Chapter 2 – The Nuts and Bolts of House Buying
Before we get to the fun stuff — like looking at how much you can afford — we need to get a little more familiar with housing jargon. After all, if you don’t know what these terms mean, how are you going to negotiate the best deal and understand all the contracts you’ll sign? Let’s start with the mortgage paperwork. My mortgage contract was 30 pages long and it was about as simple as they come. I know this stuff isn’t the most scintillating literature, but when you consider that your house is likely the largest purchase you’ll ever make, I think it’s pretty important to understand the details.
What’s In a Mortgage Anyway?
A mortgage is basically a loan used almost exclusively for real estate transactions in which the property is essentially collateral for the loan. If you don’t make the payments, the bank/lender can seize ownership of the property. Because mortgages entail a large amount of money and are backed by a physical asset, they allow most people to borrow money at a relatively low interest rate and pay it off over several (usually 25) years. Mortgages aren’t like any other loan. They have some pretty specific characteristics, including the…
In order to get a mortgage loan, you need to pay a certain percentage of the purchase price upfront. In other words, you can’t borrow 100% of what the house costs. There was a brief period of time when borrowing 100% of the purchase price was allowed and it was referred to as a “zero-down” mortgage. This is no longer doable. To buy a house in Canada you need to come up with at least 5% of the agreed upon price upfront. Alternatively, to avoid paying CMHC insurance, you need to pay 20% of the purchase price upfront. Then you can mortgage the remaining 80%. Once you’re able to commit to a 20% down payment, your mortgage will be referred to as a conventional mortgage. If you purchase a house with 5%-19.99% down, then you’ll be signing up for a high-ratio mortgage. Many people recommend coming up with a 20% down payment no matter what, as it gives you financial breathing room.
Many people are confused about what CMHC insurance actually is. They believe it is some type of home insurance that will protect them in case something bad happens (like most other kinds of insurance). That isn’t the case. CMHC stands for Canadian Mortgage and Housing Corporation and its insurance which the government essentially forces you to buy. It doesn’t protect you – it protects the lender (your financial institution). The government promotes this “default insurance” to prevent a sudden surge in home foreclosures from destroying the Canadian economy. When you think about what a 5% down payment actually means – that you’ve borrowed 19x the amount of money you had – you can see why banks need to be protected from that sort of risk. The insurance premium for this mandatory CMHC insurance is added on to your mortgage. You can figure out how much will get tacked on by using their calculator. The amount is based on what percentage of the purchase price you put down. While the insurance cost itself is usually rolled into your mortgage payments, if you live in Manitoba, Ontario, or Quebec, the provincial taxes on that insurance premium are due upon closing the property. This can be a real surprise at a time when money is already likely to be tight. For example, if you purchase a home for $300,000 and make a 10% down payment, a $6,480 insurance premium will be added to your mortgage. Then, if you live in Ontario where PST is 8%, a further $518.40 will be due in cash, before you get the keys to your palace.
Here’s a confusing term that few laypeople truly understand. Albeit, many pretend that they do so that they don’t look “silly”. Classic Emperor-hasno-clothes type of stuff. Amortization refers to the process of making periodic payments to decrease loan principal over time. An amortization schedule tells you how long you’ll be paying off a mortgage loan. The most common initial amortization is 25 years in Canada. You can change your amortization period on the fly if you want to, simply by making bigger payments. The more you pay on each payment, the quicker you’ll pay down the loan.
Some first-time homebuyers mistakenly think their mortgage loan is locked in for the entire length of the initial amortization. In other words, they believe that if they go to Bank X and take out a 25-year mortgage, that mortgage needs to be held by that institution for the next 25 years. This is fortunately not the case. Mortgages get broken up into chunks of time called terms. Terms can be for almost any length of time but are usually in increments of one year. The most popular length of time in Canada is five years. But this doesn’t mean that five-year terms are the best. Indeed, many experts recommend one-year terms, for example. Others believe in trying to “time the market” and lock into a 10-year term when interest rates are low. This rarely works since people are generally poor at predicting interest rates. At the end of each term (i.e., “maturity”) the holder of the mortgage can move the mortgage loan over to another lender and/or renegotiate any items they wish to change in the mortgage contract. In fact, studies show that people who are willing to change lenders as their term ends often end up paying less over the course of their mortgage. That’s because companies are betting that if they offer you a great deal to transfer your mortgage to them, inertia will take over, your life will get busy, and when the term ends you’ll simply renew with them. Statistics back up this idea, with more than 3 out of 4 Canadians sticking with their mortgage providers at maturity. Consumers should remember that at the end of each term they hold a fair amount of negotiating leverage. Never be afraid to try and negotiate for more favourable terms.
