You visited what seems to be a thousand homes with your spouse, and you finally agreed on one! Congratulations!
Now you’ll make an offer and then you will have to start to learn a new language: the language of mortgages. You probably learned a few words from your real estate agent, and when the time to talk to your broker comes you will need to learn a few new ones…
The main things you’re probably worried about:
- how much it will cost on a monthly (or bi-weekly) basis
- How long you’ll have to pay it?
- What will be the interest rate?
As we will see, all of these are closely related and understanding how exactly one affects the others is not rocket science, but can help you make an informed decision about your mortgage.
The first variable you will have to face is the monthly (or bi-weekly) cost. It makes sense, as this is the value that will have the most direct impact on your finances. If this number is bigger than what you have budgeted for, you’ll have to tweak your options. Not only because you will WANT to, but because the lender will not allow you take a mortgage which you cannot pay.
The second number you will have to decide upon is what we call the Amortization Period. Let’s take things slower here and define some terms we’ll use from now on, shall we?
First off, to amortize a loan is simply to pay it off. When we say John amortized his loan, it means he paid all of it, to the last cent. John repaid all of his debt!
We all know a mortgage is nothing more than a loan, right? So go ahead and start saying you will amortize your mortgage in 20, 15 or 10 years. Next summer, during the family barbecue, ask your cousin “how long will it take for you to amortize your mortgage?” and enjoy some funny faces questioning you!
What takes us to the definition of Amortization Period. The amortization period for a mortgage is the amount of time it will take for it to be paid off (or amortized — see?, we are already being fancy with words here)
Going back to our decisions, we saw you will need to decide on your monthly budget and for how long you do want to pay for your house. Actually, these two factors are interdependent. The longer the amortization period, the smaller the monthly payment. Bear with me: if you take the full value of your house and divide it by 12 months, you will end up with a huge monthly payment. Likewise, if you take this same full value and divide it up to 300 months (the equivalent to 25 years), you will come to a way more manageable monthly payment.
Term of the mortgage
However, as we said before, a mortgage is a loan. And every loan carries interest with it. So it’s safe to say the third decision you’ll have to face is the interest rate on your mortgage.
You don’t really choose the interest rate, at least not directly. The interest rate is tied to the agreement between you and the lender, and this agreement is called the term of your mortgage.
The term is not the same as the mortgage per se. The term of your mortgage is for how long the agreement you signed on with your broker will be valid. After this period you’ll have to renegotiate the mortgage, also known as “renew” the mortgage.
The terms can be fixed or variable, meaning you may choose a term with fixed interest rates or a term with variable interest rates. In the case of a fixed term, you will always know exactly how much you will pay every month until the end of your term, as the interest rate won’t change. Now, on a variable term, your interest rate may fluctuate because it’s tied in to the prime rate (which is basically defined by Bank of Canada).
If you think about it, it’s understandable why so many Canadians are choosing fixed term mortgages: interest rates are super low nowadays. Actually, historic low. It means some people expect it to go up at some point, so they prefer to lock in a low rate for the foreseeable future.
But what if you chose a variable term and you believe the interest rates will go up soon? Are you doomed to pay more and more every month until you are broken and house poor? No, you may have a card up your sleeve, you may be able to change your term from variable to fixed. Note, however, that you may incur in fees, depending on what you agreed upon on your term.
Open, closed, convertible
You may be presented with yet another set of options: open, closed, or convertible. All of these are related to how much freedom you have to pay your loan.
The closed mortgage type is the one where you cannot repay your loan freely. If you want to pay out, make prepayments, or even renegotiate or refinance, you will incur in prepayment fees. Usually, you can make extra payments of up to 20% of the original mortgage value.
On the other hand, an open mortgage gives you the flexibility to repay your mortgage freely during the term, without additional costs. Think about using some extra money, like a tax return or any windfall, towards your house!
And then we have the convertible. The convertible is an open mortgage with the possibility of converting it to a closed mortgage. It makes sense if you were expecting a windfall and you used this extra money to repay part of your loan (thus making use of the open mortgage advantage), but now you’ll only rely on your salary, for example. Then you convert it from open to closed, and you may benefit from a better interest rate for the future.
Why is all of this important?
You must be asking yourself “but why do I need to know all of that?”
Because nobody will ever take as good care of your money as yourself. Even if your broker or bank manager may have your best interests in mind, they don’t know you or your financial situation as well as you do.
Besides, being well informed about what you are buying is always a good thing. This way we can be better consumers, take more informed and grounded decisions and avoid any future disappointments or frustrations (or even some financial problems)!
It’s not uncommon that people take more house than they can afford. And then they end up being what we call “house poor”. They have a nice house, but they can’t afford the monthly payments or even other costs associated with home ownership.
It may take some time to and effort to master these concepts and really understand the difference they can make in your decisions, but it will all pay off in the future! After all, we all want to always have the best possible deals and outcomes to everything related to our money, right?