For many Canadians, the prospect of owning a home is one of life’s greatest dreams. Indeed for most of the world, it represents the single most significant purchase we will make in our lives. However, the road to homeownership isn’t necessarily easy, and buyers can be susceptible to pitfalls if they are not diligent. Therefore, selecting the best Canadian mortgage is essential to maintaining financial success.
The mortgage is perhaps the most crucial component of the journey to homeownership. In a nutshell, a mortgage is a large loan that finances a substantial portion of the property that you want to buy. Most homebuyers on the market will use a Canadian mortgage to pay the total cost of a property, as paying out of pocket is unfeasible for most. However, even if an individual has the funds to buy a property outright, it may still be advisable to mortgage it, so one property doesn’t tie up all their capital.
Canadian Mortgage Basics
A mortgage is a loan agreement between two counterparties: the lender and the borrower. The lender is usually a bank, private institution (such as a credit union), or alternative lender, and the borrower is the person seeking the mortgage. Once the borrower approaches the lender for a mortgage in Canada, a few industry terminologies may sound unfamiliar but essential.
The principal amount is the total mortgage amount that the lender is advancing. This amount should not be confused with the purchase price of the house. The principal amount will generally be a percentage of the total purchase price that depends on the contemplated purchase price of the home, less the down payment that the borrower makes.
Canadian mortgage lenders require borrowers to use some of their money to commit to the mortgage. This downpayment finances the purchase of the house partially. Think of this as the lender ensuring the borrower has some “skin in the game.” Note that higher down payments often result in the best mortgage rates in Canada. The Canadian government has stipulated that for varying levels of property purchase prices. By purchase price, the minimum down payment amount is as follows:
- < $500,000: 5% of the purchase price
- $500,000 up to $999,999: 5% of the first $500,000 and then 10% for any amount above $500,000. For example, for a $750,000 home, the minimum down payment would be: (5% of $500,000 + 10% of $250,000) = $50,000
- $1,000,000 or more: 20% of the purchase price
The mortgage term is the duration you commit to a lender and the mortgage agreement you sign with them. Typically, this is five years but can range from 6 months to 10 years. When the mortgage term is complete, the mortgage gets renewed at the new rate available, or the borrower is free to refinance with another lender.
The amortization period is the total time it will take the borrower to pay off the loan in full. Most Canadian mortgages have an amortization cap of 25 years, with some exceptions. The choice of amortization periods is dependent on the borrower. Shorter amortization periods mean higher monthly payments but lower total interest costs paid over the life of the loan. The opposite is true for more extended amortization periods. Below is an example that illustrates this relationship. At the same principal and interest amount, a longer amortization of 25 years versus 20 years provides $377.61 in lower monthly payments on the home loan. Still, it ends up costing $83,857.44 more in interest over the additional five-year period.
The interest rate is the cost of borrowing money. Most commonly expressed as an annualized number, this represents the amount of money you pay each year to hold the mortgage. For example, a 4% interest rate on a $500,000 house means that each year, the borrower will pay $20,000 in interest costs on top of the principal repayments they have to make. Interest rates can be fixed or adjustable rates. Depending on the borrower’s preferences and where they see the market going, you might choose one or the other:
- A fixed-rate mortgage in Canada remains the same through the length of the loan until the loan is paid off or refinanced. This offers easier budgeting of monthly loan costs for borrowers.
- An adjustable-rate Canadian mortgage (also called ARM or variable rate) is an interest rate that fluctuates based on a reference rate called the Prime rate. The bank may assign a plus or minus amount to calculate the ARM depending on the prime rate. For example, if prime is 5%, prime – 0.5% means that the borrower will pay 4.5% on their mortgage.
Types of Mortgages
There are two main types of mortgages: open and closed. An open mortgage is when the borrower is not penalized for repaying the mortgage at a quicker rate than stipulated by the loan agreement. As you might guess, a closed mortgage in Canada does penalize you for faster repayments. Depending on personal preferences and individual financial situations, an open or closed mortgage might be preferable. The circumstances in which borrowers would most likely choose an open mortgage include the following:
- Anticipation that their income will rise soon, which would enable them to make faster repayments on the loan, and thereby incur fewer interest costs over the life of the loan.