Closed vs. Open Mortgages
There are two main considerations when comparing mortgage terms. One is whether to go with an open or a closed mortgage. The terms “open” and “closed” basically refer to whether a person can pay off their entire mortgage (or a very large chunk of it) early with no penalty. You can have either an open or a closed mortgage with either a variable or fixed interest rate. The choices are independent of one another.
Keeping It Simple (The Closed Mortgage)
Most Canadians prefer the simplicity of a basic closed mortgage with fixed interest payments. They are easy to understand and there are no surprises; however, closed mortgages cannot be fully paid before the end of their term. Most lenders allow limited pre-payment privileges (i.e., extra payments over and above your normal mortgage payment). These privileges allow you to pay a certain percentage of the original mortgage amount with no penalty, but full payoff requires that you pay a penalty – unless you wait for your maturity date. The vast majority of Canadians don’t have the means to pay their mortgage off all at once or at an extremely accelerated rate; therefore, most aren’t worried about the fact that they are “locked in” for the length of their term. In exchange for sacrificing some flexibility with a closed mortgage, lenders will usually reward you with a significantly lower interest rate compared to an open mortgage. Typically, the majority of rates you see displayed on rate comparison sites or bank advertisements are for closed mortgages.
Staying Limber (The Open Mortgage)
An open mortgage is appropriate for people who want flexibility built into their mortgage. You can typically pay off an open mortgage at any time without penalty or convert it to a closed mortgage. Some people like this flexibility if they expect to sell their home relatively soon, or come into a large sum of money, which they can use to pay off their entire mortgage.
Rates of Interest – Variable vs. Fixed
One of the most important decisions you’ll have to make when looking at what sort of mortgage to pursue is your rate of interest. There are two main types of ways to choose to pay interest when it comes to mortgages and they are broadly known as variable and fixed. There’s also a niche option called a hybrid where you can actually have each: part fixed and part variable. But for simplicity’s sake, few people go this route. The terms “variable” and “fixed” refer to whether your mortgage rate can change during the term. As the names would imply:
- a variable interest rate will go up or down as the prime rate changes over the course of a mortgage term,
- a fixed interest rate will stay the same for the length of your mortgage term no matter what happens to the prime rate of interest.
A prime rate of interest is the interest rate that a bank gives its “most trusted” or credit-worthy customers. It’s influenced by the Bank of Canada’s overnight rate (a.k.a. key interest rate). When you hear that the Bank of Canada lowered the key interest rate, this means that you should be able to borrow money at a lower rate of interest going forward. Most big financial institutions will have the same prime interest rate, but it doesn’t hurt to double check your lender, especially if the Bank of Canada has just changed the key interest rate. When you are comparing mortgages, finding the best interest rate could save you hundreds or even thousands of dollars over the course of your term. That’s why it’s important to “compare apples to apples”. Most places will list their current mortgage rates as Prime + X (almost always listing the closed mortgage rates due to the relatively low number of people that request open mortgages). These days, if you have a long relationship with a lender and/or you are considered quite a safe risk (see our article on credit scores for more information), you can negotiate a mortgage interest rate down to Prime -.80% or lower. For example, if I go to my local credit union and I see their prime interest rate is 3%, then I would try negotiating down to 2.2% (a.k.a. Prime -.8%). If you don’t have an enviable relationship with a financial institution you can still ask for this sort of discount and negotiate from there. Alternatively, you can go online and, in seconds, see what sort of rates lenders from around the country are offering. You will see that mortgage rates are categorized by length of the mortgage term and whether the rate is fixed or variable. The biggest discounts are provided to those willing to take on the uncertainty of a closed variable mortgage. I have no way of knowing which type of mortgage is best for your specific situation; however, many long-term studies that looked at decades-worth of data have concluded that the majority of people would pay the least amount of money over the course of their mortgage by steadily using short-term, variable mortgage rates, and renegotiating frequently. For many folks, however, paying the very rock bottom amount of interest over the course of their mortgage is not the only relevant consideration. Some are afraid of not being able to make the monthly or weekly payments if interest rates go up. Others hate the rigmarole of negotiating a new mortgage term every year or so. (Even though with internet comparison shopping this process is now easier than ever before). If you can afford a bit of a bump in interest rates over the term of your mortgage, then negotiating a good discounted variable is often the best way to go. But you need to decide if you can live with the risk of higher interest costs. Remember that no one really knows what the prime interest rate (and consequently what variable rate mortgages) will do over the long term. It’s impossible to tell where rates are headed six months out, never mind over five-to-ten years. Here’s a graph that will give you some historical context on interest rates (it should not be depended upon to predict the future).
