For most Canadians, owning a home is one of life’s most meaningful goals. And indeed, for most of the world, it represents the single most significant purchase made in a lifetime. However, the road to homeownership isn’t necessarily easy, and homebuyers may be susceptible to many pitfalls if they are not diligent. Selecting the right Canadian mortgage for you or your family isn’t just about buying a home; it is essential to maintaining financial well-being.
In short, a mortgage is a large loan that finances a substantial portion of property purchases. Most buyers will use a Canadian mortgage to pay the total cost of a property. This is because paying cash out of pocket is unfeasible for most. However, even if an individual has the funds to buy a property outright, a mortgage may still be advisable. Likely, you don’t want all of your liquid capital tied up in one property.
Canadian Mortgage Basics
A mortgage is a loan agreement between two counterparties: the lender and the homebuyer. 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. When the borrower approaches the lender for a mortgage in Canada, both parties must understand the same home buying terminology.
The principal amount is the total mortgage amount the lender is loaning to the homebuyer. This amount should not be confused with the property’s purchase price. 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 pays.
Canadian mortgage lenders require borrowers to use some of their own money to commit to the mortgage. This down payment partially finances the purchase of the property. Think of this as the lender ensuring the homebuyer has some “skin in the game.” Note that higher down payments often result in the best mortgage rates in Canada.
The Government of Canada has stipulated varying down payments based on the property’s purchase price. 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
It is important to note that all lenders will perform due diligence on your down payment funds. This process usually includes determining where the funds have been for the previous 90-day period to ensure compliance with Anti-Money Laundering (AML) requirements.
The mortgage term is the loan duration the homebuyer commits to with the lender. Typically, this is five years, but it can also range from six months to ten years. The mortgage is renewed when the mortgage term is complete (usually at a new rate). At each renewal, the borrower is free to refinance the mortgage 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 period 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 monthly mortgage payments that are $377.61 lower. Still, this mortgage costs $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 the borrower will pay $20,000 in interest costs each year on top of the principal repayments.
Interest rates can be fixed-rate or adjustable-rate. Depending on the homebuyer’s view of potential market conditions during the mortgage term, they may choose either.
- Fixed-rate mortgage: This mortgage rate remains the same through the mortgage term until refinanced or paid off. This offers borrowers predictable budgeting of monthly loan costs.
- An adjustable-rate (or variable-rate) mortgage: Also called ARM, this mortgage carries an interest rate that fluctuates based on the prime rate set by the Bank of Canada. The bank may assign a plus or minus amount to calculate the ARM depending on the current prime rate. For example, if prime is 5%, prime – 0.5% means the borrower will pay 4.5% on their mortgage.
Types of Canadian 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 mortgage agreement. As you might guess, a closed mortgage in Canada penalizes borrowers for faster repayments.
Depending on the borrower’s financial situation and personal preference, they may choose either option. The circumstances in which borrowers would most likely choose an open mortgage include the following:
- Anticipation that their income will rise soon, enabling them to make faster repayments on loan, and thereby incurring fewer interest costs over the mortgage term
- 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 the home soon in the near term (in this scenario, selling the house and using the proceeds to repay the mortgage would incur a substantial prepayment penalty in a closed mortgage)
Most borrowers opt for a closed mortgage in Canada due to the lower interest rates they offer.
Obtaining a Canadian Mortgage: 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. Then, you can work out your total mortgage capacity and the purchase price of the home that you can afford.
The Government of Canada has a simple mortgage qualifier calculator you can use to determine what might fit your budget.
Once you understand your budget, you can start looking at homes with your budget parameters and apply for a mortgage pre-approval.
A mortgage pre-approval is a non-binding document that indicates how much a 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 multiple lenders to get the best deal possible.
Now comes the “fun” part. You can narrow down your property search and make an offer on your new home (as long as it fits within the pre-approved price range).
Assuming your offer is accepted, it is time to order a property inspection. A home inspection evaluates the property’s structure, foundation, roofing, electrical, and other potential risks. This inspection is completed to validate whether it is safe for occupancy or whether it needs any pre-purchase repairs.
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Complete the documentation required (more details below) to fulfill all mortgage application requirements. The lender will ask for various items to make a final credit decision at this stage. Promptly provide this information to expedite your approval process.
If you were honest during the pre-approval process and have your down payment in order, this step should be a breeze.
The lender will engage a third-party appraisal service to provide an unbiased estimate of the home’s value. This appraisal lets the lender know whether the price is fair and whether the mortgage’s level of risk is commensurated 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 and verified, the lender will send closing documents to the closing attorney. 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
The last pertinent information is in preparation for the mortgage application. Before you start approaching lenders, it is best to have the following documents available for review:
- T4 slips and paystubs
- Latest tax returns
- Credit history document
- Recent bank statements
- Two types of Government-issued photo ID
Lenders will use this information to validate that you are a trustworthy borrower and determine the appropriate mortgage terms. 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 Canadian Mortgage
- Income and job/business stability: If you are consistently making more than you are spending, that is good news to a lender because it demonstrates you have the adequate cash flow to make regular principal and interest repayments
- Debt repayment history: Your credit report and score provides a good indication of how responsible you have been
- Debt-to-income (DTI) ratio: Your credit history will also detail other outstanding debts you hold with other creditors and can therefore be used to calculate your DTI (the lower your debt level versus the income you generate, the lower your likely mortgage interest rate)
- Loan-to-value (LTV) ratio: This calculation is the mortgage principal requested divided by the total market value of the property (the lower this number is, the better the mortgage rate and terms)
- Capital reserves: Some lenders will also ask for a full view of all your accounts to verify that you have liquid funds to cover immediate living expenses in case of an unforeseen situation
Even after you close a mortgage and take possession of the property, you should keep an eye on interest rate movements. An opportunity to refinance your mortgage may become available if the Bank of Canada reduces the prime rate.
Be sure to budget conservatively. Mortgage payments are serious business and can run several thousands of dollars each month. Ensure that you have forecasted all your typical monthly expenses (e.g., food, entertainment, transport) and an emergency reserve (e.g., 5-10% of your monthly income for surprise circumstances). Also, don’t overstretch yourself for the slightly bigger, more expensive house. In the long term, this incremental increase in square footage won’t make you happier. But, struggling to make your mortgage payments each month will likely strain your mental and physical health.