Here’s part 10 of my 10 step series on mortgages here at Financial Uproar every Wednesday. Every step of the process will be covered from the application to qualifying to tips and tricks to save money on your mortgage and everything in between. To read all of these just click on the category Mortgage Basics.
Finally, the sweet, sweet end to this train wreck of a series. Are you sick of mortgages yet? Oh you aren’t? Good.
This post will be the combination of all the others, the massive how to guide for Canadian mortgages. It’s your one stop shop about everything a borrower needs to know before signing their name on the bottom line of a mortgage contract. This guide is so awesome and huge that it actually has its own gravitational pull. It’s going to be legen -wait for it- dary!
How I Met Your Mother is the best.
Anyway, every step from the application process to money saving tips will be shared in this post. Be sure to bookmark it, since I’m sure you’ll be referring to it on an hourly basis for the rest of your life.
The Application Process
Chances are you’ll spend that initial meeting nervously waiting for the lender to approve you. You give the lender all of your information and they spend some time inputting that into a computer. Then you give them the information on the house you’re buying. At some point the lender pulls your credit report as well. If the lender likes the information, the borrower is approved. If not, borrowers are rejected and they probably cry. At least, that’s what I would do.
After that initial approval, a borrower must then prove to the mortgage lender that the information contained in the application is factual. If you’re dealing with your bank some of this verification comes easy; after all, they can just check your account to see whether you have as much money as you say. Other verifications are a little harder and might require some hustling on your part to get these things done.
A borrower will need several kinds of statements to prove their income, the source of their down payment and other paperwork such as information on the house being purchased, any child support or alimony payments (either paid out or received) and a copy of the purchase contract. Income is proven by paystubs and a letter from the employer for salaried borrowers, and by 2 years of Notice of Assesssments for self employed borrowers.
With all the mortgage fraud that exists in the market, lenders remain extra cautious when it comes to confirming a borrower’s information. By the end of the process, most borrowers will be frustrated by the mountains of paperwork.
The Down Payment
To get a mortgage in Canada, a borrower has to have at least 5% of the property’s value for a down payment. The lender supplies the rest of the money to pay for the house and the borrower slowly pays back the lender. To avoid CMHC insurance premiums, a borrower must put 20% of the house’s value up as a down payment.
For the most part, any money you have sitting in any account can be used as a down payment. Money in a chequing or savings account obviously can. It’s the same thing with money or even securities sitting in a brokerage account, except the securities will have to be sold. Even a borrower’s RRSP can be used, providing the borrower pays that money back in 15 years. If the borrower doesn’t, that money will be taxed. You can even use your TFSA or equity in an existing property as a down payment.
The borrower has two options if they don’t have the cash available to cover the down payment. They can either borrow the money or get the money as a gift from a relative. A borrower can either borrower the money in the form of a unsecured line of credit, or use a cash back mortgage to repay a down payment loan. A cash back mortgage can’t be used directly for the down payment. Or, if a borrower has a relative that is willing to help them, they can get a gift from that relative, providing both parties sign a simple agreement that there is no expectation of repayment.
Canadian lenders are extremely flexible when it comes to down payments. If you can’t come up with the required down payment, then maybe homeownership should be rethought.
Income Qualifying
The two ratios that determine your maximum mortgage are gross debt service ratio (GDS) and total debt service ratio (TDS). The formulas are as follows:
GDS: Payment + Property Tax + Heat + ½ Condo Fees = less than 32% of gross income
TDS: Payment + Property Tax + Heat + ½ Condo Fees + All Other Debts = less than 40% of gross income
The formulas are much less complicated than they appear to be. If you made $72,000 per year (that’s $6,000) per month then all you’d need to do is multiply 6000 by .32 and .40 to get the maximums, in this case being $1920 and $2400.
What that means is $1920 per month maximum can go toward the mortgage payment, property tax, gas bills and half the condo fees (if applicable). This also gives the borrower a maximum of $480 per month of debt payments the lender will tolerate.
Depending on how high a borrower’s credit score is, GDS and TDS ratios can go higher. Any borrower with a credit score above 680 can have a GDS or TDS up to 44% of their gross income.
Let’s look at a real world example.
Couple A makes a combined $80,000 per year. What’s the maximum mortgage they’d qualify for? They have excellent credit (both above 700) and have a car payment of $400 per month. They’re looking for a 5 year fixed rate of 4.5%.
Income: $6666 per month
Debt: $400
Property Taxes (estimate) $400
Heat: $85
Condo Fees: N/A
So we multiply $6666 by .44 to get $2933.33. This is the maximum the couple can pay for their commitments.
