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How mortgage work? A complete explanation

Explaining mortgages – how they work and how to choose them when buying a condo in Toronto

Numerous cities in the developed world are expensive to live in. That expensive factor is chiefly present in real estate, where the living can become cumbersome for those who moved in recently. New York, London, Tokyo, Luanda, Sydney, Melbourne, Hong Kong, Amsterdam, Los Angeles, and Toronto ranks among them.

Speaking of, Toronto is North America’s most expensive city when it comes to real estate (especially housing). Its residential space is the most expensive and is more expensive than that of Mexico City, Chicago, and New York.

With prices of homes going sky-high in Canada’s financial capital, residents are using mortgages to help themselves buy homes. They do so without paying the whole purchase price upfront but rather pay an advance and monthly payments to help secure the home.

Let us now examine important factors worth considering when Torontonians are looking to purchase a home in Toronto and other areas of the Greater Toronto Area (GTA).

Mortgages – How do they work?

A mortgage is a loan from a bank, a housing mortgage provider, or any other financial institution to help buyers purchase a residential property which could be a suburban home, an apartment, a loft, or a decent condo from a list of Toronto condos for sale.

When buyers obtain one, they make a promise to the mortgage lender that the amount of money they have borrowed will be paid back on the terms the buyers have agreed upon. The property to be purchased is to be used as collateral.

Why is the property being used that way? Such a rule is an insurance policy because if buyers break the promise of paying the mortgage payments timely, the bank/mortgage lender has the right to foreclose on the property. The payments that they make to the lender include interest on the loan as well as part of the principal i.e. the loan’s total amount.

Getting a pre-approval for a mortgage

Buyers getting pre-approved for a mortgage will help buyers understand the responsibilities of homeownership. This further allows them to set a much more realistic budget. When they get pre-approved, they will then find out the maximum amount they can spend on a home, the monthly mortgage payment, and what their mortgage rate will be for the first term.

If interest rates take an upward hike during the first 120 or 160 days of buyers’ pre-approval, they will be protected by their lender. Subsequently, if the interest rates are reduced then the lender will follow & honor such rates.

Buyers can get pre-approved without a cost as it does not involve any. This indicates the seller that the buyer is financially stable and can thus be given a competitive offer.

The factors that are to be considered whenever buyers look for a pre-approval are credit score, down payment, the debt service ratio, and supporting documents. When buyers are pre-approved, they can use it as a guide when they search for homes in their desired price range.

The mortgage interest rate – what is it?

There are two kinds of mortgage interest rates and they are closed (fixed) and open (variable). Those who a closed mortgage rates indicate that the payments the buyer makes will stay the same throughout their mortgage’s term.

For instance, a 5-year closed rate is the most common kind of mortgage interest rate present in Canada.  5 years being the length of the mortgage’s term before the home buyers must renew the mortgage rate. Though closed rates are often higher, they also provide the most stable and consistent mortgage payment in the years to come.

On the other hand, the open rate is driven by economic factors (on which it depends on heavily). It will also fluctuate with the market interest rate (which is also known as the prime rate). If it is predicted that the interest rates will fall, then the open rate is highly preferred.

The economy took a hit this year due to the COVID-19 pandemic which will take a lot of time to recover. Keeping this into consideration, choosing an open interest rate is best at this time as it is predicted that banks won’t be increasing their interest rates unless and until the economy starts to grow at a stable pace.

When the open interest rates start rising again, buyers can remove the additional pre-payment to help themselves make more consistent payments over time.

It should however be understood that if the interest rates rise, the value of the buyer’s property falls. The financial condition of buyers can change, and they might face a hard time either selling their home or making payments on an open rate.

The mortgage term – how is it chosen?

A mortgage term is the length of the time the mortgage will be in effect. Terms typically range from a few months to five years or more. At the end of each term, buyers must renew their mortgage. They will also most likely require multiple terms to pay off the mortgage completely.

When the buyers pay off their mortgage completely, they do not need to renew it. They can choose a short-term mortgage, a long-term one, or a convertible term.

A short-term mortgage is beneficial if the buyers want to renegotiate their mortgage for a lower interest rate or change lenders without having to pay extra fees. If they predict that interest rates will reduce then this is a worthwhile option for them.

Although buyers could obtain potential benefits if the interest rates are reduced, they also must understand that if interest rates go upwards, they then will need to renegotiate their mortgage at a higher interest rate.

A long-term mortgage has a closed and locked-in interest rate for a long time. They are often best in terms of budgeting because buyers have the exact knowledge of how much exactly they are paying. They also do not have to pay a pre-payment penalty if they wish to make changes to their mortgage contract.

In a convertible mortgage, the home buyer’s short-term mortgage can be changed into a long term one. The lender will then change the interest rate based on what they offer to home buyers in the long run.

What are the different mortgage payment options and payment frequencies present?

The payment frequency is often decided when the home buyer and their lender arrange the buyer’s mortgage. This refers to how often will the home buyer make their mortgage payments. The options for mortgage payment frequencies are as under:

  • Monthly basis – One payment per month for a total of 12 payments made in a year.
  • Semi-Monthly basis – Two payments per month for a total of 24 payments made in a year.
  • Bi-weekly basis – Payments made every 2 weeks totaling 26 payments made in a year.
  • Weekly basis – One payment to be made per week totaling up to 52 payments in a year.

Homebuyers also have the option to selected accelerated weekly and bi-weekly payments. This is a good option to consider if home buyers are looking to pay off their mortgage quickly. This will help them save a precious amount of dollars in interest charges. Through accelerated payment options, home buyers will make the equivalent of one extra monthly payment each year.

Selecting a payback period – how is it done?

A payback period is different when compared to a mortgage term. The latter is the length of time a home buyer commits to their respective mortgage rate, lender, and associated terms and conditions. It also has to be renewed often (like after every 5 years) and acts as a ‘restart’ button on the mortgage.

On the other hand, a mortgage payback period is the length of time it will take the home buyer to pay off their whole mortgage.

As of March 2020, the maximum payback period of a mortgage is around 25 years especially on homes insured by Canada Mortgage and Housing Corporation (CMHC). If the buyers are paying more than 20% on the down payment on their purchase, some lenders may give them an amortization period of around 30 years. Hence, they can choose either a short-term payback period or a long term one.

A short payback period necessitates large monthly payments. How is it beneficial? It has lower interest rates in comparison to longer payback periods which involve lower payments each month but at high-interest rates.

A longer payback period can allow home buyers to buy a home that they were not able to obtain on a shorter payback period. How is this beneficial for buyers? If their property value increased by C$ 250,000 with time, this will become their profit once they sell it.

Conclusion

If home buyers having a mortgage payment it off sooner instead of later, they will always be able to enjoy its benefits as it can save them a lot in interest payments in the long term. However, there are options for those who wish to make smaller payments to free up more money in their budget for some purchases.

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