MORTGAGES EXPLAINED


Most people buying a home require a mortgage to finance the purchase. Shopping around for a mortgage is a good idea since different banks and other financial institutions offer a wide variety of options and rates. Before heading to the bank or contacting a mortgage broker, it's helpful to know a bit of mortgage terminology.

What is a mortgage? A mortgage is a loan that is secured by the property being financed. The mortgage allows the borrower to live in the home while repaying the loan.

Interest Rate: interest is the cost of borrowing money. A higher interest rate means that it will cost more to borrow money. Although interest rates fluctuate with the economy, the interest rate on a mortgage will usually be fixed for the term of the mortgage (unless it is a variable-rate mortgage). Shopping around for a low rate can save a borrower down the road. Even a difference in interest rates of 2% can have great implications on how much a borrower pays over the life of a mortgage. For example, let's imagine that a borrower takes out a $100,000 mortgage, amortized over 25 years and calculated biannually (see below or the glossary of terms for definitions). If the interest rate is 5%, the monthly payments would be $581, and the total interest paid over the 25 year period would total $74,480. If the interest rate is 7%, the monthly payments would be $700, and the total interest paid would be $110,122. The difference in interest paid over the life of the mortgage would be about $35,640.

Interest on a mortgage is compounded. This means that interest is added to the amount owing before subsequent interest calculations are made. The result is that a borrower is paying interest on the interest that the lender is already owed. In Ontario, the
Mortgage Act specifies that interest on a mortgage cannot be compounded more frequently than on a semiannual basis (every 6 months).

Mortgage Term: the mortgage term is the period of time that a bank lends money to a buyer. Generally, mortgage terms range from six months to five years, with five years being the norm. At the end of the term, the mortgage is payable in full, unless the buyer renews the mortgage for another term (the buyer may also arrange new financing with another lender).

Amortization: when people describe their mortgage, they usually note the mortgage term and amortization period. A mortgage terms is usually three to five years, and the amortization period is typically 15 to 25 years. Buyers usually renew the mortgage several times over the amortization period, since the monthly payments required to pay a mortgage in full within a typical term (five years) are typically too great for the average person. Lenders assume that the mortgage will be renewed successive times and calculate (amortize) the mortgage over a longer period of time, typically 25 years. When calculating the amortization period, the lender takes into account the payment of the principal (actual amount borrowed) and interest. The shorter the amortization period, the less interest a buyer will pay. Similar to interest rates, the amortization period can have a significant impact on how much interest a borrower pays. For example, let's imagine that a borrower takes out a $100,000 mortgage at a 6% interest rate calculated biannually. If amortized over 25 years, the borrower’s monthly payments would be about $640, and the total interest paid would work out to about $91,940. If amortized over 20 years, the monthly payments would be about $712, but the total interest paid would be only $70,925. By reducing the amortization period by 5 years, the borrower in this example would save $21,015.

As you can see, having lower interest rates and reducing the amortization period can help a borrower pay less interest and pay off a mortgage more quickly.

How else can borrowers reduce the amount of interest paid on a mortgage and reduce the amortization period?


Ways to Reduce Interest on a Mortgage
  1. 1. Use biweekly accelerated payments
  2. 2. Utilize prepayment privileges
  3. 3. Make a larger down payment
  4. 4. Assume a mortgage at a lower interest rate

Accelerated Bi-weekly Mortgage Payments: borrowers can repay a mortgage faster and reduce the total interest paid by making bi-weekly accelerated payments instead of monthly payments. For example, let's imagine a borrower takes out a $100,000 mortgage, amortized over 25 years, calculated biannually and at a 5% interest rate. If the borrower makes regular monthly payments, they would be paying $582 per month and would end up paying $74,483 in interest over the life of the mortgage. If the borrower made accelerated bi-weekly payments instead, he or she would pay slightly more per year, but would be finished paying off the mortgage 3.5 years sooner and would save about $12,000 in interest charges over the life of the mortgage.

