• Adam Stapley

How to Buy Your First Home: What is a Mortgage?

Updated: Aug 27, 2021

As a first time home buyer, one of the most important questions you should ask is what is a mortgage? Most Canadians will use a mortgage to buy a home. The fact is, a mortgage is a secured loan like any other, with the added stability of using real estate as collateral.

Red house on a hill: Most Canadians will use a mortgage to buy a home. This article will explore what a mortgage is

This article will explore how to use a mortgage to buy a home. You will learn how a mortgage is calculated and why you should use a mortgage broker to help you understand your contract.


How is a Mortgage Payment Calculated?


There are three factors considered when calculating your mortgage payment.


Principal


Principal is the amount of money you are borrowing. As you make mortgage payments, a part of each payment will include principal, reducing the amount you owe over time.


Interest Rate


Interest rate is the cost of borrowing money from a mortgage lender. The higher the interest rate, the more costly the loan and vice versa. With each mortgage payment, a portion will go towards interest payments to the lender.


Amortization


Amortization is the period over which the loan will be repaid in full using the minimum repayment. The longer the amortization period, the lower the payment and the more interest you pay to the lender and vice versa. The typical amortization for first time home buyers is 25 years.


Mortgage Terms You Need to Know


Term


When you borrow money for a mortgage, your loan consists of several terms. A term is the amount of time over which each contract is in effect. The mortgage contract during each term will dictate the agreed interest rate, payment schedule, prepayment privileges and penalties that apply to your loan for that period. The most common mortgage term in Canada is a 5-year mortgage.

Laptop, calendar and list sitting on desk: Here are some mortgage terms you need to know

The end of your mortgage term is known as the maturity date. At maturity, you either pay back the outstanding mortgage balance in its entirety or renew your mortgage. If you renew your mortgage, your lender will offer a new interest rate and set of payment terms. Paying your entire mortgage at the end of the term may occur with cash savings, an unexpected windfall, refinancing the loan with another mortgage lender or by selling the property.


Fixed-rate


A fixed-rate is a type of mortgage interest rate. The interest rate set at the beginning of your mortgage term will not change if it is a fixed-rate. Most Canadians use a fixed-rate mortgage when they buy a home. This type of interest rate gives peace of mind not having to worry about fluctuations in mortgage payment as the economy goes through its ups and downs.


Variable-rate


Variable-rate interest rates can fluctuate during the term of your mortgage contract. Variable rates are set in relation to


prime lending rates. Each institution's prime lending rate is determined by an overnight interest rate set by The Bank of Canada. The central bank uses the overnight lending rate to regulate the Canadian economy in response to rising or decreasing inflation.


How all this relates to your mortgage is simple. If the economy is doing well and there is increasing inflation, interest rates go up. This increase has the effect of increasing your monthly payment. If the economy is not doing so well and regulators have concerns about the economic health and economic inflation is low they lower rates. This rate decrease can lower your monthly payment.


Prepayment privilege


If you’re like most first time home buyers, the thought of spending the next 25 years in debt can cause some stress. To help you get out of debt faster, mortgage lenders may allow you to prepay a part of your mortgage. A mortgage prepayment is an extra payment towards your principal balance. Making a prepayment, either as a lump sum or through a voluntary increase to your regular repayment, reduces your balance faster, decreases the interest you pay over time and helps you become debt-free faster.


Each mortgage lender will have different policies for mortgage prepayment penalties. They may also have sever

Two people in front of laptops with pen and paper: prepayment privileges and penalties are very important to know when getting a mortgage

al individual mortgage products with unique prepayment privileges. It is important to work with a mortgage agent or broker to determine which mortgage product best suits long-term goals.


Prepayment penalty


With most mortgages, you will incur a prepayment penalty when breaking the mortgage contract before the maturity date of your current term. Your mortgage contract will state in advance how the lender will calculate prepayment penalties. Since these penalties can add gargantuan exit costs to your loan, they are crucial to discuss when applying for a mortgage.


Prepayment penalties will vary greatly depending on the mortgage lender, the mortgage product, the interest rate, the outstanding loan balance and at what point during the term you break the mortgage.


Fixed-rate mortgages held with banks have the highest prepayment penalties that may range from several thousand to several tens of thousands of dollars. Variable-rate mortgages have the lowest cost of breaking, with a calculation based on three months of interest.


