Being a first-time home buyer can be overwhelming: Not only must you find an option that suites your family, neighbourhood and amenity needs (not to mention your budget), chances are you’re navigating the world of mortgage financing for the first time.
Choosing the right type of mortgage for your needs can potentially save you thousands of dollars – a big advantage in hot real estate markets like Toronto – so it’s important to understand how various mortgage products work, and how they differ from each other.
Here’s a quick brush up on mortgage type basics, so you can make an educated decision whether you’re working with a broker, big bank, or credit union lender to secure your home financing.
The Difference Between Conventional and High-Ratio Mortgages
One of the biggest deciding factors in the type of mortgage you’ll qualify for – and how much you’ll pay over time – is your down payment, which is the amount you’ll pay up front on your home purchase. By law in Canada, you must pay a minimum of 5 per cent of the home’s overall sale price, and the more you put down, the smaller your mortgage will be.
Those who pay 20 per cent down or more are eligible for a conventional (also referred to as low-ratio) mortgage. Because they’ve invested more equity, these borrowers are considered to be fairly low-risk, and are not required to pay for mortgage default insurance.
Those who pay less than 20 per cent, however, are considered unconventional, or high-ratio, borrowers. They’re required to take out mortgage default insurance coverage, which protects the mortgage lender in the event they fail to make their payments and default on their loan. The premiums for this coverage are calculated on a sliding scale based on the down payment size, and are rolled into the regular mortgage payments.
In Canada, there are restrictions on what kind of properties can be financed with a high ratio mortgage. They cannot be used to fund a home priced over $1 million or for rental properties. Borrowers cannot take longer than 25 years to pay off a high-ratio mortgage, and cannot have more than one at a time; any additional properties purchased must be paid with at least 20 per cent down.
Understanding Closed and Open Mortgages
Once a buyer has determined what kind of mortgage they qualify for, they must choose between an open or closed mortgage product.
Closed mortgages are the most common: The borrower agrees to make regular payments for a set period of time (called the mortgage term), and can only make limited prepayments if they want to pay it off sooner. You’ll be charged a fee for paying a closed mortgage off too soon; the lender expects to make a certain amount of profit on their loan investment, and will make the borrower pay if they break it off early.
An open mortgage essentially allows a borrower to pay their loan off early in full without incurring a fee. An open mortgage can be a great option for those who know they’ll be in the financial situation to pay their mortgage off fast – for example, an expected inheritance or boost in income. Interest rates tend to be higher for open mortgages due to this added flexibility and the fact the lender may not profit from a set amount of interest over time.
Fixed Versus Variable Mortgage Rates
Next, the borrower must choose between a fixed or variable mortgage rate – and there are pros and cons associated with both.
Fixed mortgage rates are traditionally the most popular for Canadian borrowers as they provide the greatest financial security. With a fixed rate, you’re “locked in” to your mortgage for the entire term, which means your interest rate is guaranteed to stay the same for its duration. For example, if you have entered a five-year fixed mortgage term with a rate of 2.50 per cent, that’s the interest you’ll pay each month for five years, regardless of any economic factors that could cause rates to rise. Fixed rates are ideal for those who seek month-to-month peace of mind.
Lenders set the pricing for their fixed rates on the performance of the bond market, which rises and falls with investor confidence and other economic factors. In a strong economy, bond yields tend to be low; investors are willing to accept a smaller payoff in exchange for very little risk. The opposite is true in a volatile economy, and the resulting higher bond yields prompt lenders to increase their cost of borrowing – think the double-digit mortgage rates experienced during the 1980’s recession.
Variable mortgage rates, by contrast, are not set in stone, and can rise or drop during the mortgage term because they are directly tied to lenders’ prime rates. The prime rate is generally the best interest rate a bank can offer an ideal borrower. Variable rate prices are set as a percentage in addition to prime. For example, if prime is 2 per cent, and the rate is prime + 0.5 per cent, the mortgage rate will be 2.5 per cent.
However, prime rates can change over time because they are based on the Bank of Canada’s overnight lending rate. The central bank sets the cost of borrowing throughout the country, based on economic performance. In a stable economy, the BoC will often increase its rate (in turn affecting prime rates), but will cut it during a time of economic risk in efforts to keep borrowing and credit liquid. It’s important for variable borrowers to be aware of how these factors may shift, and impact their mortgage affordability.
What Mortgage Type is Best for You?
Determining the best mortgage product for your needs really depends on your personal financial situation. For example, if you know you’ll have the financial ability to aggressively pay down your mortgage, an open option or closed mortgage with flexible prepayment options could be to your advantage. As well, if you know you won’t be able to pay more than 20 per cent down on your home purchase, it’s important to factor in the cost of mortgage default insurance payments into your overall debt servicing budget. Working closely with a mortgage broker to find a competitive mortgage rate and features to suit your needs is the first step to becoming mortgage free!