Step 1: Obtain a mortgage
Unless you’ve robbed a bank, uncovered buried treasure or hit your lucky numbers on the lotto, then your first step to buying a home will be to get a mortgage.
Not too many people can afford to buy a home without a mortgage. To put it simply, a mortgage is a loan that is primarily used to buy a home. Lenders will loan you a large sum of money, and use your home as collateral, or security, for the loan.
When you sign for a mortgage, you’re signing a legal contract that says if you fail to repay what you borrowed, the property used to secure the loan will be taken by the lender.
The amount of the loan is referred to as the principal, and you are expected to repay the principal with interest during the repayment period.
Step 2: Getting help – bank or broker?
When you’re ready to discuss the types of mortgages you qualify for, one of the decisions you’ll have to make is whether to get a mortgage through a bank or a broker.
Joan Dal Bianco, vice-president of real estate secured lending at TD Canada Trust in Toronto, suggests first-time buyers at least have a conversation with their existing financial institutions because they already have a relationship with them. Besides adding a comfort factor, going where you’re known can also make the application process easier, she says. There are certain qualifying criteria that everyone has to meet regarding credit scores, down payments and income – you have to prove your income, your credit score will be checked by the institution – and your bank will already have that information on file.
David Kuo, vice-president retail branch network for Ontario East at HSBC in Toronto says first-time buyers will often choose banks because of the overall financial advice banks can provide existing customers. “The banks will help you with overall wealth planning, because for some of these first-time homebuyers, their home is probably their biggest wealth,” says Kuo. If a first-time buyer has extra money, and they’re not sure if they should pay down their mortgage or put it into an RRSP, RESP or tax free savings account, banks will help buyers make the decision by giving a more overall, holistic suggestion. A mortgage broker, on the other hand, might focus only on the mortgage itself, he says.
One potential limitation of dealing with a bank as opposed to a mortgage broker is that a bank is limited to whatever products they offer. If you work with a mortgage broker, you have access to a wider array of products because brokers may work with 50 different lenders, says Calgary-based Gary Siegle, regional manager of Alberta South and Saskatchewan for mortgage brokerage firm Invis. In addition, brokers specialize in mortgages only, whereas a loans officer in a bank may deal in different types of lending.
Ultimately, the decision is a personal choice. But it’s important to shop around when taking this important first step.
Step 3: Getting pre-approved
Before you look at homes, most realtors, lenders and brokers will suggest you get preapproved for a mortgage. This free service will help you determine how much you can afford to borrow based on your qualification and personal credit rating. Your lender or broker will ask questions about your income and personal financials as well as check your credit score.
They’ll come back with an amount you’ve been approved for, along with a rate that will be guaranteed for a specified time, up to 120 days. If the rates go higher, your rate will not be affected. If the rates drop, you will get the lower rate.
Getting pre-approved will give you the confidence you need when searching for a home. You’ll be in a better position to negotiate prices and have a clear picture of what you can afford.
While the pre-approval is no-obligation, the amount you’re pre-approved for is also not guaranteed. Final approvals will need to be done with the help of a lawyer and your lender upon submission of the proper documentation.
Dal Bianco says that sometimes when people go to their lender for pre-approval, they estimate their income. Since a lot of people earn bonuses, they often overestimate their actual earnings. When it comes time to provide the lender with confirmation of income, your lender could find out you earn $65,000 or even $50,000 when you believed you made $75,000.
She stresses the importance of providing your banker or broker with as much information as possible. Be sure to ask your lender what you need to bring when making your appointment so you can get as accurate a calculation as you can.
Siegle agrees. It’s possible to use estimates to figure out what you can pre-qualify for, but there’s greater benefit in being able to verify your income and source of down payment, so the amount of the loan is more accurate. “It removes another layer of doubt,” he says.
Make sure you aren’t looking at houses out of your price range. If you’re pre-approved for $200,000, it makes no sense to fall in love with a home that is $250,000, he says.
Step 4: Determining size of loan
Generally speaking, the maximum you can borrow is 95% of the value of your home, so you’ll need the other 5% in the form of a down payment. Use our mortgage calculator to find out how much you can borrow.
But 95% of a $200,000home is $190,000. In today’s environment, it’s wise not to over-extend yourself. “If you go to the maximum you’re not leaving yourself much room for a rainy day,” says Dal Bianco, adding with rising unemployment rates and an uncertain economic environment, a rainy day could come sooner than you think. “Everybody should have a bit of savings set aside, so I wouldn’t advise going to your maximum.”
“Most people don’t want to give up their lifestyle in order to have a home,” she says. “Our parents and grandparents may have been willing to put everything they had to paying off their home. But most people today still want to be able to enjoy life a little – they want to go on vacations and go out for dinners occasionally, and so not extending yourself is helpful.”
