Mortgage

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A mortgage loan or mortgage is a loan used to purchase real estate, typically a house. The loan is secured by the purchased property and is formally registered on the title of the property. The mortgage amount is reduced by the amount of your down payment, which is the amount of money you pay upfront when purchasing a home. Many financial institutions will pre-approve potential property purchasers so they know ahead of time the amount they can afford to spend to purchase a property.

Interest is charged on the amount you borrow, which is known as the principal. Mortgages have both a term and an amortization period that are used to calculate the payment amounts and schedule. The amortization period is the length of time it will take you to pay off your entire mortgage. The mortgage term is the amount of time your mortgage contract is in effect. At the end of each term, you need to renew your mortgage for another term.

The amount of your down payment has a significant impact on the amount of interest you will pay over the lifetime of the mortgage. If your down payment is less than 20% of the purchase price, you will need mortgage loan insurance. In Canada, the minimum down payment required is 5% of the purchase price.

For many people, owning their own home is a long-held desire. Very few people will be able to achieve this goal without first acquiring a mortgage (89% of homes purchased in 2015 had a mortgage or a home equity line of credit[1]). The home purchase, and the associated mortgage debt, is often the biggest single financial commitment of a person's life. It is usually recommended to shop around as Canadian financial institutions are generally competitive on mortgage rates and terms.

Buy vs. rent

Main article: Owning vs renting‎

Home ownership is not for everyone. There are both financial and non-financial factors that can influence the decision.

Can you afford a mortgage?

Mortgage professionals use two simple calculations to determine the maximum mortgage that you can afford, your Gross Debt Service Ratio and Total Debt Service Ratio.

The Canada Mortgage and Housing Corporation (CHMC) website contains a number of home buying tools[2] that will calculate the maximum house price you can afford, the maximum mortgage amount you can borrow, and your monthly mortgage payments.

Gross Debt Service Ratio

The percentage of gross annual income required to cover payments associated with housing. Payments include mortgage principal, interest, property taxes and sometimes include secondary financing, heating, condominium fees or pad rent.

"To qualify for CMHC insurance, the total should not exceed 32% of your gross monthly household income". [3]

Total Debt Service Ratio

The percentage of gross annual income required to cover payments associated with housing and all other debts and obligations, such as auto loans and credit cards.

Acording to the CMHC, "it should not exceed 40% of your gross monthly household income".[3]

Should you borrow the maximum?

There is a difference between housing affordability – how much you can actually afford to spend each month – and how large a mortgage lenders will approve you for.[4]

The gross debt service ratio and the total debt service ratio calculations mentioned above are used by lenders to make sure that they will get their money back (and meet mortgage insurer’s guidelines[5]). On the other hand, the bigger the mortgage, the more interest the lender will ultimately receive. So lenders will offer you as much money as they reckon you will be able to repay.

But if you borrow the maximum, will there be any room left in your budget for unforeseen expenses, saving for retirement, dining out once in a while, perhaps going on vacation, deciding to work four days a week instead of five for a while, etc.? If interest rates rise, how will this impact your finances? Borrowing less than the lender will let you have could be a wise choice.

Consumer advocates and debt-management experts propose rules-of thumb such as housing costs (mortgage, property taxes, heating, condo fees, insurance) should be no more than 35% of your net (i.e. after tax and deductions) income.[6][7] For most people, 35% per cent of net income is obviously a lot less than 32% of gross income.

Frequency of mortgage payments

Let's say that you have a 5 year mortgage for $100,000 at 5% amortized over 25 years. Monthly payments are $581.60. After 10 years, the remaining mortgage is $73,796.14 If you make weekly payments of $145.40, the remaining mortgage is $66,136.06. Your total payment has not changed but, by paying weekly, the outstanding mortgage balance declines more rapidly. More of your payment is going toward principal reduction than interest payment. A calculator which demonstrates the impact of various payment frequencies can be found here[8].

Similarly, making a regular additional payment will reduce your outstanding mortgage balance quickly depending on the size of the additional payment. For example, adding $25 to the $581.60 monthly payment would reduce the mortgage by approximately $1,700 after 5 years and result in about $200 less interest being paid.

Mortgage terms

Open or closed mortgage?

According to RBC Royal Bank:

"Closed term mortgages are usually the better choice if you're not planning to pay off your mortgage in the short term. Interest rates for closed term mortgages are generally lower than for open term mortgages. Closed term mortgages offer you the ability to save on interest costs and payoff your mortgage faster. You will pay a prepayment charge if you wish to renegotiate your interest rate, prepay more than your mortgage allows or pay off your mortgage balance prior to the end of its term."

