When it comes to getting a mortgage, there are a lot of common questions that potential mortgage holders have such as “what is your interest rate?” and “what is the monthly payment?”. While it can be easy to think that these are the only two questions that matter, there is actually a lot more to your mortgage contract than just the rate and monthly fees.
The Rate Debate
The rate debate is a hot topic in the mortgage world. Not just the rates itself, but the importance of the rate versus other factors in the mortgage - such as terms and penalties. As a borrower, it can be easy to get caught up in one thing but, if you’re not paying close attention, ignoring other factors could cost you in the long run. Let’s talk about the rate.
While not the only factor, the rate remains a vital component of any mortgage product. The interest rate is the percentage of interest you are paying on the principal loan; lower interest rates mean more money to the principle mortgage and less paid on interest. Who doesn’t want that?
Variable Vs. Fixed
There are two types of mortgage rates: variable/adjustable rate and fixed rate. A fixed-rate is just that - a fixed amount of interest that you would pay for the term of the mortgage. A variable-rate, on the other hand, is based on the current Prime Rate and can fluctuate depending on the markets. Fixed rates are typically tied to the world economy where the variable rate is linked to the Canadian economy.
Fixed-Rate Mortgage: First-time homebuyers typically love the stability of a fixed rate when just entering the mortgage space. The benefit of this type of mortgage rate is that your payments don’t change throughout the life of the term. However, should the Prime Rate drop, you won’t be able to take advantage of potential interest savings. Adversely if prime increases your fixed rate and payment are protected against the hike.
Variable-Rate Mortgage: As variable-rate mortgages are based on the Prime Rate in Canada; it means that the amount of interest you pay on your mortgage could go up or down as the economy fluctuates. When considering a variable-rate mortgage, some individuals will set standard payments (based on the same mortgage at a fixed-rate), this means that should Prime drop and interest rates lower, they are paying more to the principal as opposed to paying interest. If the rates go up, they simply pay more interest instead of direct to the principal loan. Other variable-rate mortgage holders will simply allow their payments to drop with Prime Rate decreases, or increase should the rate go up.
When considering your mortgage, other conditions such as penalties can be important factors for deciding which is the best product for you. For instance, if you have two competing products, say 1.95% interest fixed-rate and a 2.05% interest variable-rate, it seems as though it is a pretty easy decision. However, what about the ability to make extra payments? And what are the penalties?
It is easy to think that nothing will change throughout your 5-year mortgage term, so you probably haven’t even considered the penalties. However, when looking at the fixed versus variable rate mortgage, penalties can be quite different. Where variable rates typically charge three-year interest, a fixed-rate mortgage uses an Interest Rate Differential (IRD) calculation.
Given that nearly 70% of fixed mortgages are broken before the term ends, this is an important variable. Fixed-rate mortgages are typically okay when the penalty is your contract rate versus the Benchmark rate. However, when penalties are based on the Benchmark rate (sometimes called the Bank of Canada rate), it is typically much higher than your contract rate, resulting in greater penalties.
In some cases, penalties for breaking a fixed mortgage can sometimes be two or three times higher than that of a variable-rate. While the interest rate is lower, lower penalties are sometimes best should anything happen down the line.
Another key point to consider is whether or not your mortgage is portable, meaning it can be moved to a different property. This means that you can take your existing mortgage – along with its current rate and terms – from one property and move it to another. This can only be done if you're purchasing a new property at the same time as you are selling the old one.
Conventional vs. High-Ratio Mortgage
Another consideration beyond just the interest rate, is whether or not you will be obtaining a conventional or a high-ratio mortgage. Whenever possible, it is recommended to put 20 percent down payment on a new home. This results in a conventional mortgage. However, as not everyone is able to do this, many buyers will end up with a high-ratio mortgage product.
So, what does this mean?
High-ratio mortgages need to be insured by either Genworth Financial, the Canada Mortgage and Housing Corporation (CMHC), or Canada Guaranty. This is due to the Bank Act, which will only allow financial institutions to lend up to 80 percent of the homes purchase price WITHOUT mortgage default insurance. Insurance on the mortgage is important to protect the lender should you default on your payments, leaving the insurer to deal with the borrower.
The difference between conventional and high-ratio mortgages is that high-ratio mortgages (or any mortgage with less than 20% down) require default insurance, which results in an insurance premium. This is added to and paid along with the mortgage, but is an important factor when considering your monthly payments. These premiums are based on the loan to value (LTV), which is the amount of the loan versus the value of your home. It is important to note that these premiums are added to your mortgage principal, which is an extra cost to you. Additionally, since the premiums are part of the balance these premiums also have the interest charged to it.
All high-ratio mortgages are regulated to have mortgage insurance. In having mortgage default insurance as a requirement, the lender's risk is far less hence high ratio mortgages generally yield lower interest rates.
Smart Questions to Ask
To ensure you understand your mortgage contract and how it could affect you now and, in the future, I have compiled a few smart questions to ask before you sign.
What is my interest rate? Can I qualify for a better one?
Do you recommend a fixed or variable-rate?
What are the penalties for breaking my mortgage?
Are there any prepayment privileges?
Will I require default insurance? If so, what are the premiums?
What will my monthly payment be?
Is my mortgage portable/assumable?
These are just a few examples of good questions to ask. It is important to do your own research and be diligent with any contract you are signing.