How exactly do mortgages work?
The general concept of a mortgage seems simple – it is a loan that helps you purchase your dream home. As you dive deeper into mortgages, however, it can begin to get complicated. Navigating the terminologies and different options available can be confusing, and often frustrating.
To help shed some light on the lending process, I’ve broken down the key aspects of how mortgages work.
Homes are expensive, and for most Canadians, we cannot afford to purchase a home without some help. This is where mortgages come in. The most fundamental thing to understand about mortgages is that they are a loan secured by a property. What this means is that a lender will grant you a loan to help you purchase a home, and together you will agree upon a set of repayment terms. You will agree to repay a set amount of the principal plus interest, either monthly, biweekly, weekly, etc. Since a property secures a mortgage (i.e. your home), if you default on these repayment terms, your lender will gain the power of sale over your home. This means that the lender will be able to sell your home as a means to get their money back.
With mortgages, you have some options around how long you have to pay back the loan. This repayment period is know as an amortization period. 25 and 30-year amortizations are the most common durations, although there are shorter – and in a few cases, longer – options available. The important thing to consider is that the shorter your amortization period is, the larger your regular payments will be. With longer amortization periods, your payments will decrease as they are spread out over a longer period of time. However, you will end up paying more in interest charges.
Interest rate structure
Another option you have with mortgages is choosing the interest rate type. In Canada, there are a couple of different types of interest rate structures that we see most often.
With this option, the interest rate will stay constant for a term (often five years) throughout the amortization period. The benefit of this structure is that your regular payments will always be the same amount. Therefore, this provides you with some stability in your budget. Sometimes, this stability comes at the cost of a slightly higher interest rate.
Adjustable-rate mortgage (ARM) or variable-rate mortgage (VRM)
With ARMs or VRMs, your interest rate will change periodically based upon the current prime rate. The adjustments to your interest rate can occur up to eight times a year and, in most cases, this will change the amount of your regular payments along with the interest rate. The benefit of this option is that you can potentially save money if the prime rate is below the rate offered by the fixed-rate alternative. On the other hand, there is the potential to end up paying more, and you do not have the luxury of stability when it comes to your monthly payments.
In some cases, depending on the lender that you have your mortgage with, your payment amount will not change as the rate changes and it can lead to a negative amortization scenario. Your mortgage broker can help you determine whether the risks are right for your situation.
Open vs. closed mortgages
Over time, you might want to make a lump-sum payment towards your principal, in addition to your regular payments. Depending on if you have an open or closed mortgage, however, this will regulate the conditions surrounding your options in making any lump-sum payments.
Open mortgages are fairly flexible when it comes to making additional payments, and will let you do so without penalty. To compensate for this flexibility, however, open mortgages typically will charge a higher interest rate.
Closed mortgages often have penalties or limits attached to any additional payments that you make. However, these restrictions often lead to lower interest rates, so it’s important to read the fine print.
Once you understand your options, the next step is getting approved for a mortgage. To qualify for a mortgage, you will have to prove your ability to repay the loan to the lender. Lenders will look at your financial information such as your pre-tax income, expenses, debts, and credit score to determine the feasibility of you taking on a mortgage. If everything looks fine to the lender, you will get your approval and can go out and purchase your dream home!
Finding a mortgage that works for you is an important step in the homebuying process. Understanding how mortgages work is also important. As a mortgage broker, I have the resources to help you navigate the process and answer any questions or concerns you may have. Feel free to reach out anytime by giving me a call or booking a free consultation here.