Understanding Mortgages

Unless you are among the very small group with the cash available to purchase your home outright, you will need to obtain a mortgage. Most homebuyers know that you will need to provide a down payment, the portion of the purchase price you pay yourself. The balance of the purchase price is borrowed from a bank or trust company in the form of a mortgage.

It is in your best interest to make as large a down payment as you can legitimately afford after considering the numerous economic factors that go into buying a home. (For more information on these costs, please review The Cost of Buying a Home). A normal down payment is 25% or more of the purchase price of the home, though it is possible to find situations where as little as 5% down will be accepted.

Always remember that the larger the down payment, the less your home will cost in the long run. For example, if you purchase a $150,000 home with 25% down, a mortgage at 8% interest and an amortization period of 25 years, you will pay $38,692 less interest over time than if you buy the same house with 5% down.

Once you have negotiated a purchase price and determined the size of the down payment you are able to make, you will need to apply to a bank or trust company for a mortgage. If you are looking to build a long-term relationship with a financial institution or personal attention and support are important to you, you should seriously consider a smaller financial institution, like an established and reputable community trust company.

Another item to remember is that the mortgage business is a very competitive one. Banks and trust companies compete actively for qualified borrowers. Most of us are intimidated when approaching a bank or trust company for a loan. Always remember, you are the buyer and the financial institution want to sell you their service.

When you have chosen a bank or trust company that best suits you, you will need to submit a mortgage application. This is a process by which the financial institution evaluates how much you can afford to borrow and under what terms. Their goal is to safeguard the principal of the loan, but in doing so, they can provide you with a valuable service. Qualifying your ability to make your mortgage payments on a consistent basis is in your best interest as well as theirs. Most banks and trust companies charge a mortgage application fee for processing your application. This charge is typically refunded to you if your application isn’t accepted.

When you submit a mortgage application, you will be required to submit certain documentation. The requirements may vary from one financial institution to another, so be sure to confirm exactly what yours will require. You can save yourself valuable time and demonstrate a certain level of organization by assembling this information in advance and submitting it with your application.

Typically you will need to provide the following:

> a copy of the real estate listing for the home you wish to purchase;
> a copy of the offer accepted by the vendor;
> a survey or Certificate of Location;
> confirmation of your employment status, including your position, salary and the length of time that you have held that position (or, if you are self-employed, you will need to provide copies of your tax assessments for the last three years);
> a statement of assets and liabilities including current statements of any outstanding debts; and
> a detailed breakdown of the assets you intend to use for the down payment.

Once the bank or trust company has received your documentation, they will process your application. In doing so, they will perform a credit check and verify the personal information you have provided. They will also hire a professional appraiser to verify the value of the home you wish to purchase in order to determine whether it meets their criteria for a mortgage. You will be required to pay the cost of the appraisal, usually upon submission of your mortgage application. Unlike the mortgage application fee, this appraisal fee is non-refundable, even if your application is not accepted.

It is sometimes possible to apply for a mortgage and receive an approval prior to making any offer to purchase a home. In such a case, your bank or trust company will pre-approve the terms, conditions and maximum amount of your mortgage pending a final credit approval and property appraisal. Pre-approval allows you to search for a home and negotiate terms with a better level of confidence as to how much you can afford to spend.

Before you apply for your mortgage, there are a number of standard features and variables that you need to understand. These days mortgages come in many forms and flavours. Being informed about how mortgages work and what options are available is the best way to customize your mortgage to needs and can significantly reduce the overall cost of your home over time. Some of the key elements you need to understand, along with the ways in which they can impact your overall costs, are outlined below:

The interest rate represents the cost of borrowing money and determines your monthly mortgage payment. Borrowing from the example of the $150,000 home we used above (and assuming a 25% down payment and 25 year amortization period), an 8% interest rate results in a monthly mortgage payment $915.87. The same mortgage at a 5% interest rate means a monthly payment of $697.94 – a savings of more than $200 per month, $2500 per year or $65,000 over the 25 year amortization period! At an 11% interest rate, your monthly payment would be $1155.05.

The amortization period represents the time frame, in years, that it will take you to repay the mortgage and fully pay for your home. Amortization periods can vary widely depending on a number of factors, but the most common range is 15 to 25 years. Many people opt for a longer period to keep their individual mortgage payments low, especially early on.

