What first-time homeowners need to know

What first-time homeowners need to know

For most people, buying a home is the single largest purchase you will make in your lifetime. But before committing to a purchase, there are a few things you need to know.

Before we start on strategy, we should discuss some terminology.  

Principal and interest

The principal is the initial size of the mortgage. The interest is the “rent” that is paid by mortgage holders to a lender (usually a financial institution). Most loans require payments that include a portion of interest and a portion towards paying off the loan itself. In essence, the balance of the loan = balance of the principal.

Amortization period versus mortgage term

A mortgage is simply a loan to purchase a home. The security for the loan is usually the home itself. Two important factors about a mortgage are the amortization period and the term of the mortgage.  

The amortization period is the length of time to fully pay off the loan. The term of the mortgage is the length of time your mortgage agreement, such as the interest rate and the payment, are in effect.  

A typical amortization period in Canada is usually between 15 to 25 years, whereas a typical term for a mortgage agreement may only be five years. Consequently, you may need to renew the mortgage agreement several times over the amortization period.

Fixed versus variable term mortgages

Financial institutions are creative about how to package various mortgage products, but generally mortgages fall into two categories: fixed term and variable term.  

In a fixed term mortgage, the payments and interest rate are fixed for the duration of the term of the mortgage. Even if interest rates fluctuate, the payments remain fixed for the duration of the term of the mortgage. In contrast, under a variable term mortgage, payments are not fixed and will fluctuate with the prevailing interest rate.  

Closed versus open mortgages

Closed mortgages usually restrict the number of additional payments that can be made in a year. These additional payments apply directly to reducing the principal. Open mortgages typically have no restrictions on the number of additional payments that can be made in a year.  

Closed mortgages can be either fixed term or variable term. Likewise, open mortgages can also be fixed term or variable term, although it is more common for open mortgages to be variable.

Down payments

In Canada, lenders cannot issue a mortgage for the full value of a house. Without mortgage insurance, the maximum mortgage value is 75 per cent of the value of the home, which requires a down payment of 25 per cent of the value of the home.  

Even for a modest $100,000 home, that would require a down payment of $25,000.  However, many homeowners acquire mortgage loan insurance through the Canada Mortgage and Housing Corporation (CMHC).  

CMHC will insure up to 20 per cent of the purchase price, reducing the down payment to a minimum of five per cent. However, mortgages that require CMHC loan insurance are usually at a higher interest rate as they are considered riskier.

Closing costs

In addition to the down payment, you should budget for an additional 1.5 per cent of the value of the house for closing costs. Closing costs can include:

Some additional costs, which are not typically closing costs, but that you may need to factor into your home purchase plan, include:

Relationship between amortization period and payment amount

Regardless of the interest rate, a longer amortization period will result in a smaller regular payment. However, there is a downside. The longer the amortization period, the more interest that will be paid over the life of the mortgage.

On a typical 15-year mortgage, you can expect to pay about half of the original principal in interest over the life of the mortgage. If the amortization is increased to 25 years, you can expect to pay close to the principal amount in interest. So, on a $100,000 mortgage with a 15-year amortization, you can expect to pay approximately $50,000 in interest alone. On that same $100,000 mortgage with a 25-year amortization, the interest alone will be approximately $100,000.

So, you must balance how quickly you want to pay off the mortgage with keeping the payments manageable.

Payment frequency

Payment frequencies can be monthly, semi-monthly (twice a month), bi-weekly (every two weeks) or weekly.

There is a small advantage to paying more frequently, so there is a bit of an advantage to paying bi-weekly than paying semi-monthly or even monthly. Although there is a small advantage to paying more frequently, you should also use a payment frequency that is most convenient for you, as you will be doing it for several years.

Computing the payment amount

Most people determine the size of the mortgage they can afford by computing the payment amount. You can use a spreadsheet program as most have built-in functions to help you calculate. In addition, there are several payment calculators that are on the websites of many lenders as well as apps that are available such as the Canadian Mortgage App and Ready Set Home by CMHC.

Remember, if you require CMHC loan insurance, the interest rate will be higher than other mortgages offered by a lender, so be sure to use the correct interest rate.

Planning considerations for your mortgage

Determining the size of the mortgage

Most advisors recommend that the amount of your mortgage should be set before you do any home shopping. This will give a price range that you can operate within and narrow down your search. There is nothing more disappointing than finding a home you fall in love with and not being able to be approved for the mortgage.

Mortgage brokers deal with a variety of lenders, so they will often be able to search out the best arrangement for you. This can be far more efficient than moving from one lender to another and searching for the best arrangement on your own.

It is also advantageous to be pre-approved before you even begin shopping for your home. This will allow you to remove any anxiety regarding approval and focus on the other factors of your home, such as location, features, etc.

What to do about rising interest rates

Interest rates on mortgages are influenced not only by your own credit worthiness but by the prime lending rate set by the Bank of Canada. Right now, the Bank of Canada is concerned about inflation so, to reduce inflation, interest rates have risen and are expected to continue to rise over the next two years.

What should a new homebuyer do about increasing interest rates?

One way to address interest rate uncertainty is to wait for a more advantageous moment to enter the housing market. However, for many, buying a home is driven by non-financial factors. So, what is the best strategy?

For the next two years, you should consider a variable rate mortgage. This may seem counter intuitive, as most people want their mortgage payments to be a fixed amount and therefore gravitate to fixed term mortgages. It is easier to budget for fixed payments, and fixed payments insulate the mortgage holder from interest rate spikes.

However, lenders know this, so they usually build in a “cushion” on their fixed term mortgage rates to protect themselves from interest rate fluctuations. Fixed term mortgages rates are almost always higher than variable rate mortgages, and this is especially true today. Lenders are building in a bigger “cushion” than normal due to interest rate uncertainty. It is often to your advantage to choose a variable rate mortgage, and this is especially true today.  

There is a downside to this – your mortgage payments will fluctuate, and this can be a significant source of stress. Alternatively, consider a shorter-term mortgage such as two or three years. The expectation is that interest rates will be less volatile and may be lower by the time it comes to renew.

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Where can I get more support?

If you have coverage with us, you can call the Employee Assistance Centre at Manitoba Blue Cross at 204.786.8880 or toll free 1.800.590.5553. For the Deaf, hard-of-hearing and speech-impaired community, we can receive VRS calls.

You can also complete intake and request your first counselling appointment online.