Getting back on the debt bandwagon, this week we’re going to examine the many parts of a mortgage. Purchasing a home is likely the largest financial decision you’ll ever make and understanding what and how much you’re paying for is crucial. You might not think mortgages should be included as consumer debt, but homebuyers think with their hearts not their debt repayment calculators. The cost of home ownership in Canada has sky rocketed over the past few years, leading people looking for the ‘Canadian dream’ to take on mortgages larger than they can truly afford and without any logical way of talking themselves into it being an ‘investment’.
For 99.9% of people mortgages are a necessary evil on the path to home ownership. While I can think of a few people whose parents were generous enough to gift them an interest free house, these people are few and far between. For us mere mortals in order to own a property – we need a mortgage.
Can You Afford Your Mortgage?
If you’re employed with a solid credit history, mortgage lenders want your business. Real bad. They want all those juicy interest payments so they’ll likely let you know you can afford an awful lot of house. More than you can truly afford. As a rule of thumb, your housing expenses shouldn’t exceed 30% of your take home pay. Your housing expenses aren’t only your mortgage payment. They include property tax, insurance, maintenance and fixing broken shit. That’s a lot of added expense to be aware of.
Mortgage lenders consider your income relative to your debt and some future house expenses (like property tax). When I ran the numbers for myself, apparently I can afford a million dollar house (WTF!), with the only limiting factor as my hypothetical down payment amount. At a monthly payment of around $4,000, that’s ludicrous. Goodbye fun and good times. It’s very tempting to go with the maximum you’ve been approved for because who wouldn’t want to make their white picket fence dreams a reality? So seriously, if it’s out of your price range – do not go look! Any show on HGTV makes it seem so easy and carefree to simply add an extra $50,000 or $100,000 to your home buying budget, but it’ll really cost you.
All the Parts
The parts that do into determining your monthly payment are:
- Down payment – The amount you’ve saved up to contribute to the cost of your new home. In Canada, a minimum of 5% of the purchase price is required, however if you can save up over 20% you’ll no longer need to pay for default insurance.
- Mortgage principal – This is the purchase price of the home plus default insurance (with <20% down payment) minus the down payment. This is the dollar amount that is charged interest.
- Amortization – The amount of time it’ll take you to pay off the principal plus interest. This can be a maximum of 25 years for insured mortgages or 30 years for uninsured.
- Term – The amount of time your mortgage rate is in effect. In Canada, this is usually up to 5 years. Typically, the shorter the term, the more favourable the interest rate.
- Rate, fixed – The interest rate charged over the term doesn’t change.
- Rate, variable – The interest rate charged fluctuates with the prime rate. A variable rate mortgage is typically lower than a fixed rate because the lender doesn’t have to take on added risk. If the prime rate rises, so does your rate, unlike with a fixed rate.
- Default insurance – This protects lenders against default and is required (in Canada) if your down payment is less than 20% of the purchase price. Technically the lender pays the insurance premium, however you can expect this cost to be passed on to you and added to your principal. The premium amount is calculated on a sliding scale based on your down payment. The less your down payment, the higher your insurance premium.
Open or Closed, Fixed or Variable
When shopping for mortgages it seems obvious to choose the lowest possible rate, however this isn’t always the best case. You have to consider your risk tolerance. If you’re a hard core budgeter on a strict financial diet or the recent rate hikes by the Bank of Canada have you up at night, a fixed rate mortgage is likely a more sensible option for you. Peace of mind when it comes to the largest financial decision you’ll likely ever make is worth a few extra dollars. If that doesn’t sound like you, then by all means go with a variable rate. The lending rates are unlikely to sky rocket in the next few years and even with the recent hikes, you’re aren’t adding very much to your monthly payment. Compare the difference between the two rates using this calculator and then decide for yourself.
With an open mortgage, you can pay off your mortgage at any time or switch between a variable and fixed rate. This ultimate mortgage flexibility comes at a cost though and you should expect a higher rate for this privilege. With a closed mortgage you’re expected to be paying for the entire term. While you could pay it off before, you’ll incur a penalty to do so. This is also true if you decide to move and sell. The penalty is calculated as a multiple of how many months you have left (more months left = higher penalty).
Options to Pay Your Mortgage Back Faster
There are three options to pay your mortgage off faster and are something to consider when negotiating your mortgage terms. The first is through an annual lump sum payment. The second is by increasing your monthly payment. Both amounts will go directly to your principal, thereby significantly decreasing how much interest you’ll pay over the life of your loan. You’ll need to know if these are something financially available to you before you choose a mortgage, as some fixed mortgages don’t allow for either.
The third option is to select an accelerated payment schedule. An accelerated weekly payment is when your monthly payment is divided by four and you pay weekly. This means you’ll make 52 payments instead of the equivalent of 48 payments.
You can take years off your mortgages and save yourself thousands of dollars by employing these strategies. Here’s an awesome calculator to see what kind of a financial difference these will make for you.
Let’s run through an example using the above calculator assuming we’re the average Joe in Calgary. The average price of a home in Calgary is $478,311. The median household income in 2015 in Calgary was $104,410. Let’s also assume we’ve been diligent savers and can put 10% down ($47,831), making the balance of the loan (including insurance equal to $13,345) a total of $443,825.
In Canada with <20% down, I need to be able to afford my mortgage at the fixed 5-yr rate of 4.84%. While a lot of people see this as a major pain in their behinds, it’s wise to assume interest rates will rise and if you can still afford your payments at 4.84% you’ll be set for when they do. Assuming an accelerated bi-weekly payment at 4.84%, each payment would be $1,271 ($33,046 annually).
Now compared to the rate I’d choose, a 2-yr variable rate @2.15%, and each payment is now $956 ($24,856 annually). A monthly payment at the same rate would be $1,912 ($22,944 annually). By choosing the accelerated payment I’ll save three years off my mortgage over the 25 year amortization and $14,516! Now imagine what a difference increasing your monthly payment and adding an annual lump sum would have.