Well informed buyers should choose the mortgage that best suits their long-term financial goals.
All homeowners dream of burning their mortgage papers after making that final payment. Smart planning and prudent decisions will help make that day arrive sooner than you’d think.
However, before plunging into the real estate market, you should estimate how much you can afford. There are many online tools that can help you do this.
Lenders want to make sure your total monthly housing costs – including mortgage payments, taxes and utilities – do not exceed one-third of your household’s total gross income and that your total debt load (including car loans) is not above 40 per cent of your household’s total gross income. All lenders have software programs that can compute how much they’re willing to lend and how much house they expect you can afford to purchase.
That first big payment
A big down payment could be a great way to reduce the size of a mortgage. But people who don’t have a lot of money saved – and don’t want to wait to build a larger down payment – can take on a high-ratio mortgage. Borrowers in Canada with less than a 20 per cent down payment must purchase mortgage insurance, which protects the lender in case of default. This could cost up to 3.35 per cent of the value of the mortgage and typically gets tacked onto the principal.
Options to consider when choosing a mortgage
It’s important to consider these topics when choosing a mortgage:
- Fixed or variable interest rate
- Amortization period
- Length of term
- Open or closed
The fixed-versus-variable-rate decision has long been debated. A few years ago, Moshe Milevsky, a professor at York University, authored a report which suggested prospective homeowners go with a variable interest rate mortgage.1 But since variable rates could go up any time, many borrowers opt for the more stable fixed-rate mortgage.
Today, the advantage of variable rates is uncertain. Yes, they remain below fixed ones, but the gap has become razor thin – to the point where potential savings may not justify the risk of variable rates climbing.
Risks not so variable
For small increases in the variable rate, the payment size may remain the same. The only difference would be an increase in the amount going to pay the interest portion. However, if rates increase significantly, even by 1.5 per cent, the lender may increase the payments.
Before deciding on a variable rate, make sure the lender explains all of the possible scenarios. Specifically, find out what interest rate changes will trigger higher payments. You may be able to include the option to lock into a fixed-rate mortgage at any time, but keep in mind that by then the longer-term rates may have changed.
Fortunately, you can use a mortgage calculator to easily determine the savings of going variable versus fixed. You may decide that the upside isn’t enough to forgo the certainty provided by a fixed-rate mortgage.
Coming to terms
Mortgage terms can range from six months to 10 years. Generally, the interest rate rises with the length of the term.
The advantages of an open mortgage
Fixed-rate mortgages are generally closed. They typically allow for yearly lump-sum prepayments up to 20 per cent of the original mortgage, depending on the lender – a very important detail you ought to confirm before signing. You may also be able to increase your regular payments, as much as doubling them – perfect for people with steadily rising incomes.
Paying off the mortgage all at once or breaking it up to get a better rate often triggers financial penalties. Some lenders do offer open mortgages, which allow borrowers to pay off some, or all, of the loan at any time. However, there’s a catch: the interest rate may be significantly higher.
If there’s a chance you’ll come into some money or sell the mortgaged home before the term expires, an open mortgage could make more sense. If you plan to move before the term expires, a portable mortgage (one that can be transferred to your next home) may also be an option worth considering.
Which should you choose: A long or short amortization period?
Of all the variables to choose from, a shorter amortization period offers the fastest route to a mortgage-burning party. By law, Canadians can negotiate a mortgage that extends to 25 years. Long amortization periods are popular, especially with first-time homebuyers, since they could lower the amount of each mortgage payment. However, those lower payments could come with a price – higher interest rate costs.
Anyone taking out a mortgage ought to become very familiar with a mortgage calculator. Try plugging in shorter amortization periods and compare the increase in payments with the drop in interest costs. The sweet spot is often around 20 years, where the increase in payments isn’t so big but the savings in interest costs could be significant.
Accelerated payments could help you pay off your mortgage faster
You can pick weekly, bi-weekly and monthly payments, depending on the lender. More frequent payments will mean you’ll pay less interest over the life of the mortgage with the same interest rate.
You can also opt for “accelerated” payments that shave time off your total amortization period. While giving your lender payments a few days earlier doesn’t save much interest, accelerated payments can increase the total payments you make each year – helping you pay off your mortgage faster.
If you value simplicity, increase your total annual payments but add them up and divide by 12 to compute the equivalent monthly payment.
It’s time to get started
Once you’ve decided to purchase a home, consult with your financial security advisor, who can show you how and why you should build your mortgage into your financial security plan. He/she can then put you in touch with a London Life mortgage planning specialist who’ll help provide a mortgage solution that’s right for your situation.
1 Moshe A. Milevsky, “Mortgage Financing: Floating Your Way to Prosperity,” The Individual Finance and Insurance Decisions Centre, March 2001.