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Mortgages – The Basics

Amortization period. Variable rate. Conventional vs. high-ratio.

Mortgages come with their own unique vocabulary. We’ve all heard the terms, but do you really know what they mean? Your home is one of the biggest investments you’ll ever make so it pays to get up to speed on mortgage fundamentals.

Choose the right term for you.

The term is that length of time during which you pay down your mortgage at a set interest rate. Mortgage terms can range from as little as six months to 10 years or more.

When deciding on a mortgage term, you need to think about how important a fixed mortgage payment is to you and your budget. Whether you decide to go with a shorter or a longer term will depend on where you think interest rates are going in the future, and how important it is for you to know exactly how much your mortgage payment will be each month.

Right now, interest rates are at historically low levels. If you think interest rates will go up, or you want to know exactly how much you will pay each month, you may want to lock in for a long term—three, four or five years, maybe even longer. On the other hand, if it looks like rates will drop further, a short-term mortgage may be a better option. If you’re comfortable with payments that may fluctuate somewhat, you can go with the best of both worlds: a short-term mortgage (i.e. a 6-month variable rate mortgage) that lets you benefit from low rates, but also gives you the option of locking in for an longer term mortgage if it looks like rates are going to rise.

Decide on a fixed or variable rate.

It’s important to be aware of the difference between fixed-rate and variable-rate mortgages. With a fixed rate mortgage, the interest rate is locked in and you’ll pay the same amount for the term of your loan even if posted interest rates rise or fall.

With a variable rate mortgage, the interest rate will go up and down depending on the prime rate, which is set by your lender following the lead of the Bank of Canada. For convenience, regular payments under a variable-rate mortgage are still a fixed amount, but if rates fall, a bigger chunk of each payment goes toward the principal, meaning the loan is paid off faster. But there’s risk, too: if rates go up, the fixed payment may not cover the principal and interest you owe, and it might take longer to pay off the mortgage.

Decide on an amortization period.

Interest rates (fixed or variable) aren’t the only factor determining the size of your mortgage payment. Also important is the amortization period. That’s how many years (15, 20, 25) it will take you to pay off the mortgage if you pay a set amount each month. In Canada, 25 years is a common amortization period.

There’s a balancing act here. The longer the amortization period, the slower you pay down the mortgage and the more interest you’ll pay. On the other hand, longer amortization periods mean smaller monthly (or weekly or biweekly) payments. You can shorten the amortization period by increasing the amount of your regular payments, or making lump-sum payments if you find yourself with some extra cash.

Choose a closed vs. open mortgage.

You may also have heard of open and closed mortgages. If a mortgage is open, you can pay the whole thing off any time you want without any penalty. So if you win the lottery, you can pay off your mortgage in one fell swoop. There’s less flexibility with a closed mortgage, and the lender may charge a penalty if you try to pay off part or all of it early. Closed mortgages generally offer better rates than open mortgages, and these days, most lenders offer reasonable prepayment options even with closed mortgages. Be aware however, that closed mortgages tend to be less flexible than open mortgages.

Decide how often you will make payments.

Although we generally think of mortgage payments as monthly, they don’t have to be. You can select weekly, bi-weekly or semi-monthly payments instead. Depending on how much each payment is, choosing to pay your mortgage weekly or bi-weekly can allow you to pay it off sooner, and save you quite a bit of interest.

Will you have a high-ratio or conventional mortgage?

This depends on the size of your down payment. A conventional mortgage provides up to 80% of the home’s purchase price. With conventional mortgages, lenders don’t require insurance against default. If the mortgage is for more than 80% of the home’s purchase price, a high-ratio mortgage is what you have and the loan must be insured against the chance of your defaulting on the payments. Canada Mortgage and Housing Corporation (CMHC) offer this kind of insurance, as does Genworth Financial. Like any other kind of insurance policy, there’s a premium attached, which you can either add to the mortgage itself or pay separately.

Be smart and get pre-approved.

It is wise to get pre-approved for a mortgage before you start home-hunting. Talk to a lender and find out how much you can afford, based on your income, obligations, and credit history. The most important part is that you’ll be guaranteed the interest rate in effect at the point you’re pre-approved for 60-120 days. If rates go down, you’ll still get the lower rate, but if they go up, you keep the rate you were pre-approved on. This ensures you always get the best rate throughout the mortgage-approval process. Not only will you know the true price range you can afford, there is never an obligation to go with that lender. And remember, your pre-approved status gives you more negotiating power when putting in an offer, since sellers give more consideration to a buyer with solid financial backing.