, the interest rate used would likely be the fixed two-year closed rate. The rate may also be based on the current mortgage qualifying rate, which is the five-year posted rate from the Bank of Canada.
Lenders will usually charge the greater of the two penalties. If interest rates are going down, IRD tends to be higher. Check the penalty with your lender before choosing a mortgage. Ask your lender to estimate the penalty if you leave mid-way through your term as an example.
Along with the penalty, other fees may apply when exiting your mortgage early, such as administration fees and an amount equal to any initial discount on the rate you received. For an exact rate and other fees check with your lender.
How do lenders approve a mortgage?
When you get a mortgage from a bank, you must qualify for it. This involves passing a mortgage stress test. It verifies the likelihood you will be able to afford mortgage payments at a qualifying interest rate. You must pass this stress test even if you don’t need mortgage insurance. The stress test considers your anticipated mortgage payments against your anticipated income, expenses and other debt.
Learn more about preparing to get a mortgage from the Financial Consumer Agency of Canada.
Mortgages are large loans, and therefore generally require an application and approval process. The lender will be looking to verify that you are financially able to handle repaying the loan.
There are five major things lenders consider when approving a mortgage:
- Your income – How much you earn in a year and whether you have full-time employment.
- Your net worth – This is the difference between what you own (cash, investments, your home and other real estate) and what you owe (any loans or mortgages you already hold).
- Value of the home you’re buying – The lender needs to know your home is worth enough to cover your mortgage debt if you had to sell it. This is called the collateral for your loan.
- Your credit score – Your credit report shows your record for paying bills and credit cards, and paying back loans on time.
- The stability of your work and life situation – They may ask for a letter verifying your employment. If your family is providing financial help with the down payment, the lender may ask for a letter confirming this.
Mortgage lenders are considering several risks when they approve mortgages, including:
- Interest rates can change – This creates the risk that borrowers may not be able to keep up with their monthly payments.
- Housing prices can drop – This means there is the potential for people to not be able to pay back their mortgage if they sell their home, if their home is worth less than what they owe to the bank.
- Employment situations can change – If someone with a mortgage loses their job, they may run out of money to make their monthly payments if they don’t have mortgage insurance.
These risks mean that it’s important to verify for the lender that you are in a financial position to carry a mortgage. If you’re unable to continue with mortgage payments, the lender could take ownership of your home.
Before you decide on a mortgage, make sure to calculate what you can afford. Use our mortgage payment calculator to see what your payments might look like depending on interest rate, amortization period, term, down payment, and total purchase amount.
How can you repay a mortgage faster?
It’s important to keep up with your mortgage payments, but there may be ways you can pay down your mortgage faster if you’re able to pay additional amounts. There may be options such as:
- Paying extra amounts on your payment dates, up to 100% of the amount of your regular payment — often called a “double up” payment.
- Increasing the amount of your payments.
- Making annual lump-sum payments against the principal.
These options are usually limited in how much you can pay. For example, the amount of a lump-sum payment is usually limited to amounts of 10% to 20%, depending on the lender and the mortgage.
The frequency of your payments can also make a difference in how quickly you pay down the mortgage. For example, making payments bi-weekly (26 payments over one year) instead of twice a month (24 payments over one year), means that you would have two additional payments during one year. This might be a good option for you if you are paid bi-weekly and can time your payments to be withdrawn on the same day you are paid. Check your payment options with your lender.
What is involved in renewing a mortgage?
When you come to the end of your mortgage term — usually after three to five years — you will need to renew your mortgage. If your mortgage is with a federally regulated financial institution such as a bank, the lender must provide you with a renewal statement at least 21 days before the end of your term. They must also notify you at least 21 days ahead if they do not plan to renew your mortgage.
When your mortgage term comes to an end, you can do one of two things:
- Renew your mortgage.
- Pay off your mortgage in full.
If you want to renew your mortgage, you can either stay with the same lender, or move to a different one if their conditions are more suitable for you. Just as you would shop around for your mortgage in the beginning, you can shop around for better rates before renewing.
If you want to stay with your current lender, it may be worth negotiating for a better interest rate. You may have better options with other lenders and use this information to negotiate. Make sure you have proof of other offers you have received.
Switching to a new lender may offer a better rate, but there may also be additional costs to change. If you decided to switch, make sure to check on:
- Setup fees with the new lender.
- Appraisal fee to confirm the value of your property.
- Other fees and application processes involved.
- Mortgage insurance premiums involved when switching lenders.
Whether you stay with your current lender or switch to a new one, it’s still important to make sure your budget allows you to make payments regularly. Consider whether you can make larger or more frequent payments if you want to pay down the mortgage sooner. Learn more about mortgage renewals.
Summary
When you buy a home, you can use a mortgage to cover the amount of the purchase price not covered by your down payment. When taking on a mortgage, consider:
- How long your mortgage will be – this is the amortization period.
- How long your mortgage term will be – this is usually three to five years.
- Whether you will get a fixed or variable rate mortgage. A fixed rate mortgage keeps the same payment amounts for the term.
- The type of mortgage: open or closed.
- Additional payment options such as double-up payments or lump sum payments against the principal.
- When you need to renew the mortgage, make sure to shop around for rates in case you can get a better interest rate by switching lenders.