Accelerated payments


As a first time home buyer, if you’re looking to become debt-free faster, one trick to reduce your loan quicker is to speed up your payments. A lender may allow you to accelerate weekly and bi-weekly payment options. The payments are accelerated using a calculation that effectively increases the number of payments in a year by one monthly payment. This increase in payments results in reducing the principal balance more each year, reducing the time it takes to pay off your mortgage.


How to Qualify for a Mortgage


As you begin making preparations for buying your first home, the first step you will take is to determine your home-buying budget. This determination takes place with a mortgage pre-qualification. There are five factors that mortgage lenders consider when determining how much money they are willing to lend you to buy your first home. These factors are as follows:


Capacity


Loan capacity, or how much you qualify for, is determined by the amount of income you earn, the type of income you earn and the payments on your outstanding loans, credit cards and lines of credit.


The type of income you earn is often overlooked in importance, even though it has a massive impact on how lenders will view your income. Some examples of the types of income that mortgage lenders will look at are:


  • Full-time

  • Part-time

  • Contract

  • Salary

  • Hourly

  • Commissions

  • Self-employed

  • CPP, OAS, investment income


Depending on the source and type of income, mortgage lenders may accept an applicant who has worked in the position for as little as three months or require at least two full years of income to qualify on the application.


Credit


Handful of credit cards: It is important to build credit to buy your first home. Here is how your credit score is calculated

Credit is our history detailing our ability to manage our financial obligations. Five factors determine your credit score and whether a mortgage lender is willing to lend you money.


  • Repayment history 35% - Do you make your payments on time? Paying your bills on time, even if it is only the minimum payment, is crucial to building a healthy credit score. Missed payments or worse, accounts that fall into collections or are written off through a bankruptcy or consumer proposal will adversely affect your credit.


  • Utilization 30% - Credit utilization is the ratio of your outstanding balance to your total available limit. Do you max out your credit cards, or do you pay off the balance each month? Keeping your balances at or below 30% of your available credit limit will increase your score over time. As your utilization increases, your score can decrease over time.


  • Length of history 15% - The longer you have credit, the better your score will be. Establishing a long history with a credit provider show you can manage your financial stability. If you close your oldest accounts, this can negatively impact your credit score.


  • Types of credit 10% - Do you have a diverse range of credit available or a handful of credit cards only? Lenders like to see that you have access to a range of different credit products and services. They also classify the types of lenders from which you borrow money. Payday loan companies may be more detrimental to your credit score than borrowing money from your financial institution.


  • Credit inquiries 10% - Do you frequently apply for new credit? Hard credit checks from different providers may show lenders that you rely too much on credit, which can pose a financial risk. Regularly applying for new loans, lines of credit and credit cards will decrease your score over time. It’s best to only apply for credit when you need it.


Capital


Capital is the amount of equity you have in a property. As a first time home buyer, this is your down payment. The least amount of down payment allowed in Canada is 5% of the first $500,000 and 10% of any additional amount over $500,000. For example, the minimum down payment on a $600,000 home is $35,000 (5% x $500,000 = $25,000 and 10% of $100,000 = $10,000). If you want to start building down payment, read this article on how to build a budget and save money.


Capital also refers to your net worth. Although a minimum net worth is not always a rule for mortgage applications, lenders will look at net worth in the context of your financial stability. If you’re unfamiliar with the term, net worth is your assets (savings, investments, properties, vehicles) minus your liabilities (loans, credit card and line of credit balances). The higher your net worth, the stronger your mortgage application will look.


Character


Character is the story of who you are. It is also the story of your intention for the use of the property you are buying. As a first time home buyer, the mortgage lender will want to see that the property is within a reasonable commuting distance from where you work. The mortgage lender will also want to ensure that you are an upstanding and trustworthy individual.


Collateral


The property you wish to buy also has an impact on a mortgage lender’s willingness to loan you money. Since the property you are buying is also collateral for the loan, the lender will want to ensure that the home is marketable and worth what you are paying for it. These factors ensure that if you default on the mortgage, the lender can get their investment back through a quick sale of the property.


Factors that may negatively impact the ability to get a mortgage are:


  • Well & septic - Not all mortgage lenders are willing to lend on properties with well and septic systems. Those that do need to have the well water tested and found to be potable.