"Open term mortgages may be appealing if you are planning to pay off your mortgage in the near future. They can be repaid either in part or in full at any time without prepayment charges. Open mortgages can be converted to any other term, at any time, without a prepayment charge. Interest rates for open mortgages are generally higher than for closed mortgages because of the added pre-payment flexibility."[9]

Fixed vs. variable rate?

  • Fixed rate mortgage - A fixed rate mortgage is a mortgage where the rate of interest is fixed for a specific period of time. Generally known as the mortgage term, it usually ranges from between 6 months and 25 years. As time goes on, more of the mortgage payment goes toward the principal and less of the payment goes to the interest.
  • Variable rate mortgage - A variable rate mortgage is a mortgage that has fixed payments, but the interest rate fluctuates with any changes in interest rates. If interest rates go down, more of the payment goes to principal and if interest rates go up, more of the payment goes toward the interest.

In 2015, 76% of new homebuyers chose fixed rates, 20% chose variable/adjustable rates, and 4% chose a combination. [10] Among all new and existing mortgages in Canada, the figures were 67% fixed rate, 27% variable/adjustable rates, and 7% combination.[10]

Which type of mortgage is better for you depends on your ability to handle risk. With the exception of variable rate mortgages, all mortgages are compounded semi-annually, not in advance, by law.[11]

If you lose sleep worrying about the possibility of a .25% increase in the interest rate or get stressed thinking about the impact on your monthly budget if your monthly mortgage payment changes, then a fixed rate mortgage is for you.

You should also take the same test when choosing the length of the fixed rate mortgage term. If you breathe easier knowing that your mortgage payment is fixed for the next 5 years then a 5 year term is right for you.

If risk is not as much of an issue, then according to a detailed study by Moshe Milevsky[12], you should choose a mortgage with a short term floating (prime) interest rate. The study found that a consumer with a $100,000 mortgage and an amortization period of 15 years would have paid $22,000 more in interest payments by borrowing and then renewing at the 5 year rate as opposed to borrowing at prime and renewing annually.

In 2004 when interest rates were at historical lows, Milevsky updated[13] his original article.

  1. The first-time homebuyer and especially those who placed minimal initial down payments with high leverage ratios, are the ideal candidates for long-term fixed rate mortgages. These folks should not be taking any chances with a fluctuating interest rate. In fact, they might be hit with a double whammy if the value of their (overpriced) house declines leaving them with negative equity. To them I say, “count your blessings, don’t be greedy and lock-in at a fixed rate.”
  2. The risk-averse worrywart who is constantly looking at interest rates and wondering if ‘now’ is the time, should do what all risk-averse investors do: diversify. Indeed, there is a strong argument to be made for diversifying your mortgage debt, similar to the prudent strategy with your investment portfolio. Now, in general, diversifying your debts is a silly idea since you should put all your eggs in the one basket with the lowest interest rate. But, I do agree that split rate mortgages make some sense in today’s ultra-low environment. The ideal strategy is to partition your mortgage in two halves, one linked to a variable rate and the other closed for a longer period of time.
  3. The seasoned veteran, possibly with two stable breadwinners in the family and with a substantial amount of built-up equity in the house should still follow Shelly Short’s strategy. They can afford the risk and continue with a variable rate mortgage, making payments based on a high fixed rate schedule. This is an easy way to (think you) have your cake and eat it too. From a purely psychological point of view -- as long as you pick the payment rate to be 1% to 2% above the initial floating rate -- if and when interest rates do start to increase, it should have no noticeable impact on your monthly budget.
  4. The financially savvy arbitrageur can do even better. Most banks allow you to pre-approve a fixed rate mortgage for between 90 and 120 days. You are guaranteed the pre-approved rate regardless of what happens to mortgage rates over the next 3- 4 months. This is the closest thing to a free lunch (actually, call option on interest rates) you will ever get from a Canadian bank. If you have a floating (open) rate mortgage that allows you to pre-pay any amount anytime without penalty, then walk across the street to your bank’s competitor and ask for a pre-approval on a 5-year fixed rate mortgage. Then, keep a close eye on the Bank of Canada and the bond market. If rates increase tomorrow, exercise your free option and move your mortgage across the street, at yesterday’s rate. Otherwise, do nothing and start the process over in a few months. Understandably, the branch manager might get a bit weary of your constant requests for pre-approval…

Mortgage prepayment options

With an open mortgage, you can prepay any amount without charges.

