Mortgages 101: What’s a mortgage and how to choose between fixed and variable rates in Canada?

Selecting a mortgage is one of the biggest – and most stressful – financial decision made by many Canadians. But a clear understanding of a few basic terms and concepts can help allay some the anxiety. Here’s a primer on the basics of mortgages, along with insights into the current market.

THE BASICS

What is a mortgage?

In plain terms, a mortgage is a loan most often used to buy a house, condo or some other type of property. It’s a set amount of money provided by a lender (often a bank, credit union or mortgage company), and is repaid over a set period of time (referred to as the amortization, often 25 years). The mortgage usually includes the purchase price minus the down payment, plus mortgage insurance if your down payment is less than 20 per cent or if required by a lender.

Payments include interest plus a portion of the principal and might also include property taxes, insurance or related charges. What’s left over after paying the interest and other fees then goes toward increasing your equity, or the portion of the property that you actually own. That also serves as collateral for the loan – meaning if you fail to make payments, the bank or other lender can take possession of the property.

What is a mortgage rate?

A mortgage rate is the rate of interest charged on a mortgage. While banks and other mortgage providers may advertise a particular percentage, the actual rate depends on the borrower’s credit history, among other factors. Mortgage rates are currently at historical lows, but are not likely to get any lower for the foreseeable future. There are two main types of mortgages rates – fixed and variable.

What are the types of mortgages: fixed vs. variable?

A variable mortgage rate fluctuates based on the so-called prime rate, a benchmark lenders usually adjust based on movements in the Bank of Canada’s trendsetting overnight rate. When rates rise, homeowners pay more in interest. However, not everyone will see their monthly payments increase when rates climb. Some variable-rate mortgages keep payments steady – up to a certain threshold – even as the interest rate moves up. Instead, these borrowers will see their amortization period extended in response to higher rates, meaning it will take longer to pay off the mortgage. You can also lock into a fixed interest rate at any time, without breaking the mortgage contract – and if you break the contract with a variable rate, the penalty is often much lower.

A fixed interest rate mortgage typically locks in payments for a set term of two to five years. Fixed rates are often higher than variable, but offers peace of mind to homeowners their mortgage payments will be consistent for the years to come. It is not possible to switch from a fixed to variable rate without breaking the mortgage contract (which results in a penalty).

How do I shop for a mortgage (and should I go with a bank vs. provider)?

The first step when considering a mortgage is evaluating your current financial situation and understanding your long-term financial goals. Determine not just what you’re able to pay but also if other features – like a flexible payment schedule – would be beneficial. Being a loyal customer at a bank doesn’t necessarily guarantee a good rate. Your best option is to comparison shop. Mortgage brokers can offer insights into rates from a variety of lenders. You’d also be wise to speak with a mortgage specialist at your bank, who can likely offer better rates than the other staff

Is it better to use a bank or a broker?

The main difference is the bank mortgage only represents the products their institution offers, while a broker works with multiple lenders and is paid a referral fee. Brokers, who are regulated in Ontario by the Financial Services Regulatory Authority of Ontario, are often preferred by first-time buyers looking for the best rate.

It’s worth considering brokers who are recommended by a friend or a colleague who recently made a purchase – but also consider secondary references. You can screen brokers by e-ail: provide them an overview of your financial situation and evaluate their response.

What documents are necessary to get a mortgage?

In Canada, would-be homeowners will need access to many financial documents to get pre-approved for a mortgage and secure the loan. If you’re in the process of getting a loan, make sure you have:

• Two pieces of identification (passport, driver’s license, permanent resident card, etc);
• Proof of employment (including your salary or hourly pay rate; your position title and length of employment; if you’re self-employed, you will need your notice of assessment from the CRA for two years);
• Proof you can pay for the down payment and closing costs;
• Information about other assets and debts.

Have these documents ready ahead of time. To be especially thorough, include a cover letter, financial objectives and a short biography that runs one page at most.

What is Canada’s stress test?

Canada’s new stress test rules, which came into effect on June 1, 2021, means it’s now trickier to get approved for a mortgage. The new stress test applies to people with down payments on both sides of the 20 per cent threshold where mortgage default insurance is no longer required. You must now be able to handle the higher of a mortgage rate of 5.25 per cent or your contract mortgage rate plus two percentage points. The previous reference rate was 4.79 per cent.

What mortgage can you afford?

Getting a mortgage is one thing – being able to carry monthly payments without being “house rich but cash poor” is another. Big monthly expenses like daycare, car loans, emergency funds and saving for retirement or your children’s education don’t disappear when you’re a homeowner, so plan for those expenses while looking for a loan. Use Rob Carrick’s Real Life Ratio calculator to see how much in monthly payments you can comfortably afford.

What should you do before looking for a mortgage?

