Everything you need to know about choosing a mortgage

All homeowners dream of burning their mortgage papers after making that final payment. Smart planning and good decisions will help make that day arrive sooner than you’d think.

However, before jumping into the real estate market, you should figure out how much you can afford. There are many online tools that can help you do this.

Lenders want to make sure your total monthly housing costs – including mortgage payments, taxes and utilities – is not more than one-third of your household’s total gross income and that your total debt load (including car loans) is not above 40 per cent of your household’s total gross income.

All lenders have software programs that can figure out how much they’re willing to lend and how much house they expect you can afford.

That first big payment

A big down payment could be a great way to reduce the size of a mortgage. But people who don’t have a lot of money saved – and don’t want to wait to save up a larger down payment – can take on a high-ratio mortgage. Borrowers in Canada with less than a 20 per cent down payment must purchase mortgage insurance, which protects the lender in case of default. This could cost up to 3.35 per cent of the value of the mortgage and typically gets tacked onto the principal.

Options to consider when choosing a mortgage

It’s important to consider these topics when choosing a mortgage:

• Fixed or variable interest rate
• Amortization period
• Length of term
• Open or closed

Risks not so variable

For small increases in the variable rate, your payments may remain the same. The only difference would be an increase in the amount going to pay the interest portion. However, if rates increase significantly, even by 1.5 per cent, the lender may increase your payments.

Before deciding on a variable rate, make sure the lender explains all the possible scenarios. Specifically, find out what interest rate changes will lead to higher payments. You may be able to include the option to lock into a fixed-rate mortgage at any time, but keep in mind that by then the longer-term rates may have changed.

Fortunately, you can use a mortgage calculator - Opens in a new window to help determine the savings of going variable versus fixed. You may decide that the advantage isn’t enough to pass up the certainty provided by a fixed-rate mortgage.

Coming to terms

Mortgage terms can range from 6 months to 10 years. Generally, the interest rate rises with the length of the term.

The advantages of an open mortgage

Fixed-rate mortgages are generally closed. They typically allow for yearly lump-sum pre-payments up to 20 per cent of the original mortgage, depending on the lender – a very important detail you should confirm before signing. You may also be able to increase your regular payments, as much as doubling them – perfect for people with steadily rising incomes.

Paying off the mortgage all at once or breaking it up to get a better rate often results in financial penalties. Some lenders do offer open mortgages, which allow borrowers to pay off some, or all, of the loan at any time. However, there’s a catch: the interest rate may be significantly higher.

If there’s a chance you’ll come into some money or sell the mortgaged home before the term expires, an open mortgage could make more sense. If you plan to move before the term expires, a portable mortgage (one that can be transferred to your next home) may also be an option worth considering.

Which should you choose: A long or short amortization period?

Of all the variables to choose from, a shorter amortization period offers the fastest route to a mortgage-burning party. By law, Canadians can negotiate a mortgage that extends to 30 years. Long amortization periods are popular, especially with first-time homebuyers, since they could lower the amount of each mortgage payment. However, those lower payments could come with a price – higher interest rate costs.

Anyone taking out a mortgage should become very familiar with a mortgage calculator - Opens in a new window. Try plugging in shorter amortization periods and compare the increase in payments with the drop in interest costs. The sweet spot is often around 20 years, where the increase in payments isn’t so big but the savings in interest costs could be significant.

Accelerated payments could help you pay off your mortgage faster

You can pick weekly, bi-weekly and monthly payments, depending on the lender. More frequent payments will mean you’ll pay less interest over the life of the mortgage with the same interest rate.

You can also opt for “accelerated” payments that shave time off your total amortization period. While giving your lender payments a few days earlier doesn’t save much interest, accelerated payments can increase the total payments you make each year - helping you pay off your mortgage faster.

If you value simplicity, increase your total annual payments but add them up and divide by 12 to see the equivalent monthly payment.

It’s time to get started

Once you’ve decided to purchase a home, talk with your advisor, who can show you how and why you should build your mortgage into your financial plan.