In this day and age, it is pretty much impossible for a first time home buyer – or any buyer for that matter – to purchase a home outright for the prices homes command these days. Unless, of course, you happen to be a millionaire with plenty of disposable funds. Mortgages and its various elements have become a major topic of discussion, especially around the concepts of financial organization and long-term savings.
In this article, we shall touch upon the following topics:
- Types of mortgages that first time home buyers should consider.
- The implications of mortgage rates and the resources individuals should use to do their research.
- Who can finance a first time home buyers mortgage.
- Factors affecting housing prices and as a result, mortgages.
- The flexible financing options presented by the Canada Mortgage & Housing Corporation.
Mortgages, or Mortgage Loans, are defined as the charging of real property as a security for a debt by a debtor to a creditor, with the overarching condition that the debt will be paid off, with interest, over a specified period of time. In layman’s terms: a form of financing that is used to secure a property.
The word mortgage is a French law term meaning “death contract”. Not the prettiest of meanings but an appropriate one in this context. The term essentially outlines that the promise to payback ends when the obligations are fulfilled or the property is under foreclosure.
Before we jump into a detailed discussion of major components of mortgages, we should look at some basic mortgage terminology. We shall use this terminology throughout the article. Here
- Borrower – The person taking out the mortgage to secure financing.
- Lender – individual or organization – usually a bank or another financial institution – that provides the financing for the mortgage.
- Principal – the original size of the loan, to which interest is charged.
- Completion – start of the mortgage, conclusion of the deed.
- Redemption – final repayment of the amount outstanding.
- Foreclosure – the event when a borrower cannot pay the loan and the property is seized/repossessed.
Borrowers will generally put a cash down payment on a home – generally 5-15% of the property’s value – with the remaining amount taken as the principal for the mortgage loan. Mortgages are generally long term loans, with a maximum amortization period of 25 years. Over this period, the principal is gradually paid down, along with the accrued interest.
Canadian Mortgages Defined
For first time home buyers, purchasing a first home is a big step and making the “right decisions” all the way doesn’t come easy. Often, the debate lies around what kind of mortgage one should invest in.
Fixed vs. Variable Rate
There are two types of mortgages first time home buyers should consider: fixed rate and variable rate. In a fixed interest rate mortgage, your interest rate will not change throughout the term of your mortgage, giving you all the tools required to budget yourself accordingly.
In a variable rate mortgage, interest rates can fluctuate, creating a potential for payment increases as well as a chance of the amortization period being extended. With that said, interest rates for variable rate mortgages tend to have lower interest rates than the fixed rate, creating the potential to save money on interest over the life of the mortgage.
How to choose between the two?
There is no simple cookie-cutter answer to this question. It is very much dependent on the lifestyle of the buyer and the buyer’s financial situation. There are multiple factors that come into play when trying to make the decision between these two mortgage types. However, a case can be made for the fixed rate mortgage.
It all boils down to one aspect: financial analysis. Here’s one scenario:
- A buyer has a structured monthly budget, with mortgage payments making up a significant part of it.
- The buyer has a fixed income or is self-employed, bringing in uncertainty about long-term financial gains.
- The buyer has set aside money for a rainy day but would not like to tap into these funds unless absolutely necessary.
- Anxiety is a major issue surrounding mortgage rates and the potential implications of an increase.
The above buyer is a structured, risk-averse individual, who would like certainty and clarity. As a result, the fixed rate mortgage would be the most ideal mortgage type.
Variable interest mortgage still a good option?
Variable interest rate mortgages should not be ruled out. In fact, they could be the better option for interested first time home buyers. Let’s take a look at an example. For the sake of this example, we will use TD bank prime rates. Here are the facts:
- $300,000 mortgage with 25 year amortization.
- Fixed interest rate of $3.69% – $1528 / month payment (five year term).
- Variable interest rate – TD Mortgage Prime Rate – 0.25% – this equates to 2.75% – $1383 / month payment (five year term).
With the above facts, you can make one straightforward analysis. After five years, and keeping all the variables constant, the interest would $51,844 for a fixed rate mortgage versus $41,874 for a variable rate mortgage. Awesome right?