Prepayment Privileges: allows a borrower to pay down the mortgage whenever they want (in addition to paying regular monthly or biweekly payments). This is a very useful option because it allows a borrower to pay down the principal directly. A mortgage that allows a borrower to make additional payments, without penalty, is called an "open mortgage", which is in contrast to a "closed mortgage".
  • Open Mortgage: an open mortgage allows a borrower to make payments in addition to regular monthly payments. In contrast, a closed mortgage does not allow a borrower to make additional payments (if additional payments are made, there are usually penalties). Typically, an open mortgage will have a higher interest rate than a closed mortgage. Having an open mortgage is sometimes referred to as having “prepayment privileges”. The advantage of prepayment privileges is that the additional payments go straight to reducing the principal, thereby saving interest down the line.
  • Closed Mortgage: a closed mortgage does not allow a borrower to make additional payments (if additional payments are made, there are usually penalties). In contrast, an open mortgage allows a borrower to make payments in addition to regular monthly payments. Typically, an open mortgage will have a higher interest rate than a closed mortgage.
  • Partially Open/Closed Mortgage: allows a borrower to make limited additional payments at specific intervals in the life of the mortgage. For example, a partially open mortgage may allow a borrower to make an additional payment of 15% or less once per year.

Make a Larger Down Payment: This is probably the most obvious way to reduce the interest payments on a mortgage. However, it isn't easy for many prospective homeowners to increase their down payment. With a fixed income, saving enough to make a moderately larger down-payment ($10,000) can take months or years and often means delaying the enjoyment of a home. The decision of whether to save for a larger down payment is an individual one and should take into account the costs and benefits of your existing housing arrangement. Although a large down payment can help save money down the road, a buyer should also be mindful of the closing costs before allocating all of his/her savings to the down payment. See Costs Associated with Buying a Residential Property for more information.

Assuming a Mortgage: if you are buying a used home (not a newly built home from a builder), taking over (assuming) the existing homeowner's mortgage can be advantageous because the interest rate on an existing mortgage may be lower than current market rates. It may also avoid the costs of obtaining new financing, including some legal fees and a property appraisal. If considering this option, it may be helpful to have a lawyer review the existing mortgage as there may be terms which are unfavourable that you'll want to know about.

How do Banks Approve Borrowers?


Typically, a bank will use two calculations to approve or deny a borrower for a mortgage. The first is called the Gross Debt Service Ratio (GDS) and second is the Total Debt Service Ratio (TDS).

  • Gross Debt-Service Ratio (GDS): The GDS ratio is the percentage of a borrower’s total (gross) income that can be used to pay housing costs (including mortgage, taxes, utilities, condominium fees, etc.). Usually, a gross debt-service ratio will be about 30 to 35%, which means that a lender will want to ensure that only about 30% to 35% of a borrower’s monthly income will be applied to housing (this ensures that they have additional money for other living expenses, such as car payments, entertainment, food, etc.). This also means that a lender will not approve a borrower for a particular mortgage if their total housing costs are more than 30 to 35% of their total income. For example, if a borrower has a gross annual income of $80,000 (or $6,667 per month), then a bank will only approve them for a mortgage if their housing costs (mortgage payments, taxes, utilities, etc.) are $2,000 per month or less (which works out to a 30% GDS ratio in this example).

  • Total Debt-Service Ratio (TDS): Lenders use the total debt-service ratio to ensure that a borrower is not taking on too much debt. The TDS allows a lender to ensure that a borrower can afford housing expenses (mortgage payments, taxes, utilities, condominium fees, etc.) and other fixed debt, such as student loans, car payments, lines of credit, credit card debt, etc. Typically, a lender will not want these fixed payments to exceed 40% of the borrower's monthly income. For example, if a borrower has a gross annual income of $80,000 (or $6,667 per month), then a bank will only approve them for a mortgage if their housing costs (mortgage payments, taxes, utilities, etc.) and other fixed-debt commitments are $2,667 per month or less (which works out to a 40% TDS ratio in this example).

In addition to meeting the lender's GDS and TDS ratios, prospective borrowers will also need to demonstrate creditworthiness and employment or otherwise sufficient income.

Before visiting a bank to arrange a mortgage, a prospective borrower should obtain the following:
  • 1. List of assets and liabilities
  • 2. List of debt obligations (car payments, student debt payments, etc.)
  • 3. A letter from your employer confirming your current employment and prospects for continued employment
  • 4. Description of prospective property (if you have already selected a home)

Using an
online mortgage calculator can give you an estimate of what a bank will be prepared to lend.

Please contact us for additional information.