Understanding Mortgages

One of the first steps in buying a new home or real estate property is to take a realistic look at what you can afford and how you are going to pay for it. If you are like most people, you will probably have to finance your home purchase with a mortgage loan.

What is a Mortgage?

A mortgage is a loan that uses the home you buy as security. This loan is registered as a legal document against the title of your real estate property. Here’s a quick overview of some of the most common aspects of a home mortgage that you need to understand.
- The principal is the amount of the home loan, or the cash actually borrowed.
- The interest is the amount the lender bank charges for the use of the funds, or principal. Interest rates vary according to many factors including terms and conditions of the real estate mortgage. Mortgage payments are applied towards both principal and interest.
- The amortization period is the actual number of years that it will take to repay the entire mortgage loan in full. This normally ranges from 15 to 25 years.
- The term is the length of time for which a mortgage real estate agreement exists between you and the bank lender. Typically, terms range between six months and seven years.
- The maturity date marks the end of the term, when you can either repay the balance of the principal or renegotiate the mortgage at the current interest rates.
- Options let you tailor the real estate mortgage to fit your personal needs and circumstances. Open or closed mortgages, pre-payment options, fixed or variable rates or home portable mortgages are just a few of the available options.

Types of Mortgages

There are two basic types of home mortgages:
- Conventional Mortgage: The loan amount does not exceed 75% of the real estate property value, defined as the lesser of the purchase price or the appraised value.
- High-Ratio Mortgage, or National Housing Act Mortgage: The amount is more than 75% of the real estate property value (up to 95%). By law, a high-ratio real estate home mortgage must be insured against borrower default. The home borrower pays a mortgage insurance premium (a percentage of the total loan amount) which can be added to the mortgage loan or paid in a lump sum in advance. The borrower must also pay an insurance application fee.

How much can you afford to spend on a new home?

The amount of money you can afford to spend for a new home is determined by two factors:
- Your Downpayment. This is the amount of money you have available from your own assets. You need a minimum of 5% of the total purchase price as a downpayment for your real estate property.

A larger downpayment means lower mortgage payments or, even better, that you can pay off the mortgage faster, thereby saving thousands of dollars in interest payments. Or you may be able to buy in a higher price range, if you qualify. (Be careful, though, not to stretch your budget to the limit, and to set enough money aside to cover the other expenses of buying a home or property investment).

First time home buyers can use their RRSPs towards a downpayment and closing costs. Under the federal government’s Home Buyer’s Plan, first-time buyers can borrow up to $20,000 tax-free ($40,000 for couples) from their RRSP savings. The funds must be repaid within 15 years, but you don’t have to begin repayments for two years.

- Your ability to carry mortgage debt. Bank lenders use a simple two-step method to determine the real estate mortgage amount that you can comfortably pay back on your income. As a rule, you can usen o more than 32$ of gross income on monthly paymnents to cover principal, interest, property taxes and heating (PITH) and possibly condominium fees, or 40% of your gross income on all financial obligations. The latter could include car payments, credit card instalments and other payments in addition to the “shelter” costs listed earlier.

Once your maximum monthly payment towards “shelter costs” has been established, it is easy to determine the size of loan you can handle, depending on interest rates and amortization periods.

Be Aware of the Total Costs

When you calculate how much it will cost to buy a home or property and how much you can afford, don’t forget to consider the additional costs that you may encounter. Ask your real estate builder and the sales representative for detailed estimates, and consult with your lender and lawyer for further information.

Get Pre-Approval

It is a good idea to have your bank financing in place before you begin looking for your real estate property or home. That way you can negotiate arrangements with your real estate builder in full confidence and without delay.

A pre-approved mortgage is preliminary approval by the bank lender for a mortgage up to a certain amount, usually with a guaranteed rate for a specified number of days (90 days and sometimes longer). If interest rates go down during that period, you will get the benefit of the lower rate. If they go up, your rate stays locked in.

Pre-approved mortgage financing is simple to arrange, costs nothing and does not obligate you to go ahead with the bank loan, if you choose not to. The final mortgage amount and terms will be determined once you have reached a final agreement with your real estate builder.

Information provided courtesy of the Canadian Home Builders’ Association. For more information, visit CHBA online at www.chba.ca.

For more condominium mortgage tips and home buyer checklists for pre-construction condos, click here.