Well, no. First off, a variable interest rate is rarely ever going to stay the same for five years. Say we see an increase in the prime rate to 4.5% in month 30 of the 5-year term. Your payments go from $41,874 to $52,456 – higher than the fixed rate mortgage?
Bottom line: The choice of mortgage is dependent both on the buyer’s lifestyle and the buyer’s ability to handle financial and organizational risk. Depending on those variables, a first time home buyer can choose the appropriate mortgage type.
As you may have noticed from the example above, mortgage rates are key factors affecting mortgages and its related effects on first time home buyers. There is no hardcore definition to mortgage rates except the fact that it is the interest rate that is charged by a mortgage lender. I.e., the cost of borrowing.
Where do mortgage rates come from?
We simply have to follow the money trail. When you get a mortgage loan from a lender or a bank, the institution never holds your loan. What the lender does is take your loan into what is quintessentially known as the secondary mortgage market.
Here, the bank/lender will sell your loan to an aggregator – a third-party investor, usually a mutual fund or institutional investor. What the aggregator will do is aggregate your loan with other mortgages to create a mortgage-backed security. This mortgaged backed security is then broken down into tranches (type of shares) to sell to other investors, who will receive a return on their investment. Neat eh?
The lender and aggregator become middlemen, balancing between the home buyer and investor. The one caveat with this scenario: the home buyer wants to get the lowest rate whilst the investor wants the highest.
Online Resources: Information at your finger tip
We constantly say that we can just Google stuff. To be honest, you can! Mortgage rates can be found on each bank’s website and you can always call a mortgage broker and get your rates that way. However, there is no faster resource than technology and the online world!
Websites such as RateHub.ca and RateSupermarket.ca provide an overview of some of the best mortgage rates, consolidating rates from multiple lenders and resources (including banks) and presenting them in a neat, comparative manner. Using websites such as the ones mentioned above provides a great starting point (and perhaps a conclusion!) to best-rate hunt for your first mortgage.
Financing a loan can be done through many channels. Traditionally, folks would go to the bank and get a mortgage at their designated rate. Now however, the term “Lender” has expanded dramatically. Lenders could be private investors, individuals or organizations. The second top option to banks, these days, are mortgage brokers.
Going to the bank have been the traditional route because they have the ability to provide a loan, with the ability to consolidate your services with trustworthy service providers. They bring a level of brand recognition and trust, making them the safer option.
Limitation of banks as lenders
Banks can only offer products at their own rates, limiting the options first time home buyers have when it comes to mortgage decisions. Discounts are definitely available, but home buyers have to do the negotiation themselves, which in itself is a tedious process.
This is where mortgage brokers fall into the picture. A mortgage broker is a licensed mortgage professional with access to multiple lenders and lending sources, including a variety of different rates. This here is the key. Mortgage brokers provide first time home buyers with the ability to “shop around” for the best rate to suit both their needs and their financial situation. They do the negotiation for you and also transfer the benefits of bulk mortgage deals directly to the you. All in all, it is a win-win situation.
Mortgages make home buying a reality for first time home buyers. However, lenders put in necessary safety measures when it comes to their financial investment. This is where mortgage insurance comes into the picture.
Who is eligible?
Mortgage insurance is the protection tool that lenders use against the possibility of mortgage default. Mortgage insurance is typically required when home buyers are making a purchase with a down payment between 5% and 20%. Here are the requirements in more detail:
- Home must be located in Canada
- Down payment of at least five per cent of the price of a single-family or two-unit dwelling (or at least 10 per cent for a three- or four-unit dwelling).
- Monthly housing costs should not exceed 32 per cent of your gross household income.
- Total debt load should not be more than 40 per cent of your gross household income.
Financial implications of mortgage insurance
Mortgage insurance is solely intended to be a benefit to the lender. They have to pay an insurance premium to have access to mortgage insurance, a cost that is transferred down to the home buyer. The premium is a percentage – usually 0.5 to 2.9% – of the total mortgage, which is then presented as a single sum to be paid off or applied to the mortgage of the home. The percentage is determined based on the down payment. The higher the down payment, the lower the insurance premium.