- Expecting a windfall from an inheritance or sale of an investment that will provide them with additional liquidity to pay down the mortgage faster.
- Plans to sell off their home soon. In this scenario, selling the home and using the proceeds to repay the mortgage would incur a substantial prepayment penalty.
Most borrowers opt for a closed mortgage in Canada due to the lower interest rates offered.
Obtaining a Mortgage in Canada: A Multi-Step Walkthrough
Know Your Budget
First and foremost, as a prospective homeowner, you need to identify your budget is from a monthly payments standpoint. From there, you can work out your total mortgage capacity and the purchase price of the home that you can afford.
Once you understand your budget, you can start looking at homes within your affordability parameters and getting a mortgage pre-approval. This pre-approval is a non-binding document that indicates how much the lender is potentially willing to advance based on the borrower’s credit history, income, and net worth. Ideally, you should get a few pre-approvals from different lenders to ensure that you get the best deal possible.
Now comes the ‘fun’ part. You can start hunting for your next home and make an offer on the house of your dreams (as long as it fits within the price range you had envisioned).
Assuming the offer is accepted, it is time to order a home inspection that will evaluate its structure, foundation, roofing, electrical, and other risks to validate that it is safe for residents and whether it will need repairs.
Select a Lender for a Mortgage in Canada
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Complete the documentation required (more details below) to fulfill all mortgage application requirements. At this stage, the lender will ask for a host of items to make a final credit decision. Make sure you provide this information promptly to expedite your approval process.
The lender will engage a third-party appraiser to provide an unbiased estimate of the home’s value. This appraisal lets the lender know whether the price is fair and whether the level of risk commensurates with the property’s value.
Underwriting the Closing of a Canadian Mortgage
The final step is to wait for the lender to process and underwrite the loan. Once all checks have been completed, the lender will send closing documents to the closing attorney(s). After the papers have been signed and executed, you will receive the keys and start a new chapter of your life!
What Lenders Ask for and Evaluate
We reviewed the steps for obtaining the best Canadian mortgage. The last pertinent information is the preparation for the mortgage application. Before you start approaching lenders, it is best to have the following documents on hand:
- T4 slips and paystubs
- Latest tax returns
- Credit history document
- Recent bank statements
- 2 copies of photo ID
Lenders will use this information to validate that you are a trustworthy borrower and determine the appropriate terms of the mortgage. Generally speaking, stronger credit scores and higher incomes will receive more favourable pricing and mortgage terms than weaker income or credit histories.
Key Information Lenders Use to Evaluate an Application for a Mortgage in Canada
- Income and job/business stability: If you are consistently making more than you are spending, that is good news to a lender as it demonstrates that you have the adequate cash flow to make regular debt repayments for both principal and interest.
- Debt repayment history: Your credit history document and credit score provide a good indication of how responsible you have been historically
- Debt-to-income ratio: The credit history will also detail other outstanding debts you hold with other creditors and can therefore be used to calculate the debt-to-income metric. The lower your debt levels versus the income you generate, the lower your likely rate of interest.
- Loan-to-value ratio: Once the property has been appraised and the lender knows what type of purchase price the borrower is offering, they will determine the loan-to-value ratio. This is essentially the mortgage principal divided by the total market value of the property. The lower this number, the better the rate and terms of the loan.
- Capital reserves: Some lenders will also ask for a full view of all your accounts to verify that you have liquid reserves to cover immediate living expenses in case of an unforeseen situation.
Even once you close a mortgage and get the keys to the house, you should make sure to check interest rate movements. When central banks reduce rates, and if you are outside the term of your mortgage in Canada, this is an opportunity to refinance and potentially save thousands in interest costs.
Be sure to budget conservatively. Mortgage payments are no joke and can run up to several thousand per month. Ensure that you have forecasted all your typical monthly expenses (food, entertainment, transport, etc.) as well as an emergency reserve (up to 10% of your monthly income) for surprise circumstances. Also, don’t overstretch yourself for the slightly bigger, more expensive house. In the long term, the incremental square footage will likely not make you any happier, but struggling to make payments each month is very likely to strain your mental and physical health.