A mortgage is a loan that you get to help you buy a home or any type of property. It’s probably one of the most significant financial decision you will ever make in your life, so understanding the basics of how it works and how it could impact your bottom line is critical in your decision making.
How Mortgages Work
Any type of mortgage consists of two parts – the principal, which is the amount borrowed and the interest, which is the amount charged for the money borrowed and is calculated based on the principal amount.
For every mortgage you pay, the amount is first applied to the interest and the rest is used towards the principal. In the first years, most of the payments will pay off the interest and only a small amount goes to the principal. As you keep paying, the mortgage balance decreases over time and more of your payment goes towards paying off the principal amount. The goal, therefore, is to pay off the principal amount as fast as possible so that you reduce interest payments and save money in the long run.
Factors that May Affect Mortgage Interest Rates
Banks and lenders have very specific interest rates. These rates are influenced by many different factors, such as:
- The type of bank or mortgage lender you deal with
- How much your credit score is and your overall credit history
- How much is your annual income and total net worth?
- What type of property is being mortgaged?
- How fast do you need a mortgage?
- How long will you pay off the mortgage loan?
- How long is your mortgage term?
Types of Mortgages
There are thousands of mortgage products in the market, but most lenders will offer these common types of mortgages to first time home buyers:
Conventional / Low Ratio Mortgages
A conventional mortgage loan amounts to no more than 80% of the appraised value or purchase price of the property, whichever is less. This means the borrower is required to provide down payment that is equal to 20% or more of the property’s value or purchase price, and is not required to pay for mortgage protection insurance.
High Ratio Mortgages
A high-ratio mortgage usually amounts to more than 80% of the appraised value or purchase price of the property. The borrower contributes a down payment of less than 20% of the value/purchase price, and is required to pay for mortgage protection insurance through any of the three mortgage insurance companies in Canada, which are Canada Mortgage and Housing Corporation (CMHC), Genworth Financial or Canada Guarantee.
Open Mortgages
An open mortgage offers you the flexibility to pay either in full or partial amounts toward your mortgage at any time throughout the term, without paying any penalty charge. The interest rates are typically higher than on a close mortgage loan, but most lenders will allow you to convert to a close mortgage with lower rates at any time. So if you’re planning to sell your home in the future or you are expecting a large sum of money that you can apply towards the loan, this type of mortgage is a good option.
Closed Mortgage
A closed mortgage requires you to pay a set amount at set times. If you want the assurance that your housing payments are going to be exactly the same at any given time, then this is a good choice for you. Keep in mind, though, that this type of mortgage is not flexible, so if you want to pay more or decide to pay out the amount in full, or refinance or renegotiate your loan before the end of the term, you will have to pay for any prepayment penalties that are stated on the terms.
Fixed Rate Mortgages
In this type of mortgages, the interest rate is calculated, agreed on and locked in for the term of the mortgage. This means your interest rate will remain the same throughout the entire term of your loan regardless of market fluctuations. Lenders will often allow prepayment options that offer quicker repayment of the mortgage and for partial or full repayment of the mortgage.
Variable Rate Mortgages (VRM) / Adjustable Rate Mortgages (ARM)
The interest rate in this loan may be changed from time to time during the term of the mortgage, depending on market conditions. This can mean changes to the interest rate on your mortgage every month. The mortgage is set up based on current interest rates and will be reviewed at specified periods. Normally, monthly payments will not be affected. The total you pay every month will remain the same, however the amount that goes towards the principal will vary as interest rates vary. So when interest rates go up, more will go towards paying off the interest and less on the principal amount. On the other hand, when interest rates go down, less will be applied to the interest and more towards the principal.
Hybrid Mortgages or 50/50 Mortgages
If you can’t decide between a fixed or variable mortgage, a hybrid allows you to get the best of both worlds. It’s an option that allows you to split your mortgage into two different rates, 50% at fixed rate and 50% at variable rate. This way you get the security of fixed repayments while still protecting yourself if rates climb.
If you’re considering buying a home or other type of property, it’s very important that you do some research and get all the information you need to help you understand all the options available to you. Clearly, the best choice is to go for a mortgage type that will fit well within your budget. If you can afford to make your mortgage payments without fail, then the best possible chance you have of owning your dream home.