Start a conversation with Mortgage Agent Gary Brown and see if you can discover new financial possibilities.
Life is full of choices.
Not the least of these choices is the one to invest in living space. Often, this choice will require a mortgage and a mortgage, if needed, is simply a debt instrument that is used to help make the investment possible.
The investment options that involve living space can be broadly categorized as either: a purchase or accessing equity in an existing owned property.
Regardless of which type of investment is made, it is important to realize that there are financial consequences associated with both of them.
An obvious financial consequence is the cost of any debt used to finance the investment decision that has been made.
However, too often it is thought that “WHAT IS THE RATE?” is the only question that needs to be asked about mortgage investments. While it is a good question, it arguably only becomes important when a number of other questions have been addressed.
Unfortunately, anecdotal evidence suggests that many Canadians spend significantly less time understanding their mortgage choices than the time they spend making a car purchase. That’s ironic given that the average house price in Canada in July 2017 stands at $479,000 while the average new car price is less than $40,000.
With the above in mind, what are the questions that need to be considered when making mortgage choices?
Here is a list of some of them:
1. How well can you predict the future?
This question is intended spark some dialogue about potential future life changes. Life changes are important simply because they have the potential to lead to significant pre-payment penalties.
Many Canadians take out a five year fixed mortgage only to discover that their future has changed. History indicates that about 2/3 of these five year fixed mortgages will be broken at the 36 month mark.
When this occurs the homeowner is left vulnerable to a pre-payment penalty called an Interest Rate Differential (IRD) and “not all IRD penalties are equal”. The inputs used to calculate IRD penalties are not the same between all lenders. Pay attention to how chartered banks calculate IRD penalties, as their calculation leads to a much higher pre-payment cost.
It will pay to understand the difference.
2. What is your tolerance for risk?
Will that mortgage be a fixed rate or a variable rate? Historically, variable rates have outperformed fixed rate products, which means less interest paid by the homeowner. However, will your stomach acid handle rate fluctuations associated with variable rate products?
3. How disciplined are you as a saver?
Mortgages generally offer pre-payment privileges that, if utilized, can significantly reduce the total cost of a mortgage. Most Canadians don’t take advantage of these options.
Some discipline around saving goals can have a big impact on the total cost of mortgage debt.
4. What is your view of different amortization periods?
Often it is thought that a shorter amortization period is best. However, choosing the longest amortization period offered will lower monthly cash expenses and perhaps provide funds needed for an alternative use. This could be a home-owner operated business. It might simply be a savings plan for a rainy day or a means to take advantage of future pre-payment privileges.
It is a different way to think about mortgage planning and it could significantly reduce the cost of your debt.
5. What is your down-payment amount?
The amount of available down-payment will determine status as either a conventional or high ratio borrower. Conventional borrowers put down 20% or more of the value of the property being purchased. High ratio borrowers have a down-payment in the range of 5% to 19.99% of the value of the property.
High ratio borrowers must purchase mortgage insurance, which is financial protection solely for the lenders. As a result, the lenders generally reward high ratio borrowers with lower market interest rates on their mortgages. However, the interest rate used to qualify these borrowers is the benchmark interest rate. This qualification rate will reduce the overall amount of money that will be loaned to high ratio borrowers. Conventional borrowers currently have the option to choose a mortgage with or without mortgage insurance that is supplied by the lender. Interest rates are lower if the insurance option is chosen but the maximum amortization period is 25 years and the borrower must qualify for a mortgage at the benchmark interest rate.
Conventional borrowers who choose a mortgage without the insurance qualify at the market interest rate and can choose a 30 year amortization. However, the interest rates offered are higher due to the increased risk assumed by the lender.
6. What is your credit score?
Frequently, the answer to this question is “I don’t know”.
It is an important number because it is directly linked to how much money a lender will consider offering via a mortgage product. Credit scores are used to set the value of the debt service ratios that, in turn, determine maximum borrowing power.
Credit scores help lenders determine the credit worthiness of potential borrowers. The lower the credit score, the greater the risk that has to be assumed by the lender. As this risk increases, the choices available to the borrower also change and become more expensive.
7. What are your debt service ratios?
The amount of mortgage money offered to a borrower is capped by the lender’s established debt service ratios. There are two of them.
The first is called the Gross Debt Service (GDS) and it is calculated as follows:
-(mortgage principal + interest + property taxes + heating costs)/(income)
The second is the Total Debt Service (TDS) and it is:
-(mortgage principal + interest + property taxes + heating costs + all other debt)/(income)
The elements in these two equations can be impacted in a variety of ways. Interest rates vary between high ratio and conventional borrowing.
Property taxes are directly tied to the property being purchased or already owned.
Heating costs are a function of the amount of living space.
Income can come from numerous sources.
All other debt takes into account such things as car loans and secured and unsecured lines of credit.
As mentioned in point #6, debt service ratio values are directly tied to credit scores. The higher the credit score, the higher the allowed debt service ratio until it reaches the maximum allowed.
8. What is the best source for a mortgage?
That depends largely on the borrower.
The chartered banks and mono-line (mortgages only) lenders are the two largest sources of mortgage funds in Canada. The borrower will experience a larger personal financial risk if a 5 year fixed mortgage is written with a chartered bank. This is due to the way the chartered banks determine IRD pre-payment penalties.
The chartered banks focus on the most credit worthy customers. For everyone else, other options are required.
Interest rates are competitive between the two sources but, the mortgage with the lowest interest rate might not be the best product available, given an individual’s circumstances.
It will pay to be aware of the choices that exist.
9. What steps will help you protect your investment?
In the event of an untimely death, is there sufficient life insurance available to retire any outstanding mortgage debt? Dealing with a loved one’s death is difficult enough but to have those left behind crushed by debt that can’t be serviced is doubly difficult.
When planning a mortgage, take the time to book an appointment with a trusted financial planner. It is an excellent investment in time.