Siegle says it’s important to know how much, theoretically, you can qualify for, but also understand how big that payment is and look at it in terms of the luxuries you’d have to give up. You may need to run your budget numbers backwards to see what type of mortgage payment fits your lifestyle.
Ultimately, the decision comes down to individual choice. Some of the key factors include how confident you are that you’re going to have the same job and salary for the next two to five years, and considering what you’re giving up by going to the maximum – RRSP contributions, for instance.
The average mortgage for first-time buyers today, Kuo says, is about $200,000 to $300,000.
Step 5: Choosing a loan
With all the mortgage options available for first-time buyers, the task of choosing one that’s right for you can be daunting.
Dal Bianco says for the most part risk tolerance is a key determinant. Whether you’re comfortable having your interest rate move with the market will determine if a variable or fixed rate is right for you.
Since many buyers are often younger and taking on a large debt for the first time, many choose fixed rate options for their first mortgage term, she says. Once they’re comfortable and have had a home for a while and gone through a mortgage term or two, they can consider switching to variable. Another option may be to have a fixed rate mortgage and then get a Home Equity Line of Credit, which would be variable attached to the mortgage. This could allow them to do improvements or renovations later on.
A single person with only their own income may like the idea of knowing exactly how much they’re going to pay.
“We’re finding a lot more single women are buying homes now, and are quite comfortable with that – they’re confident in their jobs and have good paying jobs,” says Dal Bianco. “Even in pockets of the country where housing prices have increased significantly in the last several years –Alberta, British Columbia and in the GTA (Greater Toronto Area) – we’re seeing a lot more single women buying.”
Short term versus long term: Mortgages are split into terms that may range from a few months to five or more years. At the end of a mortgage term, your current lender will offer you a renewal agreement. It’s always a good idea to see what else is available in the marketplace, says Siegle, and if need be, change the terms of your mortgage if your needs or circumstances change.
When deciding what term is right for you, one thing to consider is your lifestyle and circumstance. For instance, if you’re buying a home and plan to move in three years, you may want to take a three-year term or a five-year term that’s portable.
When you’re considering term and interest rates, also look at what you can live with in terms of payment amounts, because it’s very difficult to predict where interest rates are headed. If, for example, you’re happy with current interest rates and you want to lock in a rate for as long as possible, go with a long term, or generally a five-year term, says Siegle. If interest rates appear to be rising, take advantage of the lower rate for as long as you can.
It’s also a good idea to ask if your mortgage is transferrable across provincial borders or if it is assumable. If you sell your property, you can take the mortgage with you to a new property, or have someone take over the mortgage. It could prove to be a great selling feature if you have an assumable mortgage at a very low rate. However, most lenders will need to qualify the person assuming the mortgage.
If you think rates will fall, you can choose a shorter term mortgage that offers the flexibility to switch to a longer term at any time, in case rates start to rise.
Kuo says he’s seen first-time buyers sign for short-term mortgages. Currently, one- or three-year terms are much more popular than five-year terms, he says.
In the past – even a few years ago – first-time homebuyers often wanted to fix their rate for a longer period of time so they had peace of mind. But now, in a more challenged economy, they still want to buy a home but they may prefer a shorter-term, fixed-rate option, if they decide to go with a fixed rate, he says.
Open versus closed
An open mortgage allows you to repay the mortgage – in part or in full – at any time during the term without any penalties or repayment costs. Open mortgages are usually available in shorter terms – six months or a year – and the interest rate is higher than closed mortgages. They provide flexibility until you are ready to lock into a closed term. These types of mortgages are ideal for those who are thinking of selling their home, or if their expecting to pay off the whole mortgage from the sale of another property or an inheritance.
A closed mortgage must remain unchanged for the term. The interest rates are considerably lower than open mortgages and if you’re not planning to sell your home, or expecting any boosts in income, a closed mortgage could be the right fit. Lenders allow you to pay down a lump sum of 20% of the original principal annually. If you wanted to pay more than the allotted amount, or pay the mortgage off in its entirety, you’d incur a penalty of about three months’ interest.
Most mortgages have a prepayment privilege, says Siegle, and that will vary from lender to lender or product to product. Some mortgages being offered in the marketplace right now have pretty attractive interest rates, but they don’t have very flexible prepayment privileges. Others have three options to prepay your mortgage – you can pay 25% of the original balance as a lump sum, you can increase your payments by 25% and you can even double up your payments on top of that. Some offer three different ways you can prepay your mortgage without any penalty, but they’re available at a higher rate, he says.
The most common fee incurred by buyers is when you attempt to put down more money on your loan than you’re allotted. Paying a lump sum of money annually is called an annual prepayment or a principal payment option or privilege. Some banks allow customers to pay down 10% to 20% of the principal amount per year, says Kuo.