  • Structural issues - If there are concerns related to any structural issues, most mortgage lenders need them repaired before buying the property. Structural issues can range from electrical and plumbing issues to foundation cracks and basement leaks.


  • Drug labs - Any property that is or once found to house a drug lab may be ineligible for mortgage lending. If a property once housed a marijuana grow operation, it may be possible to have the property remediated before closing, which may ease the lender's concerns.


  • Remote areas - The more remote an area, the fewer potential buyers for a property. Most mortgage lenders will need more down payment for purchasing properties that are an excessive distance from population centres.


  • Farms - Many farms may be difficult to find mortgage lending for. These types of properties often require private financing or commercial financing which carry different criteria for mortgage lending.


Types of Mortgage Lenders


Not all mortgage lenders are equal. They range in types of products, areas served extra services and more. Working with a mortgage broker can help you better understand the benefits and drawbacks of each option.


Banks

Most Canadians work with their bank when they are ready to buy a home. One of the many reasons Canadians get mortgages from their financial institution is because they already have an established relationship with their bank. One of the benefits of this relationship is they also offer a wide variety of services to meet all your financial needs. These services can include insurance, deposit accounts, credit and investment-related services.


One of the largest drawbacks of working with your bank is that you only have access to their products and services. They won’t inform you about a better option at another lender. On top of this myopic focus is that banks often have very large prepayment penalties in comparison to other options.


Working with a mortgage broker may give you access to big banks while also highlighting the range of alternative options available to you.


Monolines


Monoline lenders or mortgage finance companies are institutions that only offer mortgages. They don’t usually offer other products such as lines of credit or credit cards. Additionally, you will only find access to these lenders through a licensed mortgage agent or broker.


Monoline lenders may offer comparable mortgage products and interest rates as the top Canadian Banks. One of the crucial differences between these types of institutions is monoline lenders often have lower borrowing costs by offering more advantageous prepayment penalties to you.


Alternative lenders


There is a broad range of mortgage lenders grouped under this category of alternative lenders. These can be mortgage finance companies, credit unions or banks that offer mortgage lending opinions that aren’t typically offered by most banks and monoline lenders.


Alternative lenders have diverse solutions for borrowers with poor or damaged credit and cater to self-employed borrowers who often have difficulties finding mortgage financing. These types of lenders may charge higher interest rates and lending fees than traditional banks and monolines.


Private lenders


Private lenders consist of private individuals lending their money to another individual or mortgage finance companies that invest money for private individuals in mortgages. These lenders can offer solutions outside traditional lending criteria, such as solutions for borrowers that show no or little income or are undergoing bankruptcy or consumer proposals.


Private lenders are only accessible through licensed mortgage agents or brokers. The mortgage process with private lenders is much the same as with any traditional or alternative lender.


You will face higher interest rates and fees with a private mortgage and these types of loans are normally designed as short-term solutions that you will prepare to exit after one or two years into an alternative or traditional mortgage lender.


Why You Should Use a Mortgage Broker


Whether you plan to get your mortgage from a bank or other source, you should work with a licensed mortgage agent or broker. As an independent agent, they will work on both sides of the mortgage transaction to ensure that both parties get the best available terms and conditions.


Person sitting on couch with laptop: Mortgage brokers are small business people who act on your behalf and often work with your bank as well as several banks and lenders

A mortgage agent will have access to an array of mortgage products and they can guide you with advice specific to your individual needs. Whether your goal is to pay off your loan faster or have the most affordable monthly payment, they guide you towards that goal during the mortgage process and throughout the life of that loan.


Having a trusted mortgage agent on your side ensures that if any opportunities arise during your mortgage to save money or switch to a product that will better meet your needs, your agent will alert you to the possibility. Finally, for most traditional lending needs, mortgage lenders pay the agent a commission, making the agent's services 'free' to use.


Summary


So by now, hopefully you understand what a mortgage is. The word mortgage stems from the Latin word mort and roughly translates to death pledge. This phrase refers to the length of time over which you pay your mortgage, which may seem like it will take until your ultimate demise.


But a mortgage is much more than a death pledge. It is a path to your financial freedom. Owning a home is a basic necessity for many Canadians, and a mortgage is the solution to enable that acquisition.


A home is a place where you can build equity and save for your financial future. Owning real estate is a retirement strategy for many.

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