How to choose the right mortgage
Furnish your home financing strategy with some fundamental facts.
Becoming a homeowner is an exciting achievement, and for most people, it’s the biggest single purchase of their lives. Most also won’t be able to pay for that home in one fell swoop and will need a mortgage.
A mortgage is a loan that covers the remaining cost of the home after the down payment. What you might not realize is that there are distinct types of mortgages that offer different benefits for specific needs. This overview will help you understand those differences and put you in the driver’s seat when the time comes to make your move.
Traditional vs. re-advanceable mortgages With a traditional mortgage, you make regular fixed payments towards the loan. Each payment consists of two parts: a principal payment and an interest payment. The principal payment reduces the mortgage balance and increases the share of the home that you own. The interest payment covers the interest charged on the loan.
A re-advanceable mortgage, also known as a home equity line of credit (HELOC), allows you to repay the debt at your own pace and borrow your money back again if your needs change. An all-in-one mortgage is a special kind of HELOC that combines your mortgage, bank accounts, short-term savings and other loans into a single account. An all-in-one account also acts as an everyday banking account – which means you can deposit your income directly into the account. This allows all your money to work towards reducing your interest cost as soon as you get paid, helping you become debt-free sooner.
Here’s an example: Let’s say you deposit $2,000 into an all-in-one account. You owe $500 in interest that month, which is automatically taken from your account. The remaining $1,500 reduces your debt, and therefore the amount of interest you’re charged the next month, since your interest is calculated daily based on how much you’ve borrowed. However, unlike with a traditional mortgage, you haven’t lost access to that $1,500. Since your all-in-one mortgage is also your chequing account, you pay all your monthly expenses out of the account. Presuming you spend less than you earn (remember, you no longer have a fixed mortgage payment to make), whatever’s left at the end of the month stays in your account, keeping your debt and interest costs lower.
And here’s where an all-in-one account shines, compared to a traditional mortgage: you can spend that $1,500, and more, up to your borrowing limit, if your needs change. This could give you extra flexibility and reduce your stress if, for example, you have a lower-income month or have to deal with an unexpected expense.
Some lenders also allow you to set up “tracking sub-accounts,” which help you track specific portions of debt separately, such as for investments or home renovations. You may also be able to lock in a portion of your debt within a “term sub-account” if you’re concerned about interest rates rising in the future. This is like having a traditional fixed rate mortgage within your all-in-one account. In this case, each sub-account carries its own interest rate, term length and repayment schedule.
All-in-one mortgages can give you more financial flexibility, but there are a couple of things to keep in mind. First, having continuous access to credit could create the temptation to overspend and make it more difficult to reduce your debt. In this respect, an all-in-one mortgage may not be a good choice if you’re someone who has difficulty living within a budget. However, it is possible to place a “shadow limit” on the account that lowers your access to the full credit limit. This effectively acts as a safeguard against overspending.
Second, since the mortgage is re-advanceable, it could also reduce the amount of other loans you qualify for. But the credit you can access through your all-in-one account will most likely have a lower interest rate than other types of borrowing. So, instead of applying for a car loan specifically, you could pay for the car from your all-in-one account and monitor that part of your debt in a separate tracking sub-account.
Mortgage rate ups and downs When deciding which type of mortgage might be best, another critical consideration is what the interest rate will be for the term of the loan. You have a choice between a fixed rate or a variable rate. This can be a tough decision, depending on your current financial situation and outlook on the future. For example, is the economy expected to support rising, declining or stationary rates? Will your income be steady for the length of the term? Do you expect any life events, like a new baby or another big purchase, that could affect your ability to handle higher mortgage payments if interest rates rise?
Understanding the basic differences could mean more savings and fewer headaches in the end. A fixed interest rate doesn’t change during the length of a mortgage term, which means each payment will always be the same. This predictability allows a mortgage holder to know the cost of paying off the entire term, which typically can range from as little as six months up to 10 years.
A variable interest rate fluctuates in response to any changes in the lender’s prime rate or base rate. If the rate goes down, the payment amount may not change, but the proportion of the payment going towards reducing the principal will increase. When the rate rises, more of the payment will go towards paying the increased interest costs, which means less money is being paid towards the principal, extending the time it will take to pay off the loan. At any given time, the variable mortgage interest rate available is often lower than the available fixed rate because with a fixed rate, the lender is taking on the risk that interest rates may rise.
Today’s mortgage rates sit near historic lows, which makes it more likely that they will increase, at least over the short term. If covering the payments after a rate increase doesn’t pose too much of a problem, a lower, variable rate may be the better choice. Depending on the size of the loan, however, even a slight interest rate increase could have a significant impact on the cost of carrying a mortgage. On the other hand, if money is tight and may continue to be for some time, or if rapid rate increases appear possible, the reliability of a fixed rate may be preferable.
Open or closed? Some of the same factors that apply to variable and fixed rates can also factor into the choice between an “open” or “closed” term mortgage.
An open term mortgage offers more flexibility by allowing you to increase your payment amount and pay off the mortgage at any time, without penalty. The “openness” of the term usually comes with a higher interest rate. If you’re expecting changes to your financial situation or housing needs, however, the flexibility of an open term could still end up saving you money.
Alternatively, paying off a closed term mortgage early could result in a financial penalty, although in many cases you’re allowed to increase your regular payments or make one-time payments without incurring a penalty. Generally, interest rates are lower for a closed term mortgage. If it looks as though your situation will remain the same for the foreseeable future, a closed term mortgage with a lower interest rate might be a better choice.
For maximum flexibility, consider an all-in-one mortgage, which consolidates your debts at one low rate, allows you to repay your debt at your own pace, track portions of your debt separately, lock in a portion of your debt and even re-borrow money without applying for another loan.
About down payments When you buy property, you’ll need to make a down payment. This is your initial contribution to the full purchase price. A down payment can be as little as five per cent of the property’s value, but a bigger down payment could lead to substantial savings over time.
Anything less than a 20 per cent down payment is categorized as a high-ratio mortgage, which means you have to buy mortgage insurance. This is to help protect the lender if you stop making payments. If your down payment is 20 per cent or more of the purchase price, you can get a conventional mortgage, which doesn’t require mortgage insurance.
Minimum down payments required on the purchase price of a home
Selecting a mortgage that fits your needs can clearly work in your favour and potentially save you a lot of money. Of course, as with any major financial decision, it’s always a good idea to consult an advisor to ensure both your short-term and long-term needs are being met when buying a house.