There is quite a variance between how lenders calculate those prepayment penalties. Some charge an interest rate differential of three months’ interest. However, it’s important you ask questions, says Dal Bianco. Any mortgage documentation that you sign will tell you what penalties you could incur, and your lawyer should take you through the document and the potential penalties or fees.
Fixed versus variable
A fixed rate is an interest rate that does not change throughout the course of your mortgage term. With the same interest rate, you have a regular interest payment and you know the exact amount your payments will be each month. This can make personal budgeting easier. Having a fixed rate makes it possible for you to figure out how much of your mortgage you will have paid off by the end of the year.
“Some people like fixed rate because if they fix the rate for three years, they know exactly what their mortgage payment will be for three years, and in three years’ time their interest rate will not change. It gives them peace of mind,” says Kuo.
A variable rate is an interest rate that fluctuates with the market during your mortgage period. They provide a lot of flexibility and are especially appealing when interest rates are on their way down. Although your mortgage payment typically remains constant, the ratio between your principal and interest rate fluctuates. If interest rates go down, more money goes toward repaying your principal, helping you pay off your mortgage faster. If interest rates go up, you pay more interest and less principal. If they rise substantially, the original payment may not cover both the interest and the principal. The portion not paid is owed, and you may be asked by your lender to increase your monthly payment.
It’s a good idea to make sure your variable-rate mortgage is open or convertible to a fixed-rate mortgage so that when rates begin to rise, you can lock-in your rate for a specific term, says Siegle.
However, the onus to do so is on the customer. While some customers may follow interest rates closely, and will call their lender to switch from variable to fixed, but many customers do not. And if you’re not following interest rates regularly, you may miss out on opportunities to save money.
Most first-time buyers recognize that there will likely be some unforeseen costs that go along with home ownership. Generally speaking, Siegle says, these people likely have less tolerance for change in their payment arrangements so they have a higher tendency to go with the five-year fixed because it gives them a reasonable period of time of security, a known interest rate and payment amount.
It’s only those first-time buyers who are feeling financially secure that say they want to reduce their costs as much as possible and go for the variable even though it’s only a half a point (0.5%) difference, he says.
“It’s all about the individual’s psyche, their budget, their ability to absorb payment increases, and their desire to take advantage of payment decreases,” says Siegle. “There’s not one answer. It’s the circumstances that will help you decide what’s best for you.”
The length of time it takes you to pay back the loan is called the amortization period. Your amortization period helps determine how much your monthly payments are going to be, so if you’re trying to keep your monthly payment lower, you may want a longer amortization. But the longer your amortization, the longer you’re paying for the home. Plus, your equity takes longer to build up.
So if you’re interested in paying down your mortgage rather quickly, you may want to amortize over a shorter period of time.
You have the option to change your amortization period each time you renew your mortgage. You may want to start your mortgage with a shorter amortization period, and after your first term, you may decide to extend it if you want or need to, says Dal Bianco.
For instance, Dal Bianco says you can take up to 35 years to pay off your mortgage, but if you initially choose a 25-year amortization period and you have difficulty keeping up with the payment, extending it to 35 years would mean a lower payment, but over a longer period of time.
“The way you shorten your amortization period is, if you start at 35 years, every year you have the ability to make lump sum payments on your mortgage and you can increase the frequency,” she says. “Some people pay weekly or bi-weekly payments, as opposed to monthly, so you get about one or two extra payments in each year by doing that. That pays the mortgage down more rapidly and shortens the amortization period.”
Kuo says he’s noticed that many first-time buyers are taking the maximum amortization period, or 35 years, so they can lower their monthly payments and ease financial pressure on a monthly basis.
Siegle says when deciding how long of an amortization period to choose, you should ask yourself, ‘What impact does 35-year amortization have on my monthly payment and is that the most important thing to me right now, to manage my cash flow and have the lowest payment possible? Or do I want to pay the least amount of interest over the time I have my mortgage, in which case let me see how a three-year, a five-year or even a 20- or 30-year amortization fit me.’ If you’re a first-time buyer who hasn’t been able to save much for a down payment but you’ve got really, really good income, then you might want to look at even shorter amortization.
Choosing a 35-year amortization period should be a strategy for getting into the market and not your long-term goal, says Siegle.
However, if cash flow is really important to you, then make a commitment to increasing your payments when you get a raise or making a lump sum payment when you get a bonus. That way, you can turn your 35-year mortgage strategy and shrink it to a 20-year strategy, he says.
Are you looking to invest in property? If you like, we can get one of our mortgage experts to tell you exactly how much you can afford to borrow, which is the best mortgage for you or how much they could save you right now if you have an existing mortgage. Click here to get help choosing the best mortgage rate