Understanding Mortgages in Canada: How They Work and What to Choose

Owning a home is a dream for many Canadians and one of the biggest financial decisions they'll ever make. For many, buying a house outright can be out of reach, and so many have to rely on loans from mortgage lenders to fund their dream home.

Mortgages come in different forms and can be structured in various ways. The key is to choose a mortgage that aligns with your financial goals, current financial status, investment decisions and most of all, your ideal home. So it's important to take your time and go over the different factors involved, such as mortgage interest rate, mortgage term, insurance, down payments and much more.

To help you learn more about mortgages, we have compiled the different aspects of mortgages that you need to know before buying a house.

Qualifying for a Mortgage

In Canada, mortgages are usually issued by financial institutions such as banks and private lenders. However, lenders do not just loan to anyone as they want to reduce the chances of a borrower defaulting.

This is done through an approval process where potential house buyers are required to prove they can afford to take a mortgage and make the required payments. The following are some of the factors that lenders look at before approving a mortgage:

Credit score: You need a good credit score to convince lenders that you’re a worthy borrower. Generally, a credit score of 660 and up is considered suitable.

Down payment: The required down payment in Canada usually ranges from 5% to 20% of the total cost of the house. Down payments also vary depending on the total cost of the house. Expensive homes (let's say a $1M or more) will require a larger down payment than less costly homes (mid $500s).

Stable income: Lenders want to lend to someone with a stable source of income. So being employed with a regular salary is more convincing than a freelancer with a fluctuating income. 

With a good credit standing, you're likely to get favourable terms on your mortgage such as cheaper interest rates. With a poor credit score, some lenders may outright reject your mortgage application while others may accept, albeit with higher interest rates.

Mortgage Down Payments

To get approved for a mortgage, you have to put down a substantial amount as a down payment that goes towards the purchase of the house. In Canada, the required down payment usually ranges from 5% to 20%.

The amount also depends on the total price of the house, as more expensive homes require larger down payments, since they present more risk for the lenders. 

The following table shows how the minimums for down payments are calculated:

Mortgage Repayment Frequencies

When signing up for a mortgage, you have the option of choosing how frequent your payments should be. Some of the options include: 

Mortgage Default Insurance vs Mortgage Life Insurance

Mortgage lenders require mortgage default insurance for down payments less than 20% of the total value of the home. Lower down payments are usually considered riskier so lenders try to minimize risk by requiring borrowers to get mortgage default insurance.

If you happen to default on your required mortgage payments, the insurer pays your lender and is now responsible for recovering the outstanding amount.

On the other hand, a mortgage life insurance is an optional coverage that protects you if you can't make payments due to unfortunate circumstances such as death or serious disability.

Closed vs Open Mortgages

Closed mortgages discourage the prepayment of mortgage debt through the use of prepayment penalties, which can be significant. However, on the other hand, open mortgages allow you to pay off as much as you want at any time without incurring any penalties.

The downside with open mortgages is that they come with higher interest rates compared to closed mortgages. For most Canadians, closed mortgages are better suited as the lower interest rates are not worth trading off for payment flexibility which they may not need.

In addition, closed mortgages sometimes offer an allowance to make prepayments with little to no penalties.

Open mortgages make sense for those buyers who:

• Expect to sell their home within a short time and pay off the mortgage with the proceeds from the sale.
• Expect to receive a significant sum of money, e.g., an inheritance.
• Expect a substantial increase in household income.

Mortgage Term and Amortization Period

A mortgage term refers to the period in which your contract with your lender is valid. Longer terms come with higher interest rates, but the rate is locked for that period. Shorter terms have lower interest rates, but after the term expires, you will have to renew at the interest rates at that time, which could be higher or lower.

5 year-terms are the most common in Canada, but you can get up to 10-year terms.

Since mortgages involve colossal sums of money, the repayment period is usually spread over many years. This period is known as the amortization period. Most buyers get an amortization period of 25 years, but others can choose up to 30 years. A longer amortization period will mean lower monthly payments but a higher interest paid over the life of the mortgage.

Fixed-Rate vs Variable-Rate Mortgage

When getting a mortgage, you will have to pay off the principal amount and the interest rate. The principal amount is the total amount borrowed from the bank, while the interest is what the bank charges to pay itself for providing the mortgage.

So when it comes to interest rate, you'll have to choose between a fixed-rate and a variable-rate mortgage. A fixed-rate mortgage has a set interest rate that remains constant for the entire duration of the mortgage term. This means you have a locked rate, allowing you to easily budget your expenses since you know what you're paying.

A variable-rate mortgage comes with a lower interest rate compared to fixed-rate mortgages. However, their interest rates are influenced by external factors such as the Bank of Canada policy, inflation rate, demand for loans, etc.

So if the interest rates in Canada fall, you stand to save more, whereas if the rate increases, you may end up paying more than if you got a fixed-rate mortgage.

Conventional vs Collateral Charge Mortgage

Whenever you apply for a loan, collateral is usually required. In real estate, when you take a mortgage, a charge is placed on your property's title, thus giving the lender the right to claim it in case payment of the mortgage is defaulted.

In a conventional charge mortgage, your lender registers the actual loan amount of the mortgage loan. For example, if you borrowed $300,000 to purchase a property, your lender will register the $300,000 on the title as a conventional charge.

The conventional charge will contain all the details of the mortgage including loan amount, interest rate, total outstanding amount, etc. This type of charge only secures the mortgage loan, so if you later wish to borrow more funds, you will have to pay off the mortgage loan, discharge the conventional charge, apply for a new loan and have a new charge registered on the title.

A collateral charge mortgage allows lenders to register the actual loan amount or an amount higher than the actual loan amount. For instance, if you borrowed $300,000 to purchase a house, $350,000 may be registered on the title allowing you to borrow more from the lender in future, as long as the additional loan can be secured by the existing collateral charge.

In addition, the specific details of the mortgage are not included in the collateral charge but rather in a separate document known as a mortgage loan agreement.

Mortgage Porting

Mortgage porting is transferring your current mortgage together with its rate and terms from your current property to a new property. This is only possible if you're selling your current house and at the same time buying a new one.

If you have a closed mortgage and want to move to a new house, instead of selling your current home and breaking the mortgage, hence incurring prepayment penalties, you can port your mortgage penalty-free.

Even if your new home costs more and you have to borrow additional money, your lender can blend the existing rate and the current market rate, getting you a favourable rate than the current rate.

Mortgage porting only makes sense if you have a great rate compared to the current market rate. If you can get a cheaper rate without porting, it may make sense to refinance your mortgage or break the mortgage if you have an open mortgage.

Keep in mind some lenders do not support porting, so inquire first before choosing a lender. In addition, some mortgages like variable-rate mortgages are unportable.

Mortgage Refinancing

Refinancing a mortgage refers to breaking your current mortgage and negotiating new terms, either with your current lender or a new one. Many opt for a refinance to:

• Take advantage of lower interest rates.
• Withdraw part of the home’s equity as cash.
• Increase the mortgage term through lower monthly payments.
• Decrease the mortgage term by increasing monthly payments.

As a buyer looking to purchase a home, it's important to understand how mortgages can be structured to take advantage of any cost-saving opportunities. In addition, as a buyer, you need to know more than just mortgages. There are other factors involved in the purchase process such as the total costs of buying a home, what to look for when buying a home and much more. To help you, we have compiled several guides that may come in handy.

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