To pick the best mortgage you need to understand your options. The first step is to determine the best type of mortgage for your situation. For instance, if you think you’ll be relocated elsewhere in Canada before five years, a portable mortgage may be your best option. Or if you want to avoid extra fees you’ll want to get a conventional mortgage.
But once you’ve selected the type of mortgage, then you’ll need to shop for the most competitive option available to you and that means making some decisions on how the housing market is doing? Whether or not you’ll move quickly or stay a long time in the home? And if interest rates will remain low or start to rise?
Why do all this work? Because it will have a direct impact on your bottom line. Since a mortgage is made up of two parts—the principal and interest—you need to pay attention to how and when these parts get paid down. Ideally, you want to minimize the interest payments and maximize the principal payments…but many roads lead to this destination.
To pick the best formula for your situation, you’ll first need to understand the factors that impact how much interest you’ll end up paying for your mortgage loan.
Here’s a primer:
The size of a mortgage loan payment is calculated based on a length of time you agree to paying off that debt—this is called the amortization period. In Canada, the standard amortization period is 25 years, but home owners can also opt for amortization periods as short as one year and longer than 25 years (although the lender will really scrutinize your application if you go above 25 years, and may tack on an extra fee, or require more than 20% down payment on the property purchased).
Because of recent legislation, all Canadian home buyers must now qualify for a mortgage based on a 25-year amortization and the posted 5-year fixed rate—and this applies even if you opt for a longer or shorter amortization, or select a variable rather than fixed mortgage.
But it’s not just about qualifying for the mortgage. The amortization period is integral in the best mortgage decision because it will decide how much or how little interest you will pay during the life of the mortgage loan. Remember that the longer the amortization period, the more interest you will pay. So, a shorter amortization period will lower your overall cost of borrowing. Also, each payment—whether you make monthly, bi-monthly or weekly mortgage payments—consists of both interest and principal. That means any prepayment you make to your mortgage will help reduce your principal, and this eventually reduces the overall interest you pay on this loan.
Because interest rates can change quite dramatically over time, most lenders don’t want to negotiate a 25-year loan. For that reason, your mortgage amortization is broken up into terms. The term is shorter than the amortization period and locks you into the negotiated rates during that specified period of time. For instance, on a 25-year amortization, you might agree that for the next five years you will pay 3% interest on a fixed mortgage to your lender. The length of term you choose will depend partly on whether or not you think interest rates will rise or fall. Be aware that your current lender is not obligated to renew your mortgage for another term. While most lenders will, you may still want to shop around for a new mortgage term to ensure you’re getting the best deal.
An open mortgage means you can repay the loan, in part or in full, at any time without penalty. Interest rates are usually higher on this type of loan—for instance a home buyer in Ontario will pay 4.99% for a 1-year open mortgage vs. 1.99% for a one-year closed mortgage, as of July 3, 2015. Still, if you plan to sell your home in the near future or expect a large sum of money, an open mortgage can be a great option—especially since most lenders will allow you to convert from an open to a closed mortgage at anytime (and switch you to lower rates). But always shop around for a mortgage and never settle for the rates your current lender offers.
A closed mortgage usually offers the lowest interest rates available and it’s an excellent choice if you want security in knowing exactly how much your housing will cost you at any given time. However closed mortgages are not flexible and there are often penalties and restrictions when it comes to prepayments. Over the last decade many lenders will now allow you to prepay or make lump sum payments on a closed-term mortgage, but if you exceed these allowances there can be big penalties.
Fixed rates are based on movement in the bond market (the benchmark for a 30-year fixed rate mortgage is the yield of a 10-year bond). As bond prices rise, fixed rates will also rise and the spread between the two reflects the risk investors are willing to take when they move their money from a secure product, like bonds, to invest in a less secure investment, such as mortgage securities. There are times when that spread becomes very wide or very thin, such as the subprime mortgage crisis of 2008/2009. When this happens, rates can seem out of wack making it much harder to determine the advantage of disadvantage of fixed vs. variable options.
Variable rates are priced according to changes in money market conditions. That means if the prime rate goes up — based on changes made to the Bank of Canada’s overnight rate — then variable rates will go up. (For more on how the BoC interest rate changes impact mortgages see this post.) While these changes are more volatile, they don’t typically occur more than once per month. That means the interest rate on your mortgage could change from month to month, however your monthly payments will stay the same (but the amount applied towards the principal will change as the rate changes).
Keep in mind that open/closed mortgages refer to the flexibility you have in paying off the mortgage debt, while fixed/variable mortgages refers to how the interest rate is calculated and applied. (That means you can have: a fixed closed mortgage, a variable closed mortgage, a fixed open mortgage, and a variable open mortgage.) For more on how to choose, see my older post on the topic.