Going behind the scenes for lenders on real estate property

Published in the API Magazine – December 2006 issue on Pages 75 – 76. Most borrowers like the reassurance of having detailed knowledge of their lending institution and its financial reputation. Taking one step back, you first need to determine your level of understanding of the business of money exchange. There’s a significant difference in the risks associated with borrowing and investing and the information you should be aware of in each case.

Mortgage Shopping
There’s a lot more involved in selecting a mortgage than merely enquiring about interest rate and product flexibilities. Past articles have covered the intricacies of these topics, but how important is it to understand your real estate lender’s business?

A real estate lender’s reputation is an important criterion you should consider when taking out a loan for a real estate investment property. If you’re using a broker, they’ll usually have an opinion on the real estate lender. This opinion will often cover such things as credit policy, processing efficiency and in some cases, effectiveness in resolving disputes.

Particularly in the case of a real estate lender, you know nothing about, a little research is needed on your part to determine how long the lender has been in business for real estate investment lending and their ability to provide a consistent product.

Ask about the interest rate offered. Is it a special rate or a standard rate? This is more relevant when you’re considering a fixed rate product. There are some real estate lenders who may have a special rate advertised at the time you’re looking for a loan on your property but this rate may change significantly afterwards. It may well be a good deal to start with but when the fixed rate period is over, it may be a different matter.

Variable rate interest for real estate properties isn’t totally reliable either. Most institutions move their variable rate in line with the Reserve Bank cash rate. However, it’s not a rule that’s set in concrete and your bank lender can certainly change the interest rate, even when there’s no official cash rate adjustment. Ask about their policy on this. Is the variable interest loan written with a specific margin to reference rate (such as a standard variable) or is it unlinked?

Service: Mild, Medium or Hot?
In many cases service is a major factor when shopping for the right loan. Matching your needs with a big institution practices can be relatively easy.

With an unknown lender, however, you simply need to be a little more inquisitive. Is the service they provide perfect? Before you make up your mind, look outside the square.

Ask yourself, will they continue to provide good service after the sale, or will it grind to a halt once you sign on the dotted line? And does the company employ enough people to answer your queries in the future? A small company previously unknown to you is not necessarily to be dismissed, particularly if it meets your loan criteria.

Investing: a different kettle of fish
Many of us invest cash in the forms of term deposits, online accounts, cash management trusts, shares or managed funds. Here, the fundamental rule of investing is king – risk-return equation.

It’s usually easy to see the trade-off between the interest rate paid and the company’s financial background, especially on term deposit and debenture products. You’ll quite often see a 3 or 4 per cent gap on interest rate paid on term deposits by major banks and debenture products from small investment companies.

When considering putting your hard-earned cash into an investment company, you need to be more astute about the institution and its financial reputation. Ask yourself about the company’s ability to pay interest promised, as well as the principal when needed by you.

The newspapers may report the current cash rate of 6.25 per cent (at the time of writing), yet your company can offer an attractive 9 or 10 per cent. You should expect a higher level of risk associated with this type of investment.

It may be that your money is invested into mezzanine funds which banks are unwilling to lend against. In the unfortunate event of the investment company going belly-up, you must realise that banks have first claim against the assets, with you, as a private investor, coming in on the secondary level.

Security versus Reputation
As we can see, different assessments are required when you’re investing your cash and borrowing some funds for your property. Most mortgage originators securitise their loans so most of their assets are transferable if the real estate lender goes out of business for whatever reason. They’ll simply sell off their loan portfolio to another lender or investor (such as an insurance company or mortgage trust) or secure their portfolio as a mortgage-backed security (MBS).

MBS is an asset-backed security whose cash flows are backed by the principal and interest payment of a set of mortgages. These payments are typically made monthly over the lifetime of the underlying loans.

When your loan is administered by a new lender, they may reconsider the products structure and may offer you a new product as a substitute for your current product. This can become a hassle for you if there are significant changes in pricing and flexibilities of the new product offered. However, the mortgage lending arena in Australia is highly regulated, with many areas of legislation ensuring the rights of the consumer are met.

As an overall, when we look at security versus reputation, we clearly see that major banks offer both. Even though you may not be sure about a lender’s security, you can’t afford not to research the lending institution’s reputation.