With closed mortgages, there are generally prepayment privileges, which "allow you to pay an amount toward a closed mortgage on top of your regular payments, without triggering a prepayment charge. For example, each year, your privileges might allow you to: (*) make a lump-sum payment up to 15 percent of the original mortgage amount, and (*) increase your regular payments by up to 15 percent. Privileges vary from lender to lender."[14] Prepayment privileges are one aspect that needs to be examined closely at renewal time.

Pre-paying more than the prepayment privileges allow before renewal, or renegotiating a mortgage before renewal, signifies prepayment charges, which can be costly.

Renewing and renegotiating

According to the Financial Consumer Agency of Canada (FCAC), if your existing mortgage is with a bank, it must "provide you with a renewal statement at least 21 days before the end of the existing term". FCAC recommends that you start shopping around "a few months before the end of your mortgage term".[15]

Obtaining a good rate upon renewal

The official mortgage rates posted by banks, or mentioned in renewal letters, are just a starting point for discussion. In 2015, according to a report by Mortgage Professionals Canada, "the average actual rate for five-year fixed rate mortgages (2.81%) has been 1.87 percentage points lower than typical 'posted' rates (which have averaged 4.68%)"[10] If negociating a mortgage renewal with a bank, bring a printout of the best rates from competitors (see "Finding the best rate" below). It is also possible to take your mortgage elsewhere if you can't negotiate a competitive rate with your existing lender.

Changing the characteristics

Upon renewal it is possible to change the term of a mortgage, its amortization period, or the payment frequency. It is also possible to borrow a smaller amount than currently owed if you can afford it (i.e. make a pre-payment), or borrow a larger amount in order to finance a specific project such as home improvements. Some of these changes may involve getting mortgage default insurance or visiting a lawyer/notary to sign the mortgage agreement.[15]

Breaking your mortgage agreement

If you wish to pay off your mortgage balance in full before the term is completed you may be subject to an interest rate differential (IRD) penalty. The standard previously had been a three month interest penalty, per Canada Mortgage and Housing Corporation (CMHC) policy until 1999. Today there is no uniform policy among lenders or regulation in the Bank of Canada Act for the calculation of an IRD. Your mortgage agreement also contains detailed information about any prepayment privileges and charges that could apply. Some financial institutions have also agreed to provide additional information on prepayments under a Voluntary Code of Conduct[16]. As of March 2013, banks that are members of the Canadian Bankers Association have agreed to comply with this Code.[17]

Financial institutions have posted mortgage rates, but it is common practice to shop for and receive a discounted rate. The real danger is that posted rates will be used to calculate the penalty if you ever have to break your mortgage, probably costing you thousands of extra dollars.[18]

Finding the best rate

Sites such as Rate Supermarket or Rate Hub allow you to compare rates from different lenders.

Mortgage registration

Your lender will register what is known as a “charge.” This process provides a means of securing a mortgage or other loan against your property. There are two types they may use: standard and collateral. Ask about it before you get pre-approved so you have time to discuss the potential advantages or drawbacks, and to decide whether the option suits your needs.

You should review your mortgage registration documents before signing them to understand any and all fees and penalties that are included in the contract. Be aware of the charges associated with the eventual mortgage discharge. A number of financial institutions charge legal and registration fees to discharge a mortgage, these costs can run into the hundreds of dollars.

Standard charge

A type of mortgage that is usually registered for the actual amount of your mortgage loan. If you want to switch your existing mortgage to a different lender at the end of your term, it is generally possible to do so by transferring your mortgage. If you want to borrow additional funds, you will likely need to pay fees to discharge your existing mortgage and register a new one.[19]

Collateral charge

See also: Line of credit

A type of mortgage whose features may include the ability to potentially borrow additional funds, subject to your lender’s approval, without the need to discharge your mortgage, register a new one and pay legal fees. If you want to switch your existing mortgage to a different lender at the end of your term, note that other lenders may not accept the transfer of your mortgage. This means you may need to pay fees to discharge your mortgage and register a new one in order to change lenders.[19]

Government of Canada homeownership incentives

First-Time Home Buyers’ (FTHB) tax credit

For 2009 and subsequent years, the HBTC is a new non-refundable tax credit, based on an amount of $5,000, for certain home buyers that acquire a qualifying home after January 27, 2009 (i.e., generally means that the closing is after this date).[20]

Home Buyers’ Plan (HBP)

The Home Buyers' Plan (HBP) is a program that allows you to withdraw funds from your Registered Retirement Savings Plan (RRSPs) to buy or build a qualifying home for yourself or for a related person with a disability. You can withdraw up to $25,000 in a calendar year.[21]

Your RRSP contributions must remain in the RRSP for at least 90 days before you can withdraw them under the HBP, or they may not be deductible for any year.