$2933.33-$400-$400-$85 = $2048.33
$2048.33 is the maximum mortgage payment this couple can have. Plugging that back into a mortgage calculator, it means the couple can max themselves out at $370.087, assuming they take out a 25 year amortization. This couple could qualify for more if they extended their amortization to 30 years.
Of course, just because a borrower can qualify for a specific number, doesn’t mean they should max themselves out. I would recommend to everyone not surpassing the 32%/40% ratios, no matter what their credit score is. Ideally, I’d want a borrower to not spend 32% of their income on housing plus debt. However, I realize in many Canadian cities this isn’t very realistic.
CMHC Default Insurance
CMHC has all sorts of different homeowner products (more info on them can be found at CMHC’s website) that have different insurance policies depending on the size of the down payment and the length of the amortization. If you have a bigger down payment then the premium amount goes down. If you amortize the mortgage longer than 25 years then the insurance premium goes up. Basically anything a borrower does to make the loan more risky increases the premium amount.
CMHC insurance is mandatory for any mortgage with less than 20% down. Sometimes it required by the lender on properties with more than 20% down, especially rental properties. Once a borrower applies for a mortgage and the lender approves it, the lender then sends that mortgage into CMHC for their approval. CMHC receives the electronic submission and looks at two things- the borrower and the property.
Since so many homes have CMHC insurance, the system has a large database of similar homes in the very same neighborhood that it can use as comparables. Using the database, the system comes up with a value for the home, a number they will insure up to. Once the borrower’s credit is also verified CMHC will approve the property.
The premium is added to the principle owing the borrower doesn’t have to come up with the case for an insurance policy totalling thousands of dollars. Don’t confuse mortgage default insurance with mortgage life insurance. The only person mortgage default insurance protects is the lender. The borrower won’t see two dimes if the bank is forced to take back the house.
Fixed Or Variable Rate
Typically a borrower will save money if they go with a variable rate. According to mortgage guru Moshe Milevsky in a study published in 2001, variable rate mortgages came out ahead of their fixed rate counterparts 88% of the time since 1950. Those savings can really add up on a mortgage in the hundreds of thousands and over 25 years.
Advocates of fixed rate mortgages often cite the stability of the payment as the biggest advantage of having a fixed rate and they are absolutely correct. The borrowers who take on the standard 5 year fixed loan take comfort that their payment will be the same every month, no matter what interest rates do. For them, taking out the fixed rate hedges their interest rate risk.
Ultimately, a borrower needs to decide how much this payment certainty is worth to them before deciding on a fixed or variable rate mortgage.
There are other options for borrowers who can’t decide between a fixed or variable mortgage. They could take a short term fixed term (say 1 or 2 years) which will have an interest rate lower than a 5 year fixed. Lenders are also starting to offer hybrid products that combine a fixed and variable mortgage, giving borrowers a lower interest rate and increased rate protection if interest rates go up.
Which Should You Use? Broker or Banker?
The first advantage to using a bank employee is the lack of paperwork required. Of course, this advantage only applies if you use your own banker, and not one from a competing brand. Since the bank already knows a bunch of the borrower’s info, there’s no need to reprove that. When the borrower uses a mortgage broker, they have to prove everything they’ve stated in their application. The new lender asks for copies of bank statements, pay stubs, and the like, to prove the borrower has the required down payment, they make as much as they said, etc. For most people, the excess paperwork is annoying.
Other borrowers will value the relationship they have with their banker. They have fond feelings for their loans officer because they’ve borrowed from the bank before, or perhaps they just think she fills out her sweater nicely. Confidentiality plays an issue with this point as well. Most people don’t want all sorts of people knowing their financial information. They reason that their bank already knows all this stuff, so they aren’t giving that information to anyone else. This is one of the reasons mortgage brokers do better in large cities than in small towns.
Many mortgage brokers will tout the large number of lenders they have access to as a reason for using a broker over a banker. The reality is if the borrower fits into the standard mold, most brokers have two or three lenders they split the majority of their business with.
While the banks have gotten better in their rate transparency, the borrower still often won’t know if the rate being offered by the bank is the bank’s best rate or not. Banks still enjoy playing the posted rate game, offering naive borrowers a crappier rate, in an effort to make the bank more money. Brokers don’t play this game since they thrive on offering lower rates.
