The Mortgage: Buying and Financing a Home

For most people, buying or building a home is the largest single purchase and investment they will ever make. There are so many issues to be considered and so many decisions to be made. Once you have decided whether to buy or build, careful consideration must be given to location and neighborhood, size, interior layout and exterior design, affordability and, of course, mortgage and financing. Arranging the mortgage and financing is the first concrete step before proceeding with your purchase or building project.

Buy or Build?

Many families prefer to build a new home for a number of reasons. It may allow them to live exactly where they desired, perhaps in the area of their old family homestead. In some cases, they have a piece of land gifted or inherited from family. Building a new home provides the opportunity to have the exact layout that they want. Many prospective homeowners prefer a modern design with all the latest fashions and trends. Others are more concerned about having a new home warranty with minimal repairs and maintenance in the long term. These are all valid reasons for deciding to build. However, there is a strong case to be made for purchasing an existing home.

Often, the mortgage and cost of purchasing an existing home can be significantly less than that of building one of similar size and quality. There are no design or architectural costs, no municipal land fees for new building lots, no building permits and no site preparation costs. There are no time- consuming tasks, such as arranging a contractor, arranging building materials and selecting the many cosmetic finishing products that go into a home. There is no risk of encountering issues with the contractor with respect to agreed-upon work. Usually the basement has been finished to include a recreational area, an apartment or both. Then there is the tremendous advantage of having all supplemental exterior work completed, such as landscaping, fencing, and a storage shed or garage. An existing property often features mature trees and bushes which take years to grow and develop.

Ultimately, the final decision to buy or build will be determined by the preference of the prospective homeowners and their financial limitations and mortgage options.

Financing (in Canada)

It is recommended that financing for a new home be arranged and pre-approved before proceeding with plans to buy or build, as it is essential to know the amount of funding that is available to you. This will guide you in selecting a suitable property. Mortgage financing is available from a number of lenders under various terms and conditions, depending on your qualifications. The key criteria considered by the lender include your employment status, income, expenses, debt, assets, credit history, and amount of down payment. This information allows the lender to assess your financial situation and your ability to pay.

Federal government regulations require all borrowers to meet certain conditions in order to qualify for mortgage insurance. These include such things as a minimum down payment, a maximum gross debt service (GDS) ratio and a maximum total debt service (TDS) ratio. In Canada, the minimum down payment is currently 5 % of the purchase price. The maximum GDS ratio is currently 32 %. This means that your total monthly housing costs, including the mortgage payment (principal and interest), property taxes, insurance, and heating cannot exceed 32 % of your gross household income. The maximum TDS ratio is currently 40 % which means that your total debt load, which includes housing costs and payments on all other debt, cannot exceed 40 % of your gross annual household income.

In order to avoid a mortgage insurance premium to Canada Mortgage and Housing Corp (CMHC) or an alternate mortgage insurer, the down payment must be at least 20 % of the purchase price. Most borrowers have only the minimum down payment and therefore must pay the insurance premium which is a percentage of the mortgage amount and can be significant, usually several thousand dollars. This insurance protects the lender in the event of a foreclosure and forced sale, the proceeds of which may not be sufficient to pay the outstanding mortgage balance in full.

For those who qualify, it is highly recommended to amortize your mortgage over the shortest possible time period. The amortization period is the length of time over which the entire balance of the home loan will be paid off. The maximum amortization period for an insured mortgage is currently 25 years (recently reduced from 30 years). By having a shorter amortization period such as 15 or 20 years, you can lower your total interest cost by tens of thousands of dollars, but your mortgage payment will be somewhat higher. This decision will depend on your ability to pay.

Another method commonly used to reduce interest cost and pay off a mortgage earlier is making a biweekly or weekly mortgage payment which reduces your principal balance more quickly. Then there are annual pre-payments which are subject to limits set by the lender. You can prepay your mortgage by making an annual lump sum payment in addition to your regular payments. This pre-payment is limited to a percentage, often 15 %, of your original mortgage amount.

There are a number of types of mortgages including open, closed, variable rate, and fixed rate. When interest rates are low, as they currently are, it is often wise to lock in a mortgage for a longer term of up to 5 years at a set rate. This would be a closed mortgage with a fixed rate. A closed mortgage is subject to a pre-payment penalty if you pay off the balance prior to the renewal date. This pre-payment penalty applies even if you are paying off the balance of the home loan because you sold your home, but some lenders offer to reimburse the penalty amount if you arrange a new mortgage with them to purchase another property. The amount reimbursed or credited to you would depend on the amount of the new mortgage.

When rates are higher and you prefer not to lock in you can request an open mortgage, which has no set renewal date and no pre-payment penalty in the event of pre-payment or payment in full. You can also choose a variable rate which is essentially a floating rate that varies with changes in the prime rate. Choosing the best option will depend on several factors including the level of interest rates at the time, the forecasted direction of rates (up or down), and how long you anticipate owning the property.

Finally, and perhaps the most important of all, stay within the parameters of affordability. When committing yourself to a mortgage, consider not just the mortgage payment but also the property taxes, property insurance premiums, maintenance costs, utilities, other debts, and general living expenses. Do not over-extend yourself financially. Remember, if you borrow to the maximum of your qualified limit, you are risking future strain on your budget should interest rates rise. For example, if you owe $350,000.00 and interest rates have risen by just 2 % when your mortgage comes due for renewal, your monthly payment will increase by $583.00 per month. Could you afford such an increase? Such a scenario is very possible. By using good judgment you can avoid the “house rich, penny poor” syndrome.

Closing Costs (Canada)

When purchasing a home, consideration must be given to the various closing costs which are in addition to the actual purchase price. These closing costs can include legal fees, HST or GST/PST, and land transfer tax if applicable. Other costs such as survey, appraisal and inspection fees may apply and are subject to negotiation with the vendor. These closing costs can be significant and must be allowed for in the overall funding.

Other Important Factors to Consider

Please see my article Buying or Building a House: 5 Important Factors to Consider.

Using common sense, exercising good judgment, and doing your research can make your new home experience a very pleasant one. Good luck.

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