Choosing The Right Mortgage: Your Future is on the Dotted Line
Selecting the right mortgage will likely be the single biggest factor in the successful financing of your home. Modern technology has presented more options than ever before; however, the sheer amount of information about mortgages available online can be overwhelming for experienced buyers, not to mention a first time homebuyer.
Many people get caught up trying to find the lowest interest rate for the length of mortgage that they think they need. Unfortunately, those low teaser rates you see on mortgage comparison websites often come with a catch or two. You really need to go beyond the interest rate to find the mortgage that is right for you.
Features of Mortgages
Prepayment Options & Penalties
Most lenders will allow you to prepay a certain portion of the original mortgage amount every year without penalties; 15% of your original mortgage amount is common. For example, if your original mortgage amount was $500,000, with a 15% prepayment allowance you could prepay $75,000 every year without being charged a penalty.
If you wanted to prepay more than that, say you received an inheritance of $100,000 and wanted to put all of it against your mortgage, the first $75,000 would be penalty free, and the next $25,000 would be subject to a prepayment penalty. Depending on your mortgage terms, including whether it is a variable or fixed rate, the prepayment penalties can vary greatly.
Prepayment penalties on variable rate mortgages are typically 3 months of interest on the amount that is prepaid. Prepayment penalties on fixed rate mortgages are much more complicated. The calculation involves something called an interest rate differential (IRD) that looks at the difference between the current posted rate on a mortgage that most closely matches the remaining term of your mortgage and your current interest rate. In many cases they also look at what discount you received when you got your mortgage and add that to the IRD.
On a prepayment of $25,000, the difference would be quite small. But if you were selling your home and had several years left on your mortgage, the IRD calculation on a fixed rate mortgage could mean paying thousands in penalties more than with a variable rate one.
Portability of mortgages
Some lenders will allow you to move your existing mortgage to another property with minimal cost. Paying an administrative fee of $100 would be a huge savings over paying a prepayment penalty of several thousand to get out of your existing mortgage and get a new mortgage on your new home.
Many lenders are now offering payment vacations on their mortgages. What this means is you can choose not to make a certain number of payments every year and you will not be considered delinquent. The catch is that interest continues to accrue on your mortgage during your payment vacation. These could come in handy if you lose your job and it takes you several months to find a new one, but many advise avoid taking them.
Most lenders will allow you to change the frequency of your payment at any time. Depending on your mortgage terms, you may also be able to increase your payment by a certain amount without penalty; 100% is a common feature.
Term and Amortization
5 year fixed mortgages with a 25 year or 30 year amortization are the most common mortgages in Canada. But that doesn’t mean that its the right one for you. Most people are perpetually concerned that interest rates will rise and so will their payments. By going with a fixed rate mortgage you are paying a little more for the certainty of what your payments will be for the next few years. Some very conservative people will look at 10 year mortgages and think “Great! Now I know what my payments will be for 10 years.” The downside is you pay a lot for that. A 1.50% difference between a 5 and 10 year mortgage is not unusual. That’s a lot to pay for 10 years of certainty.
When it comes to amortization, 25 years is still the most common. If you can manage higher payments, then consider a shorter amortization. However if you are in Vancouver or Toronto, you’re probably looking for a 30 year or 35 year mortgage to keep the payments managable. But if you are required to have mortgage default insurance (because your downpayment is less than 20%), 25 years is the longest you can get.
Fixed vs Variable
Since many people like and need certainty, they go with a fixed rate mortgage and fixed payments. Variable rate mortgages typically account for less than 30% of all outstanding mortgages in Canada, but historically they’ve always had lower interest rates than comparable fixed rate mortgages. Contrary to popular belief, your payments on a variable rate mortgage can be fixed. When interest rates change, instead of your payment changing, the amortization changes. So if interest rates change your amortization gets longer; but if interest rates go down your amortization gets shorter. If you only made the minimum downpayment this may not be an option, but if you have a lot of equity in your home, a variable rate mortgage with fixed payments could be right for you.
This is usually the mortgage “feature” that shoppers focus on most, but that can be a trap. To get the lowest possible rate, you have to give up a lot of the flexibility of the features discussed above. When I spoke with a mortgage broker about the very attractive rate posted on her firm’s website, it came with a lot of restrictions: very limited prepayment features and if you wanted to or had to break your mortgage early the prepayment fees were way higher than the common 3 months of interest. Giving up a lot of flexibility to save 0.3% didn’t make sense for me. In some cases, the teaser rates only apply to insured mortgages (those with under 20% downpayment) or to mortgages above a certain amount.
Home Equity Lines of Credit
Even if you are not planning on borrowing later to make renovations for your home, you may want to make sure that your lender will allow a home equity line of credit (HELOC) to be added later. Some specialty lenders who do not offer HELOCs will not allow them, so make sure you know what terms and conditions are attached to your mortgage.
Should I Work With a Mortgage Broker?
With so many different factors to consider when shopping for a mortgage, a mortgage broker can easily show you comparisons between the different options available and help you decide what suits you best. They will do the shopping around to get you the best rate they can for you. To help win your business, brokers sometimes rebate some of their commission to effectively lower your interest rate. Brokers work on commission, which is paid by the mortgage lender. Some lenders (like a few of the big banks) won’t work with brokers because they don’t want to pay the commission, but smaller lenders (relatively speaking) that don’t have an army of salespeople in branches across the country will gladly pay the commission to a broker.
Beyond arranging your mortgage for you, some brokers will provide you with ongoing advice. If a new mortgage becomes available that would save you money they might contact you to let you know. If you’re in a variable rate mortgage, they can help you decide whether it makes sense to lock in to a fixed rate mortgage. Or when your mortgage is coming close to renewal, they will contact you to discuss your renewal options.