As with all other aspects of the home buying process, the mortgage procedure can be extremely tricky! Choose wisely, and you can save thousands of dollars over the life of your loan, but choose poorly, and you can end up paying way more than you need to in interest to the bank – and no one wants to give the bank more money than they have to. I’m going to detail everything you need to know about mortgages in order to give you a leg up when you go in to negotiate with your lender, remember: knowledge is power!
Let’s start with the 5 W’s:
Who decides how much of a mortgage I can qualify for?
The lender decides how much of a mortgage you can qualify for by first looking at two different ratios: the Gross Debt Service Ratio, and the Total Debt Service Ratio.
The gross debt service ratio, or GDS, is a preliminary measure (rule of thumb) lenders look at to give you a preliminary assessment of how much of a loan you would qualify for. The ratio takes into account what your annual mortgage payments would be including property taxes and 50% of your heating costs, and divides this number by your gross family income, multiplying by 100 to get a percentage.
= (Annual Mortgage Payments + Property Taxes + 50% Heating) / Gross Family Income x 100
An acceptable amount for the GDS to be would be approximately 30-33%; anything over that amount and the lenders would consider that an unacceptable amount of debt.
The total debt service, or TDS, is similar to the GDS, but is different because it incorporates other elements of debt that you may have, such as: auto loans, student loans, and credit cards. The lenders want you to be under 40% for this ratio, with the formula as follows:
= (Sum of all Payments and Loans + Annual Mortgage Payments + Property Taxes + 50% Heating) / Gross Income x 100
Now, situations may vary, and there are other factors taken into account when applying for a mortgage, but this is a good starting point to see how much you could approximately be qualified for.
Where can I get a mortgage?
Mortgages are received from lenders, and lenders can be anyone from a public or private institution. Many people start their mortgage search by going to the bank, but in some cases you are able to get a mortgage through a Trust Company, Private Lender, or Broker. Usually, Private Lenders are willing to take on higher risk mortgages – ones that the bank may not typically finance, whereas the broker will work with all lenders to find you the best mortgage rate in your situation (for a fee). A high risk mortgagor (borrower) might be someone who is self employed without 2 years Notice of Assessments from the CRA, or someone with a lower credit score. Needing to take out a high risk mortgage does not mean your home buying dreams are over, it may just mean that you may need to take a less traditional route to borrowing.
Banks and Trust Companies are broken out into two categories: A lenders, and B lenders. The A lenders are the banks, where they would offer lower interest rates, and the private lenders such as trust companies would offer a higher interest rate – the rate is usually higher because the B lender is taking on a higher risk mortgage and they want to mitigate their risk the best they can. Private Lenders are a highly unregulated sector of the mortgage market, where investor money is pooled to offer one year, interest only loans to very high risk borrowers.
What is a term, and how does it differentiate from my amortization period? What are the differences between types of interest calculated on my loan?
You will hear the words term and amortization period when applying for your mortgage, so let’s look at how they differ. Your amortization period is going to be the total length of your loan – the standard in Ontario is 25 years. This means that you have taken out your mortgage, and will be making payments on it finishing 25 years from your start date. Your term on the other hand is the length of time you are locked in at a certain interest rate, which is usually around 5 years. This means that every 5 years you will need to renew your mortgage – at that time you will lock in for another 5 years, until the amortization period is up and your mortgage is paid off.
There are two different types of mortgages you can choose from – the difference being the way the interest is calculated on what you owe. You can have either a fixed rate, or a variable rate mortgage, and you can change this each time your mortgage comes up for renewal at the end of your term.
When you sign up for a fixed rate mortgage, this means that you lock in your interest rate for the term of your loan. When your interest rate is locked in, meaning it does not fluctuate with the market, you will make the same payments each month on both interest and principal until your term is up.
A variable rate mortgage would mean you have an interest rate which changes with the market, and is usually described as prime +/- a certain percentage, ex. Prime + 2.5%. It is a variable rate as prime rates in the market can change, and when this happens the interest portion payment on your loan will reflect it. If prime goes down, you will see a decrease in the amount of interest charged, but if prime goes up, you will see an increase.
Fixed rates are good to lock in when interest rates are very low, as they are right now. In addition, with fixed rates you do not have to pay attention to the market to see how the prime rate is performing. Variable rate mortgages have historically shown to be cheaper over time, but you are taking on more risk in this case. The higher risk comes from fluctuation in the prime rate, and the uncertainty over where the market could go within your term as there is no cap on prime.
When should I apply for a mortgage?
Applying for preapproval on a mortgage should be one of your first steps when starting the home buying process. I would recommend having this completed even prior to meeting with your Realtor, as it is important information everyone involved in the transaction needs to have.
Why should I worry about a pre-approval?
Some people mistakenly believe they should wait until they have found the perfect house before applying for a mortgage, but I couldn’t dissuade you strongly enough against this. You need to be perfectly aware of your financial situation before looking at purchasing a home, and getting the mortgage preapproval helps with this. In addition, it helps to let you know what kind of homes and neighbourhoods are in your price range, and if you are comfortable spending all that the bank is willing to give. Also, as I’ve mentioned previously – the Toronto market moves FAST. Having your financing in order gives you a leg up on the competition, and allows you to make moves towards your dream home you might not be able to make without it.
NOTE: The bank does not always know what is best for you, and that’s why I would implore you to run your own numbers to ensure you are comfortable with the payments. Just because you are preapproved for an amount, does not mean you need to use all of it. You know you and your situation better than anyone else, so run your numbers and come up with what you are comfortable with – want to see how payments differ for varying mortgage amounts? Head on to the next page for our mortgage calculator.