There is a benefit to the buyer!
As much as an explicit benefit to the home buyer is not outlined, what mortgage insurance has enabled is the ability for a first time home buyer to purchase a house – a major capital asset – with only a 5% down payment. Yes, it does have long-term financial implications, but in return, you get the opportunity to own a major capital asset.
Other Factors Affecting Mortgages
Apart from interest and mortgage rates, there are many other factors that affect housing prices and, as a result, mortgages. Economic situation is the most obvious. As the economy slows or grows, the housing market tries to adjust to levels to meet the markets expectations. This is of course affected by the demand for housing and the supply from builders.
Another major factor is income. Income validation is a major factor that affects how much mortgage insurance you end up paying. An analysis put together by Canadian Living shows that an individual with a full-time job would pay a $9,000 premium after putting $50,000 down on a $500,000 house – essentially a 10% down payment. The premium works out to be $21,375 for a self-employed buyer investing in exactly the same property with the same down payment.
The CMHC: A major resource for first time home buyers
The Canada Mortgage and Housing Corporation is a major resource centre for first time home buyers, providing a wide range of Flexible Financing Options. Some of their programs include:
- Purchase Program – allowing home buyers to purchase a home for 5% down.
- Improvement Program – For borrowers building a new home or investing in an improvement project.
- Green Home Program– mortgage loan insurance for the purchase of energy-efficient home or to make energy-efficient improvements.
- Self-Employed Program – to help individuals who are self-employed with the ability to purchase their dream home.
This is not just another organization providing a bunch of programs with no benefit to the buyer. These individual programs offer a great benefit to first time home buyers.
Purchase-Plus Improvements Plan
Lets look at two examples: The Purchase-Plus Improvements Plan and the Green Home program. The Purchase-Plus Improvement Plan is a little known program that is an instrumental financing tool for buying a resale property – condominium or freehold – that is in need of renovations. Here’s how the program works:
- You can finance, on top of your mortgage, up to 10% of the purchase price of your property for improvements after closing.
- The allowable improvements are vast: Complete remodel of kitchens, bathrooms, flooring plumbing, electrical, and paint to name a few. You can only improve fixtures, so appliances would not be allowed since they could be removed from the property.
- The property must be appraised based on current value and value after improvements.
- The buyer must get a bid from the contractor, and the funding lender and the insurer must approve the work.
What you are essentially getting is 10% of the value of your home towards improvements and fixes and the cost is spread over a 25-year amortization in your mortgage.
So picture this: You buy a $400,000 home and receive $40,000 from this program for renovations. By doing renovations through this program, you have immediately increased the value of your property, increased living standards and spread the cost of all this over your mortgage’s amortization period, which makes it financially bearable.
Green Home Program
By the same token, the Green Home program also provides a substantial benefit to the buyer. When you purchase an energy-efficient home or opt-in to do energy-efficient renovations, the program provides first time home buyers with a 10% refund on their mortgage insurance premium and an extended amortization period without a premium surcharge. Not only do you get an incentive to live greener – which could reduce utility bills and create energy savings – but you also have little to no financial outflow doing so.
The topic of mortgage loans is one that can grow into a one-day workshop. It is important for first time home buyers to understand all the aspects of mortgages, important in making strategic financial and personal decisions. Not only is it a major financial commitment, it’s a commitment that must be maintained.
First time home buyers should do the following to ensure they are informed when buying their first home:
- Understand your financial situation. Figure out how much money you can afford for a down payment, understand your monthly bills and debt costs and ensure you weight all of these against your income and savings.
- Understand what you need vs. want. Your mortgage is dependent on the value of your home and if you are searching for a property with extravagant wants, you need to consider if its worth the financial hit. Find a property that you can invest and grow, something you can put your mark on and get a major financial return in the process.
- Consult multiple sources for information. Don’t simply walk into one place for the convenience and make a decision. See what the market has to offer, both offline and online.
- Strategize your investment. Looking into programs, such as the CMHC Green Home Program, and find ways where you can invest, save money in the long run and build on your capital asset.
- THINK LONG TERM!
As a first time home buyer, it is important you do your due diligence. It certainly pays off.