Mortgage brokers are generally more flexible than traditional bank employees. Brokers are usually willing to come over to a borrower’s house to do the application, pick up documents, etc. Banks have responded to this flexibility by introducing mobile mortgage specialists, who work out of their homes and will go visit borrowers when it’s convenient, not just during business hours.
Brokers are paid on completed deals only. Therefore, a broker is likely to try harder to get a deal done than a bank employee who is paid salary. If a borrower has a tough deal to fund, the tenacity of a broker is definitely an advantage.
Payout Penalties
A payout penalty is a fee the lending institution charges a borrower for breaking the mortgage early, typically because the borrower has sold their house. When a borrower repays their mortgage early, the lender gets this lump sum they have to lend out again, this time at a shorter term. Lenders build in a payout penalty in the mortgage to compensate them for such an event.
There are two types of payout penalties a borrower will get charged. The lender will charge whichever one gives them the most money. Isn’t capitalism great? Most mortgages give the borrower the right to prepay 20% of the total principle a year or increase their payment by 20% without a penalty.
The first penalty is three months interest. This one is pretty simple, the lender just charges the borrower 3 months worth of interest.
The interest rate differential (IRD) is somewhat complex to figure out, so let’s crack out our math. It’s essentially the amount owing, multiplied by the interest rate difference between the current rate and the rate on the mortgage for the amount of time left, multiplied by the amount of time remaining. The IRD is only charged when rates have come down, because the lender wants a borrower to remain locked in at a higher rate.
Let’s look at an example. A borrower owes $300,000, 2 years in on a 5 year fixed mortgage at 5.89%. 3 year rates are now 3.89%. How much would the payout penalty be?
$300,000 x 2% x 3 years = 6% of the mortgage balance = $18,000.
By the time somebody pays their real estate agent, that penalty can easily represent the entire profit from the sale of a house. Meanwhile, a borrower who is paying down their mortgage aggressively, will want to limit their yearly repayment at 19.9%.
Borrowers can minimize these fees by being smart. If they know they’re planning on selling soon, then they’ll want to take out an open mortgage, which allows any prepayment without a penalty.
Credit Scores
If a borrower has a credit score above 680, they’ll qualify for any mortgage product CMHC offers. Any credit score above 680 is considered an excellent score, at least according to CMHC. If a borrower has a credit score above 680, CMHC allows the borrower to spend up to 44% of their income on the mortgage, heat, taxes and any other debts. If the borrower’s credit score is below 680, the borrower can only go up to 42% of their income. Any credit score below 610 and a borrower is pretty much out of luck without a co-signer.
Lenders are also looking for at least 2 years of history on a borrower’s credit report, usually from a car loan or credit card. Someone can have a great 1 year old credit report, but still be declined for a mortgage. Alternate sources of credit will be considered for the CMHC New To Canada Program, since the borrower doesn’t have enough time to gain the credit history needed. Possible examples of this can include rent payments or any utility payment. A year of history is needed, with only one late payment accepted. This program applies to recent immigrants or Canadians with a short credit history.
What a borrower needs to do is ask their lender for a bi-weekly accelerated payment. The bi-weekly accelerated payment would be exactly half of the monthly payment, except made every 14 days instead of 15 or 16. That one simple step can cut a mortgage from 25 to 21.9 years just by paying the semi-monthly payment every two weeks.
Remember, the borrower has to ask the lender for bi-weekly accelerated payments, not just bi-weekly.
Typically variable rate mortgages can be had at a 1.5% discount to the comparable fixed rate product. If a borrower knows they’ll stay in the same home for the next 5 years, a 5 year variable mortgage is a solid choice.
Alternatively, a borrower can take a shorter term fixed mortgage, from 1 to 3 years. If a borrower knows there’s a chance they’ll be selling the house in the next couple of years, a shorter term can save thousands in a mortgage payout penalty. The short term fixed products won’t have the same discount as the variable products, but they’ll still be cheaper than a 5 year or longer fixed mortgage.
Putting down 20% (to avoid CMHC fees) and aggressively paying down the mortgage are other easy ways to save thousands over the course of a mortgage. You can thank me by giving some of that money to me.
Shopping around at renewal time will usually get the borrower a better deal, since many lenders won’t offer their best rates in the renewal letter. Spending less on a house will also save the borrower money in interest over the long term.
Conclusion
Getting a mortgage in Canada isn’t an easy process, especially for a naive borrower who has no idea about the process. Hopefully this guide can serve to save borrowers some money and to make the whole process easier and lead to making this stressful experience a little easier.
As always, feel free to ask any questions in the comments.
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