Mortgages 101: What you need to know before looking for a home

This article is part of Global News’s Home School series, which gives Canadians the basics they need to know about the housing market that they never learned in school.

For many Canadians, the quest to buy their first home begins and ends at one place: the mortgage.

A mortgage is a particular kind of loan that uses the property itself to back the financing. Since few people have enough cash on hand to buy a home outright, this is the most common way for prospective buyers to finance the purchase.

But the process of securing what, for many homeowners, will be the biggest loan of their lives is not exactly straightforward.

Between the multiple stages of approval, the choices between fixed and variable rates and the impact from the Bank of Canada, homebuyers have a lot to weigh before and after signing on the dotted line.

Here’s everything you need to know about mortgages.

Meghan Symons of Real Mortgage Associates in Georgetown, Ont., says brokers or agents like her should really be the “first stop” for someone gearing up to take a run at the housing market.

First, some terminology: a mortgage broker or mortgage agent generally refers to someone who works independently of lenders to help buyers compare mortgage rates from a variety of institutions.

That compares to a mortgage specialist or adviser at a bank or specific lender who can offer you only products from their institution. Some Canadians may prefer this route because of the convenience of getting their mortgage where they already do their banking, and some institutions might offer discounts or perks for having multiple products with them.

Symons argues that brokers and agents can help you compare mortgage rates from a variety of sources to make sure you’re getting the best deal, or a product that fits your specific needs.

Whichever route you take to get a mortgage, Symons says doing this part first is important to avoid disappointment or complications down the line.

Symons says she’s had clients come to her after they’ve been working with a realtor and have found the home of their dreams, only to find out too late that they can’t get as big a mortgage as they’d need to buy it.

“We really want to educate first-time homebuyers … to start their homebuying process with the mortgage specialist, get that pre-approval and then be confident in your search with your realtor to know exactly what you can afford,” she says.

Inquiring with a mortgage agent can also be a low-stakes way to figure out whether homebuying is right for you, because in most cases, you don’t have to pay them.

Mortgage brokers and agents are not paid directly by the borrower at any part in the process — they’re paid by the lender at the end. Symons notes there are exceptions to this rule, like if you’re working with an alternative lender for your mortgage, in which case you may pay a broker fee.

One other thing a good mortgage rep can help you figure out is not just how big of a mortgage you can qualify for, but what you can afford, Symons says.

Many first-time homebuyers coming from renting are unaware how home ownership will affect their monthly budgets when additional costs such as property taxes and maintenance are added into the equation, she says.

Securing a mortgage is not a one-and-done process. There are multiple stages to go through in qualifying for a mortgage, each with a bit more certainty for what you can ultimately afford in a home.

First is pre-qualification. Symons describes this as a “very high-level” sense of what you can afford based on what your income and credit score are as well as what assets and other debts you might have.

You can do this both with a broker and some online rate comparing sites to get a sense of some sample mortgage rates and amounts.

But this is just based on taking your word on your income and other information — in order to get pre-approved for a mortgage, you’ll need to actually submit proof of income, banking information and other pieces of verification to your mortgage.

If you are borrowing from a major bank, you will also need to meet the stress test set out by the country’s banking regulator  — more on that later.

This will also factor in how much of a downpayment you’ve got to put on a property, as well as an estimate of property taxes you’ll be responsible for in a hypothetical home.

Once your mortgage rep tells you that you’ve hit this stage, you’ve got the “licence to shop,” Symons says, where you can work with a realtor to find homes in your budget as determined by the mortgage pre-approval.

When you’ve found that perfect property, make a successful bid and sign the purchase agreement, the next step is to get conditional approval from the lender itself, which involves sending through a few more documents to secure the exact mortgage amount you’ll need to complete the deal.

Conditional approval puts a homebuyer in a holding pattern between the time the agreement is in place and when the purchase closes, at which point the mortgage becomes active and the transfer of funds to the seller is complete.

Real estate lawyers facilitate this transaction with the lender once you’ve signed all forms and delivered the deposits and necessary information.

There’s one other thing that’s worth mentioning about mortgage qualification.

While the entire process is set up for a lender to gauge whether you’re in a secure enough position to meet the monthly payments on your mortgage and other obligations, in Canada, most financial institutions actually test your budget assuming your mortgage rate is higher than it really is.

This is called the stress test. Federally regulated lenders like the big banks have to test borrowers based on whether they could handle a mortgage rate of 5.25 per cent or two percentage points more than the actual mortgage rate you’re being offered — whichever is the higher of the two.

For example, if a bank offers you a mortgage rate of 4.64 per cent, it’s going to test you to see if you could handle payments at 6.64 per cent interest. If you had a much lower offer rate of 2.2 per cent, the bank would test you at the bar of 5.25 per cent interest.

The Canadian government instituted this check in 2018 to make sure homebuyers wouldn’t commit to a mortgage that they couldn’t afford if interest rates suddenly rose — something that’s come into play recently as many of those who bought at low mortgage rates in the COVID-19 pandemic are facing much higher interest rates on their loans today.

