Understanding Mortgages

One of the first steps in buying a new home is to take a realistic look at what you can afford and how you are going to pay for it. If you are like most people, you will probably have to finance your home purchase with a mortgage loan.

What is a mortgage?
A mortgage is a loan that uses the home you buy as security. This loan is registered as a legal document against the title of your property. Here's a quick overview of some of the most common aspects of a mortgage that you need to understand.

  • The principal is the amount of the loan, or the cash actually borrowed.
  • The interest is the amount the lender charges for the use of the funds, or principal. Interest rates vary according to many factors, including terms and conditions of the mortgage. Mortgage payments are applied toward both principal and interest.
  • The amortization period is the actual number of years that it will take to repay the entire mortgage loan in full. This normally ranges from 15 to 25 years.
  • The term is the length of time for which a mortgage agreement exists between you and your lender. Typically, terms range between six months and seven years.
  • The maturity date marks the end of the term, when you can either repay the balance of the principal or renegotiate the mortgage at then current interest rates.
  • Options let you tailor the mortgage to fit your personal needs and circumstances. Open or closed mortgages, pre-payment options, fixed or variable rates or portable mortgages are just a few of the available options.

Types of mortgages
There are two basic types of mortgages:

  • Conventional mortgage: The loan amount does not exceed 75% of the property value, defined as the lesser of the purchase price or the appraised value.
  • High-ratio mortgage: The amount is more than 75% of the property value (up to 95%). By law, a high-ratio mortgage must be insured against borrower default. The borrower pays a mortgage insurance premium (a percentage of the total loan amount) which can be added to the mortgage loan or paid in a lump sum in advance. The borrower must also pay an insurance application fee.

How much can you afford to spend on a new home?
The amount of money you can afford to spend for a new home is determined by two factors:

  • Your downpayment. This is the amount of money you have available from your own assets. You need a minimum of 5% of the total purchase price as a downpayment.

A larger downpayment means lower mortgage payments or, even better, that you can pay off the mortgage faster, thereby saving thousands of dollars in interest payments. Or you may be able to buy in a higher price range, if you qualify. (Be careful, though, not to stretch your budget to the limit, and to set enough money aside to cover the other expenses of buying a home.)

First time home buyers can use their RRSPs towards a downpayment and closing costs. Under the federal government's Home Buyer's Plan, first-time buyers can borrow up to $20,000 tax-free ($40,000 for couples) from their RRSP savings. The funds must be repaid within 15 years, but you don't have to begin repayments for two years.

  • Your ability to carry mortgage debt. Lenders use a simple two-step method to determine the mortgage amount that you can comfortably pay back on your income. As a rule, you can use no more that 32% of gross income on monthly payments to cover principal, interest, property taxes and heating (PITH) and possibly condominium fees, or 40% of gross income on all financial obligations. The latter could include car payments, credit card installments and other payments in addition to the "shelter" costs listed earlier.

Once your maximum monthly payment towards "shelter costs" has been established, it is easy to determine the size of loan you can handle, depending on interest rates and amortization periods.

Be aware of the total costs
When you calculate how much it will cost to buy a home and how much you can afford, don't forget to consider the additional costs that you may encounter. Ask your builder and the sales representative for detailed estimates, and consult with your lender and lawyer for further information.

Get pre-approval
It is a good idea to have your financing in place before you begin looking for your home. That way you can negotiate arrangements with your builder in full confidence and without delay.

A pre-approved mortgage is preliminary approval by the lender for a mortgage up to a certain amount, usually with a guaranteed rate for a specified number of days (90 days and sometimes longer). If interest rates go down during that period, you will get the benefit of the lower rate. If they go up, your rate stays locked in.

Pre-approved mortgage financing is simple to arrange, costs nothing and does not obligate you to go ahead with the loan, if you choose not to. The final mortgage amount and terms will be determined once you have reached a final agreement with your builder.

Source: Canadian Home Builders' Association