What is a Mortgage?
A mortgage is a special type of loan used to purchase real estate. Like other types of loans, it includes both the amount you borrow (the principal) and the interest. However, mortgages are unique in that (a) the loan is secured against a property, (b) you often need to make a down payment, and (c) you often pay a penalty if you leave the contract early.
Each mortgage payment first reduces the interest, then pays down your principal. When you start paying off your mortgage, most of your payment goes toward the interest. Once you’re almost finished paying off your debt, your payments primarily tackle the principal.
Most mortgages have terms between 15 and 30 years. This term length ensures that your payments are manageable. Some mortgages may be as short as 5 years in length. It largely depends on the type of mortgage you get and how much you can afford.
Types of Mortgages
Not all mortgages are made alike. Here is a basic overview of each type of mortgage.
Insured vs Insurable vs Uninsured Mortgages
Conventional (insurable) mortgages require a 20% down payment, which helps assure lenders that you can handle the financial responsibility. Some lenders require you to pay mortgage insurance. This lowers the interest rate but adds the cost of the insurance to your monthly payments. If you’re taking out a mortgage under unusual terms (for more than $1 million or longer than a 30-year repayment term), your mortgage likely won’t be insured, which raises the interest rate.
Open vs. Closed Mortgages
Lenders make the most money when you repay the mortgage in installments over the full term. If you pay it off in full early (i.e. prepay), you’re essentially reducing your lender’s profits. To make up for this, they’ll charge a higher interest rate on the mortgage. Only choose an open mortgage if you know you’ll get a cash windfall or plan to sell within a few years.
Closed mortgages are more common. You can pay more than you’re required to, but you’ll be limited to how much extra you can pay. In return for minimizing the lender’s risk, you’ll likely enjoy a lower interest rate.
Fixed vs. Variable Mortgages
With a fixed-rate mortgage, the amount of interest you’re expected to pay is amortized, i.e. added to the lump sum, then divided into equal monthly payments. This ensures that you have the same amount to pay each month for the term of your loan, even if you’re technically paying different amounts to your principal and interest. In exchange for this consistency, you’ll likely pay slightly higher interest rates.
In variable-rate mortgages (aka adjustable rate mortgages), your monthly interest rate fluctuates with the market. However, you tend to pay less in interest overall. This option is ideal if you have very good cash flow and/or you want a shorter mortgage length.
Are You Ready for a Mortgage?
Ask yourself these questions to determine if a mortgage is the right choice for you.
You plan to stay in the area for a long time and can commit to the repayment terms.
A mortgage is a long-term commitment. You should only take one out if you plan to stay in a home for at least 5 to 10 years. (You can sell a home before your mortgage is fully paid, but you’ll need to make sure that the home sale proceeds would cover the balance — or refinance the mortgage.)
Your debt-to-income ratio is good.
Mortgage lenders look at a range of criteria to determine if you’re able to handle a mortgage. The two primary metrics are the Gross Debt Service (GDS) Ratio and the Total Debt Service (TDS) Ratio. The GDS Ratio compares your gross monthly income to your home expenses, which includes the anticipated mortgage payment and property taxes. Ideally, your GDS Ratio is below 39%.
The TDS Ratio is similar to the GDS Ratio, except it also incorporates your other debt. Your TDS should be below 44%, meaning that your total housing costs and debt obligations take up no more than 44% percent of your income.
You're financially able to make regular payments.
In general, you should have a steady source of income that you expect to continue for the next decade. Lenders will look at your past two years of income to assess your financial security. Naturally, a regular job with a guaranteed salary or hourly pay is ideal. If you’re self-employed or part-time, you can still get a mortgage, but you’ll need to submit additional documentation.
Ultimately, lenders want to be sure they won’t be at risk for lending you money. And unlike many other types of loans, a mortgage uses the purchased item (real estate) as security. You will be expected to make every mortgage payment on time for the entire repayment period. If you fall behind in payments, your mortgage lender can take back the property because it’s collateral for the loan.
You have enough set aside to handle a large expense at once.
Lenders also want to know that you can handle the initial costs of a home purchase, which typically include a down payment and additional fees. So, make sure that you have savings for a down payment and closing costs, which can take up to 4 percent of the whole purchase price.
Be prepared to show your lender that you have other assets, such as savings accounts, investments, and vehicles. This demonstrates that you’re committed to long-term financial responsibility.
The Steps to Obtaining a Mortgage
If you’re ready to take out a mortgage, your first step is to look for a lender. Your existing financial institution may have some good options, but it’s always worth your time to shop around. Different lenders use different criteria to qualify you, and some are able to offer better interest rates. An independent mortgage broker can help you evaluate options, and they’re more likely to offer an unbiased perspective.
You’ll also need to decide which type of mortgage you need. Review the list above, and don’t be afraid to ask potential lenders for suggestions based on your financial profile. Once you’ve identified your best options, try to get pre-approved. In this process, you’ll send documents to a potential lender so they can give you an idea of your mortgage terms. Often, you’ll need a pre-approval before you make an offer on a property.
After you’ve chosen the property you wish to purchase, you’ll request official approval from your lender. Assuming that all goes according to plan, you’ll receive the final offer and sign the documents to accept the loan. In Canada, you’ll need the presence of a notary and/or lawyer to make things official. Once your mortgage is approved, be prepared to pay closing costs, which include fees for title transfer, insurance, and other costs.
If you’re uncertain how to get a mortgage in Canada, don’t be afraid to reach out to your financial institution or an independent mortgage broker for advice. In general, you’ll need to have good clarity on your financial and property ownership goals. Be prepared to show detailed documentation of your income, assets, and liabilities, as well as proof of your financial responsibility. By doing your homework, you can get the best mortgage option for your needs.