Mortgages - Moving Beyond Interest Rates

When you were looking to secure a mortgage, what did you consider? 

 

I'll guess that the interest rate was a primary consideration.  If many lenders offer similar rates, what else should you consider when securing your first mortgage or renegotiating a subsequent mortgage?

 

It turns out that the lowest rate may not result in the best choice.  In fact, many low-rate, no-frill mortgages are riddled with risk.  Mortgages are complex with are a zillion options and features that may be important to you when making your decision. 

 

For those who aren't totally clear, a mortgage is unique from a loan in that the property being 'mortgaged' acts as collateral for the loan itself.

 

 As this can be one of the biggest debts you work to repay in a lifetime, it can be worthwhile to understand the lingo associated with mortgages and what to look for when you secure your first mortgage or re-sign an existing mortgage.

 

With the help of my friend and colleague, Paul Macara at The Mortgage Group, this article is meant to unveil common mortgage related verbiage and considerations for selecting the right product.

 

The Qualification Process

 

For those who aren't totally familiar, acquiring a mortgage can involve a two-step process.  The first step is usually a pre-approval.  In many cases, pre-approval involves checking your credit report and assessing your likelihood of borrowing based on verbal exchange of information.  Things like length of time with an employer, income, debts, and assets may be discussed.  With this information, a broker can make a general assessment of whether an approval is likely.

 

A formal pre-approval, will provide you with a 120-day rate hold, in most cases.  This means that if interest rates increased in the 120-day period after qualification, the agreed rate would be valid until the 120-day period lapsed.

 

 A 'subject to financing' condition is often included as part of the real estate negotiation process.  On first glance, this might seem redundant (pre-qualification is already complete) however, this consideration is crucial and becoming even more-so in this heated housing market. 

 

Once a lender determines your credit worthiness and the amount you can successfully borrow (during pre-qualification), they'll want to verify the information you've provided verbally or in writing with formal paperwork.  Often employment letters, pay stubs, tax returns, and bank details are required to formalize an application.  Many variables can interrupt the final approval from a lender.

 

In addition to personal details, the bank will want to ensure that the property you look to purchase is actually worth the amount you've offered (the appraisal).

 

In essence, while you might be well equipped to pay a $500,000 loan, they'll likely want to appraise (or value) that property to ensure that if you defaulted on payments, passed away, etc, they could resell the property and repay the balance owing upon successful sale of the property. 

 

For example, if you offered $700,000 on a property that is valued at $500,000, it would be difficult for a lender to recoup all their money if $600,000 had been borrowed or mortgaged.

 

Mortgage Term

 

The term is the length of time you agree to the terms and conditions of the mortgage.  Terms usually range between 1 to 5 years.

 

Amortization

 

This is the rate at which the loan is paid off based on the payment schedule and level of interest of the initially agreed mortgage.  This is commonly 25 years in length. 

 

Although 25 year amortizations are common, a 30 year amortization is possible when at least 20% is paid as the down payment.

 

When less than 20% is used as a down payment, the mortgage is considered high-ratio.  High-ratio, essentially means, higher risk for a lender.  As you can imagine, the less down payment made, the more unlikely it becomes that a lender could recoup all their costs should you default on your payments.  These mortgages (those with anything less than 20% down payment) require insurance from one of three primary insurers:  Genworth, CanadaGauranty (AKA CG), and Canada Mortgage and Housing Corporation (AKA CMHC). 

 

Insurance is secured by payment of an insurance premium and it is meant to insure the lender.  Where lenders may be reluctant or unwilling to lend to a person with less than 20% down, the insurance coverage makes lending more appealing - offering less risk.  This insurance premium can be payable in a lump sum (but is most often added to the total mortgage amount), or is blended and payable over the life of the mortgage.  Paul helped me to understand that the premium actually remains in place over the life of the entire mortgage.  This means that each time a term expires and requires renewal, the insurance premium can help the borrower achieve a more aggressive interest rate as the lender has added protection.  That is, unless the property is re-mortgaged.  Re-mortgaging involves borrowing against the property.

 

An example I used in a prior article detailed that when $44,800 was put down on a property worth $698,000, the CMHC Premium payable was $26,128.  These premiums are astronomical, so in my opinion, it is worth making every effort to make a 20% down payment when possible.

 

Payment Schedule

 

The number of regularly scheduled payments made directly affect the total interest and principle paid on the mortgage.  Where there are 12 payment made in the course of one year when making monthly payments, 26 payments are made when making bi-weekly payments.  This small decision (paying bi weekly rather than monthly) can accelerate the reduction of interest paid over the life of the mortgage, as in most cases, the two additional payments are applied directly to the principle.  Common payment schedules include: weekly, bi-weekly, semi-monthly, and monthly.