Generally, you have to repay all withdrawals to your RRSPs within a period of no more than 15 years. You will have to repay an amount to your RRSPs each year until your HBP balance is zero. If you do not repay the amount due for a year, it will have to be included in your income for that year.[22]

Critics of the HBP point out that RRSPs are supposed to help Canadians save and invest for retirement, not buy real estate:

Imagine a young couple, both 30 years of age and both with $20,000 or so in their respective RRSPs. Through the HBP, these disciplined savers are converted into spenders. They remove money that could grow to roughly $96,000 in value over 40 years (assuming a 4-per-cent average annual growth rate) and turn it into a pile of bricks and lumber. Okay, a house. (...) Through the HBP, the federal government is telling us that buying a house is important enough to scoop down-payment money out of your retirement savings. Why is Ottawa handing out bad financial advice? [23]

Critics also point out that using your RRSP to buy real estate decreases your overall diversification, apart from hurting your portfolio returns:

Should you divert money you have saved in your RRSP to your mortgage? In general: No. You want to have other assets besides your home, and the rate of return on investing in your mortgage is probably less than what you could have earned in your RRSP. Diverting your RRSP savings to your mortgage would reduce your overall diversification even further, making a bad thing worse. [24]

Mortgage brokers vs. banks and credit unions

Among people who purchased homes in 2015, 45% obtained their mortgage from a bank, 42% from mortgage brokers, 10% from credit unions, and 3% from other sources. Among those refinancing, banks were more popular at 62%.[10]

The following table compares getting a mortgage directly through a bank or credit union with using a mortgage broker.[25]

Bank or credit union Mortgage Broker
Description Chartered banking institution or credit union with personal banking, credit card, loan and mortgage services Licensed mortgage specialist with access to multiple lenders and mortgage rates. An intermediary whose commission is paid by the lender providing the mortgage product
Lender Yes No
Puts application together Yes Yes
Examples TD, RBC, BMO, CIBC, Scotia, National Bank, Desjardins The Mortgage Centre, Dominion Lending, Safebridge Financial, True North Mortgage, Multi-Prêts
Pros Banks and credit unions allow you to consolidate your services with a provider you have an ongoing relationship with and have deemed trustworthy Mortgage brokers essentially 'shop' around, negotiate for you, and present the lowest rate on the market. Volume discounts achieved by mortgage brokers are passed directly to you
Cons Can only access and offer you their own rates and products. Banks will regularly give discounts on their posted mortgage rates; however, you are responsible for this negotiation Mortgage brokers are a less familiar avenue, and first-time home buyers would not have pre-existing relationships with them

Insurance

Main article: Mortgage insurance

Mortgage loan insurance

Typically, lenders require mortgage loan insurance for loans made to anyone that wishes to purchase a home with less than 20% of the purchase price. The Canadian Bank Act prohibits most federally regulated lending institutions from providing mortgages without mortgage loan insurance for amounts that exceed 80% of the value of the home or purchases with less than 20% down payment.

Through your lender, CMHC Mortgage Loan Insurance enables you to finance up to 95% of the purchase price of a home.[26] Mortgage loan insurance helps protect lenders against mortgage default, and enables consumers to purchase homes with a minimum down payment of 5% — with interest rates comparable to those with a 20% down payment. Effective February 15, 2016, the minimum down payment for new insured mortgages will increase from 5 per cent to 10 per cent for the portion of the house price above $500,000. The 5 per cent minimum down payment for properties up to $500,000 remains unchanged.[27]

On June 21, 2012 the Canadian government announced changes that limit the availability of government-backed insured mortgages to homes with a purchase price of less than $1 million.[28]

Mortgage life insurance

Depending on the size of the mortgage, it is prudent to protect your family by having insurance. A bank will offer you mortgage insurance that guarantees that your remaining mortgage at the time of your death will not be a burden to your estate. An alternative to consider is term insurance which may provide better value.