“They’re basically saying, we want to make sure that if the interest rate changes you are still able to afford your mortgage,” Symons says.

Alternative lenders such as credit unions are not subject to the federal stress test, but typically have their own tests they’ll put borrowers through to gauge the amount of risk they’re taking by offering the mortgage.

When you take on a mortgage, you’ll have a set rate that determines how much additional interest you’re paying on the loan in addition to paying down the principal — the original amount you took out to begin with to finance your purchase.

A typical term is five years or fewer, depending on the arrangement you have with your lender. At the end of your term, you’ll have to renew with either the same lender or, potentially, a new one — again, more on that a bit later.

Mortgage terms are distinct from the overall amount of time it takes to pay off the mortgage, called the amortization. In Canada, this period is typically 25 years.

Canadians looking to take out a mortgage or renew at the end of their term on an existing mortgage will have an option between fixed and variable products, with some important distinctions within those categories as well.

Variable-rate mortgages are directly influenced by the Bank of Canada’s target for the overnight rate, commonly called the central bank’s policy rate or benchmark interest rate.

The Bank of Canada sets the standard for interest rates with its policy rate, which filters down to lenders’ prime rates.

Banks typically use their prime rates to set variable-rate mortgages, offering something like, prime minus a certain percentage to determine what rate these mortgage holders pay.

But because of this setup, the rates on these mortgages are, well, variable — they move up or down immediately in line with the Bank of Canada’s rate decisions.

If you take out this mortgage, then what you pay could change month to month based on what the Bank of Canada does.

There’s another option here, however.

Some lenders will also offer variable mortgages with static payments, which means your monthly payment typically won’t change with the Bank of Canada’s decisions. Instead, those rate changes will affect how much of your payments go toward the interest portion of the loan compared with the principal amount.

If you pay off more and more interest and less and less principal, the amortization of your mortgage can be extended, though you’ll often have to reset to your original amortization length when you renew with higher payments. The opposite is true if rates go down — your amortization would get shorter.

But if you eventually hit a point where you’re only paying off interest as rates rise, you’ll hit what’s called a trigger rate, which can force an immediate lump-sum payment or increased regular payments on your mortgage. (You can read all about trigger rates over here).

Want more consistency when it comes to your mortgage payments? Fixed-rate mortgages are the traditionally popular options for Canadians who want predictability.

A fixed-rate mortgage will see your interest rate stay the same for the entire length of your mortgage term.

“There are no changes to your amortization. There’s no changes to your monthly payments. It’s static,” Symons says.

But the offer on a fixed rate is typically higher than you’d get with a variable option. The rate you’re offered here isn’t directly influenced by the Bank of Canada — it’s tied to the bond market.

The yield, or rate of return, on the five-year bond will affect what kinds of rates lenders offer on five-year fixed-rate mortgages, and so on and so forth.

Still, the central bank’s policy rate does have an indirect influence here, as bond traders will try to anticipate where the Bank of Canada is taking its benchmark rate and yields will adjust closer to that mark.

Because of the nature of this relationship, fixed mortgage rates can fluctuate outside of Bank of Canada decisions, whenever new data is released or when concern or excitement about possible economic developments spreads.

When you’re gearing up to buy a home, you might be fairly certain you’ll be in that house for the long haul.

But Symons says homeowners should know before picking a mortgage that life happens. You might have to move or sell that home, or you might have lost your job and can’t carry the mortgage anymore.

In these cases, you might have to break that mortgage before you pay it off — and in most cases, that means paying a penalty.

If you’re moving and buying a bigger home within Canada and your mortgage is with a big bank, typically that loan will be “portable,” meaning you can bring it over to the new property or take on a new rate for the mortgage without being charged a fee, as long as you stick with that lender.

But in other instances, such as refinancing a mortgage at a lower rate, there could be a penalty based on the differences in rates as well as the type of mortgage you have.

In the case of fixed-rate mortgages, you’ll either pay the equivalent of three months’ worth of interest on the mortgage or a penalty called the interest rate differential (IRD) — whichever one is larger.

Here, you’ll typically pay interest fees based on the difference between today’s posted rate from the lender and the interest rate you originally signed up for. The Financial Consumer Agency of Canada has more in-depth information about the IRD here.

Symons says the IRD is where homeowners can come up against “quite substantial” penalties costing thousands of dollars.

Alternatively, variable-rate mortgages don’t usually come with an IRD option, instead defaulting to the three months’ interest penalty.

Symons says this makes variable rates the more “flexible” of the two options. You can also usually convert a variable-rate mortgage to the fixed alternative at any point without paying a penalty.

Aside from breaking a mortgage, IRD penalties can arise when you pay off a mortgage early.

If these penalties for breaking a mortgage or changing up your payment schedule are surprising to you, you’re not alone.

Symons says helping clients understand the ins and outs of a mortgage is an ongoing process for agents like her, and that communication doesn’t end when the purchase is finalized.

She says it’s important to stay in touch with whichever mortgage rep you’re working with as your situation changes and as you approach renewals, as they can help you figure out payment options that fit your needs.

“It is nice to be able to help the client the whole journey,” Symons says.