 

Tip:  Ask your Mortgage person about the benefits of bi-weekly versus monthly payments.

 

 

Portable Mortgages

 

Let's imagine you sign a 5 year mortgage term with an incredible interest rate.  Three years into the term, interest rates have risen and you need to move.  Rather than breaking your current 5 year term and facing penalties, the potential to 'port' your mortgage allows you to transfer it to a new property, without penalties, while maintaining your existing terms and conditions.  However, in most cases, the funds required for the new property may be higher or lower than the existing property.  In cases where less money is needed, a penalty may be payable on the difference.  For example, if the currenct mortgage is $300,000, but only a $200,000 mortgage is required for the new property, a penalty would be payable on the $100,000 unused.

 

The primary benefits of a portable mortgage are maintaining a great interest rate and avoiding prepayment penalties. 

 

Tip:  When shopping for a mortgage, ask if the mortgage is portable.

 

If I break my Term, How Much will it Cost Me?

 

This is SO INCREDIBLY IMPORTANT to pay attention too.  These are your pre-payment penalties.  Again, let's assume you sign a 5 year term.  So often we assume, 'how much could life possibly change in 5 years?'  Similar to the brief example above, let's assume 3 years into your term, you have to sell (breaking the 5-year term, 2 years early).  In the event your mortgage isn't portable or you sell without the intention of buying again, you'd have to pay-out the mortgage upon selling, but keep in mind the lender has already counted the interest money they planned to earn during the 5 year term.  Since your need to cash-out early will disrupt their interest pay-out, there are usually penalties that follow.  In some cases, severe monetary penalties.

 

One of the biggest factors involved in determining your mortgage prepayment penalty is whether you have a fixed or variable mortgage.  Fixed rate holders may pay either the greater of interest rate differential or three months interest, where variable rate holders pay three months interest. 

 

Out of interest, the interest rate differential is calculated by taking the difference between the originally agreed interest rate and the interest rate the lender could charge now, based on the remaining term of the mortgage.  You can imagine the significance of this penalty if interest rates increased heavily from the time you signed your mortgage agreement.  Note:  Lenders means of calculating the Interest Rate Differential can vary significantly, so it's important to ask questions and read the fine print.

 

Below are two examples of a mortgage penalties - one via RBC and one through MCAP.  Both examples consider fixed rate mortgages which have $400,000 outstanding, and are calculating breaking a mortgage two years early.  The difference in penalties are astounding.  RBC's penalty is $15,275, while MCAP's penalty is $2,775.

 

I used an online tool for calculating prepayment penalties and you can find it HERE.

 

RBC Mortgage Penalty Example

 

MCAP Mortgage Penalty Example

 

Tip:  As these penalties can be astronomical, ask your mortgage person to clarify your potential penalty BEFORE signing your mortgage agreement.  Make sure you have crystal clear information on how they calculate what you'd owe should you need to break the mortgage.  In some cases, a low rate is offered in lieu of a huge penalty. 

 

Open Mortgage

 

An open mortgage is one that can be paid off in full at any time with no penalty.  These mortgages usually have a high premium.

 

Fixed Rate Mortgage

 

A fixed mortgage is one that has the same interest rate for the duration of the term.  For example, if an interest rate of 2.70% was agreed over a 5-year term, that would be the interest rate for all 5 years, even though the Bank of Canada Rates might be fluctuating.

 

Variable Rate Mortgage

 

A variable mortgage often has a lower rate than a fixed rate mortgage.  In this case, the interest rate will fluctuate with prime - check here for the current rate.  While your payment would remain the same, the amount being applied to principle versus interest will shift.

 

Tip:  Ask your mortgage representative if you sign a variable rate mortgage, if you can switch to fixed at any time.  WhichMortgage.ca has a great article on how to decide between Fixed and Variable Rate Mortgages.

 

Prepayment Privileges

 

Once you've decided whether you'll make payments monthly, semi-monthly, bi-weekly, or weekly, you'll want to know the prepayment privileges within the  mortgage contract you choose.  Typically, they range from 10 to 20% of the original principle amount borrowed and can be made on regularly scheduled payments or on the calendar anniversary of the mortgage

 

I've included some of the verbiage from a previous mortgage agreement so you can see how it's worded in this case.

Prepayment Privilege

 

Difference between Bank Mortgage Specialists and Mortgage Brokers

 

From what I understand, most bank representatives can only sell products specific to their institution (ie. RBC Such-And-Such Mortgage or CIBC Such-And-Such Mortgage), where mortgage brokers are licensed and can shop amongst numerous lenders and products.  

 

In addition to this article, you can dive deeper into mortgages by visiting: www.loanscanada.ca/mortgages.

 

Aside from the topics listed above, is there anything else you feel is crucial to ask a mortgage representative?