Reverse mortgage

A reverse mortgage is a loan that is designed for homeowners 55 years of age and older (if you have a spouse, the age qualification applies to both of you). A reverse mortgage is secured by the equity in the home, which is the portion of the home's value that is debt-free. It allows homeowners to obtain cash, without having to sell their home. Not all lenders offer reverse mortgages.[29]

Smith Manoeuvre

See also: Financial Wisdom Forum • Smith Manoeuvre - Questions

Mortgage interest payments are not tax deductible in Canada. Fraser Smith, a BC based financial strategist, developed a method that has become known as the Smith Manoeuvre, that employs refined debt conversion techniques to transform mortgage interest into tax deductions. The Smith Manoeuvre uses the common tools of Canadian financial institutions and CRA (Revenue Canada). It has been reviewed by the CRA.[30]

Please note that this is an advanced tax planning method that should be fully understood before being undertaken.

See also

References

  1. Robert McLister, Data Highlights from the Fall Mortgage Report, canadianmortgagetrends.com, December 30, 2015, viewed January 4, 2016
  2. Canada Mortgage and Housing Corporation Mortgage Calculator Viewed May 29, 2009
  3. 3.0 3.1 Canada Mortgage and Housing Corporation How Much Can You Afford? Viewed March 15, 2014
  4. B. Cornett (consumer advocate), How Much House Can I Afford to Buy?, Home Buying Institute, 2014, viewed February 4, 2015
  5. How much mortgage should you and your spouse carry?, The Globe and Mail, August 12, 2014, viewed February 4, 2015
  6. G. Vaz-Oxlade, Gail’s Guide to Building a Budget, viewed February 4, 2015
  7. Credit Counselling Society (a registered charity) How Much Money You Should Spend on Living Expenses - Budgeting Guidelines for Income, viewed February 4, 2015
  8. A Consumer's Guide to the World of Mortgages Mortgage Analyzer Calculator Viewed August 14, 2009
  9. RBC Royal Bank, Closed, Open and Convertible Mortgages, viewed March 15, 2014.
  10. 10.0 10.1 10.2 10.3 Will Dunning, Annual State of the Residential Mortgage Market in Canada, December 2015, viewed January 4, 2016
  11. Interest Act, Section 6. Viewed March 16, 2014.
  12. Moshe Milevsky. Mortgage Financing: Floating Your Way to Prosperity, Viewed July 24, 2009
  13. Moshe Milevsky. Mortgage Financing: Should You Still Float? Four Answers, Viewed July 24, 2009
  14. FCAC, Mortgage prepayment: Know your options, viewed January 4, 2016
  15. 15.0 15.1 Financial Consumer Agency of Canada, Renewing and renegotiating your mortgage, viewed January 4, 2016
  16. FCAC, Code of Conduct for Federally Regulated Financial Institutions—Mortgage Prepayment Information, viewed December 5, 2013.
  17. FCAC, Buying your First Home: Three steps to successful mortgage shopping, viewed December 5, 2013.
  18. Rob Carrick, The hidden trap of mortgage penalties - The Globe and Mail, viewed December 5, 2013.
  19. 19.0 19.1 Financial Consumer Association of Canada, Glossary, viewed March 16, 2014.
  20. Canada Revenue Agency First-Time Home Buyers’ (FTHB) Tax Credit Viewed August 16, 2009
  21. Canada Mortgage and Housing Corporation Expansion of the Home Buyers’ Plan (HBP) Viewed May 29, 2009
  22. Canada Revenue Agency, Home Buyers' Plan (HBP), viewed July 24, 2012
  23. R. Carrick, Why the Home Buyers’ Plan should be wound down, The Globe and Mail, February 4, 2013, viewed February 1, 2015
  24. Your RRSP and your Mortgage: Is it a good idea?
  25. Ratehub.ca, Bank vs. Mortgage Broker, viewed February 4, 2015; modified slightly to include credit unions and other examples of banks and brokers
  26. Canada Mortgage and Housing Corporation, Who Needs Mortgage Loan Insurance? | CMHC, viewed July 24, 2012.
  27. Government of Canada Takes Action to Maintain a Healthy, Competitive and Stable Housing Market, viewed December 11, 2015.
  28. Department of Finance Canada, Harper Government Takes Further Action to Strengthen Canada's Housing Market - June 2012, viewed March 16, 2014.
  29. Financial Consumer Agency of Canada, Understanding Reverse Mortgages, viewed July 24, 2012
  30. The Smith Manoeuvre - Is Your Mortgage Tax Deductible?, viewed March 16, 2014.

Further reading

External links

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