Down payments and interest rates are important, but they aren’t the only key items in your mortgage contract. There are a few other important elements as well. Most people largely ignore them as they’re blinded by the enthusiasm to get into their new home. One is your ability to make extra principal payments (over and above the minimum that you agreed to pay). You might think that, like many other loans, if you run into some cash through a promotion or inheritance you can simply pay off your mortgage and celebrate. That isn’t the case with closed mortgages. Lenders carefully manage the speed at which you pay back your loan. Their goal is obviously to keep your repayments relatively slow in order to collect the maximum amount of interest. As a result, most closed mortgage contracts only allow you to pre-pay 10% to 20% of your mortgage each year before a penalty kicks in. For some people, prepayment size doesn’t matter at all as they don’t plan on making any extra payments on their mortgage, but for others it could be a major factor.
Breaking Your Mortgage
“Man, interest rates are going through the basement and that new credit union has a great rate if I transfer over – but how do I get out of my current mortgage?” Unlike diamonds, mortgages aren’t forever. Most people simply wait until their mortgage term is up before switching institutions or trying to get a lower interest rate. Alternatively, some lenders let you “blend” your old interest rate with a new lower one if you extend the length of your mortgage with them. If these options don’t sound great to you, there are usually built-in ways to get out of (“break”) your closed mortgage contract. Traditionally, most lenders charge the equivalent of three months’ worth of interest in order to get out of a contract; however, now there are all manner of ways to calculate penalties for terminating a mortgage early. One is based upon a concept called the Interest Rate Differential (IRD). I’m not even sure I could describe some of the weird calculus banks use in these instances, so make sure your lender explains it before you sign on the dotted line.
Weekly, Bi-weekly, or Monthly Payments
How money comes out of your account to make periodic mortgage payments is also something you’ll have to decide on. Many people recommend going with a more frequent rate such as weekly or bi-weekly. That’s because as you pay your mortgage down quicker, you pay substantially less interest over the course of the loan. Other folks like to schedule their mortgage payment to be withdrawn from their account the day after payday (or the Monday after). Since the mortgage is their largest payment, it makes it easier to budget for the rest of the pay period.
Construction or Building Mortgages
If you’re looking to build your own house right off the bat, you are in a somewhat unique position. New-build mortgages are sort of a separate category altogether. Most of the time lenders will release parts of the loan – or “draws” – at various agreed-upon stages of completion. Often these stages will include the land purchase, lock up (windows and doors are installed), drywall installation, and occupancy (with occupancy permits being issued). The process of getting your mortgage funds released can be somewhat confusing. You have to have enough of your own funds to reach certain stages before the next level of funding kicks in. The reason for all these rules is the relatively high level of risk that a new construction mortgage presents for a lender. If you decide to abandon the project as it’s being built and default on the mortgage payments (at a massive hit to your credit score), the bank would be left with a halffinished building – not exactly an ideal situation. New construction mortgages will typically only lend up to 75% to 80% of the appraised value of your finished home (as defined by an appraiser and cost estimates from your builder). This means that, as the buyer, you may need 20% to 25% of the value of the finished house in order to secure this type of mortgage. That makes draw mortgages less accessible for most first-time homebuyers.
Another niche strategy for getting into a home is using a rent-to-own option. These mortgages are most often used by people who cannot get a conventional or high-ratio mortgage for the time being, but are hoping that after a period of renting they will qualify. Some experts claim that renting to own is never a great option. Others think that for people in a very small percentage of situations (such as a recent divorcee), it makes some sense. The basic idea is that if a buyer finds a home they like, they pre-negotiate a deal with the seller whereby they will rent the home for a certain amount of time. Sellers sometimes use a deal like this as a “carrot-on-the-stick” incentive to get people into their house. Most of the time buyers will pay an upfront fee of 2% the house’s appraised value +/-, in order to give themselves the “option to purchase” at the end of the agreement. Sometimes an extra premium is also added into the monthly rent. That goes towards the prospective buyer’s down payment at the end of the agreement. The main reason these mortgages are controversial is that if a buyer still does not qualify for a mortgage at the end of the agreement (and sometimes the appraised value of the house has gone up substantially during the rental period), then they lose the amount they paid at the beginning in order to have an option to purchase, as well as their monthly premiums. Most experts agree that if you can qualify for a conventional or high-ratio mortgage on your own, you should go that route instead of renting to own.