Before you go house-hunting, it’s important to understand your financial situation. Here are five things to understand before you look:

Find out your credit score: Bank of Nova Scotia, Canadian Imperial Bank of Commerce and Royal Bank of Canada, and the credit card issuer Capital One will let you check your score for free, as will online lender Borrowell and Credit Karma. Your credit score is not affected if you check it, and it will give you a good sense of where you stand financially.

Calculate your debt load: Use the debt service calculator offered by CMHC to see if your gross debt-service ratio is under 35 per cent (the rate required for people applying for mortgages insured by CMHC).

Understand the mortgage market: RateSpy.com’s mortgage rate news page will keep you on top of what’s happening with mortgages and the housing sector. If you want to understand how mortgage rates are set, read the Bank of Canada’s briefing note.

Compare rates: Use the mortgage dashboard on the Canadian Mortgage Trends website to see prime rates, the five-year Government of Canada bond yield, the benchmark qualifying rate and a typical rate for fixed five-year and variable-rate mortgages.

Consider mortgage penalties: A low rate is important, but watch out for penalties that lenders may charge for breaking your mortgage contract. Moving, refinancing at a lower rate, making additional payments toward your loan or paying off your mortgage early can all result in steep fees depending on your lender and the features of your mortgage. With a variable rate, terminating your contract early will usually result in a penalty equal to three months’ worth of interest on your remaining balance. With a fixed rate, penalties can be much higher and could reach tens of thousands of dollars. There are different formulas to calculate the penalty on fixed-rate mortgages, so make sure to ask your lender how they do it. Consider also how much you’re allowed to pre-pay toward the mortgage every year and whether you could transfer your mortgage to a new property without penalty. Use the mortgage payment calculator on Ratehub.ca, where you can compare four different mortgage offerings.

PAYING OFF YOUR MORTGAGE

What are the pros and cons of paying off the mortgage ahead of schedule?

Paying off a mortgage earlier than expected will save money on interest and enables you to divert significant amounts of money to pay down debt or increase savings. But there can be downsides. People can become so fixated on paying off their mortgages that they end up paying for other expenses using lines of credit or credit cards. In addition, some banks will charge a “prepayment penalty” to those who end their mortgages ahead of schedule.

Is it better to pay off the mortgage or invest?

The first step should be to establish an emergency fund of three to six months of expenses. Having cash kept safely in a high interest savings account protects your financial and emotional health if you lose a job, have your income cut or run into unexpected big expenses.

Once an emergency fund is established, consider your risk tolerance toward investing. Generally, it’s better to pay down the mortgage faster if the interest rate is greater than the expected return from investing. Paying down debt is a form of savings and means that, in the future, you will have extra cash flow that can be redirected to retirement savings or higher spending.

Should you pay off the mortgage or save for retirement?

If you pay down the mortgage, you get a guaranteed return and the emotional and financial benefits of being mortgage-free. But if you focus on RRSPs first, you may well be further ahead in the long run. For young adults who can’t afford to do both, it may be more tax-efficient to delay RRSP payments and pay off the mortgage early instead. Watch as Rob Carrick and Barbara Garbens offer further insights on this topic.

THE FUTURE

What’s in store for mortgage rates in 2022?

As of January, Canadians might be able to get a five-year fixed rate as low as 2.89 per cent and a five-year variable rate as low as 1.39 per cent for mortgages that don’t require insurance, according to Robert McLister, a mortgage planner and contributor to The Globe. For insured mortgages, the best rates are even lower. That said, analysts and industry experts widely believe mortgage rates will climb higher this year.

The Bank of Canada has signalled it will likely make multiple rate hikes between now and the end of 2022, gradually lifting the overnight rate from its current low of 0.25 per cent by a quarter of a percentage point at a time. The central bank’s trendsetting overnight rate has a direct impact on variable rate mortgages and lines of credit. When the overnight rate climbs, banks usually adjust their own prime rates, which are the benchmarks to which variable rates are pegged. Some analysts say the overnight rate could reach 2 per cent by the end of the year. For many homeowners, that could mean paying hundreds – if not thousands – of dollars more a year.

For example, take a five-year mortgage with a variable rate of 1.15 per cent, a down payment of 10 per cent and amortization of 25 years on a home priced at $720,000, which is roughly the current national average home price. With a rate increase of a quarter of a percentage point, the monthly payment on such a mortgage would climb from $2,762 to $2,844, costing the homeowner $82 more a month and $984 more over 12 months, according to calculations by Lowestrates.ca.

Expectations of central bank rate increases have also been putting upward pressure on fixed mortgage rates, which are influenced by trends in the bond market.

What else can Canadians expect in the 2022 mortgage market?

Robert McLister offered some insights for the year ahead. In addition to rate increases, he suggested there will be new restraints on lending, such as increasing the minimum down payment for investors from 20 per cent to between 25 and 35 per cent. New restrictions, combined with other factors, could lead to a growth in housing inventory and a slowdown in the rate of mortgage growth.

With reports from Erica Alini, Rob Carrick, Jessie Willms and Robert McLister.