Returning to the example of the $150,000 home again (and assuming a 25% down payment and 8% interest rate), you will need a mortgage of $120,000. Selecting a 25 year amortization period will give you a monthly mortgage payment $915.87. Reducing your amortization period to 20 years increases your monthly mortgage payment to $994.04, but will save you $36,183 in interest in the long run. Selecting an amortization period of 15 years increases your mortgage payment to $1137.80, but will save you $69,948!

The mortgage term specifies the length of the time (within the overall amortization period) that the terms and conditions of the mortgage agreement apply, typically 6 months to 10 years. When the term expires, the mortgage is typically renegotiated to take into account market conditions, your current financial situation and the prevailing interest rates. This is also your opportunity to re-evaluate the terms and conditions offered by competing banks and trust companies.

The length of the term that you select will have an impact on the rate of interest that you will be paying. The shorter the term, the lower the rate of interest. This may seem like the best choice, but a longer term, even with a higher rate of interest, will safeguard you against future increases in the prevailing interest rates. If interest rates are low and you feel they are unlikely to go much lower, you would do well to choose a longer term and secure a low rate of interest for a number of years. This also allows you to accurately predict and budget for your monthly expenses for a longer period of time. If interest rates are high, you will likely want to choose a short term so that you will be able to benefit if interest rates fall by the time your term expires.

There are other means of reducing your overall long-term cost. Increasing your payment frequency to a semi-monthly, bi-weekly or weekly payment can reduce both your amortization period and total interest cost. Including a prepayment clause in your mortgage contract entitles you to the option of making a once a year lump sum payment against the principal of the mortgage.

You may also want to retain the option to make an doubled payment in any given month. Using the established example, if you make an additional payment of $915.87 along with your usual payment in that amount once a year, that additional payment applies directly the principal of your mortgage. This will reduce your amortization period by almost five years and will represent a total savings of $35,919.

Banks and trust companies today customize the services they offer, including mortgages. In order to fully understand and appreciate the types of mortgage and features that are available at any given time, you will need to shop around to a selection of financial institutions.

Some widely available types and features of mortgages are as follows:

A closed mortgage is the most common kind. The interest rate and other variables are locked in for the full term of the mortgage. They offer you the security of a longer mortgage term and knowing exactly what your monthly payments will be. They also usually feature the lowest interest rates available. If you ever wish to renegotiate your interest rate or any other part of the mortgage agreement, you will likely be subject to additional fees and penalties.

An open mortgage allows you the option of paying off the principal in part or in full at any given time without being subject to any penalties. They are generally only available in shorter terms and feature higher interest rates than a closed mortgage.

A convertible mortgage offers the security of a closed mortgage with the option of switching to a longer-term closed mortgage at any time without penalty. This allows you protection from rising interest rates with the flexibility of switching to a lower interest rate if they fall.

A fixed-rate mortgage can be either open or closed but in either case the interest rate and monthly payments remain the same for the term of the mortgage. A varible-rate mortgage features fixed monthly payments, but in the event that interest rates go down, more of the payment is applied to the principal and less to interest. Conversely, if rates go up, more is applied to interest and less to the principal. Variable-rate mortgages tend to be open shorter in term.

If you expect that you may be moving within the term of your mortgage, you may want to make sure that it is transferable. Portability allows you to transfer the balance of your current mortgage along with the existing terms and interest rate to a new home, subject to credit approval and a formal appraisal of the new property.

You may also wish to include an add on clause in your mortgage agreement. This allows you to borrow additional funds, and increase the principal of the mortgage, against the equity you have established in your home. The interest rate on the additional funds will be negotiated according to current interest rates. An add on clause is very handy if you anticipate doing any major renovation to your home within the term of the mortgage. Exercising this option is usually subject to credit approval and a new appraisal of the home.

If you anticipate selling your home during the term of the mortgage, you may want to negotiate an assumable mortgage. This allows any future buyer who meets the criteria of the bank or financial institution to take over the balance and obligations of the mortgage. This can serve as a powerful incentive to potential buyers if your existing mortgage features lower interest rates than are currently available.

As demonstrated by many of the examples used, these considerations can individually or collectively have a dramatic influence on your mortgage payments and the overall cost of your home. It is well worth your time to develop a detailed understanding of mortgages and to find the bank or trust company that best suits your specific financial situation and requirements.