Mortgage Basics

Mortgage

Buying a home is an important financial decision. It is important to familiarize yourself with the features of the  different types of mortgages, so that you understand your prepayment options and can effectively pay down your mortgage quicker without incurring a penalty.

  • Mortgage Term – The period of time your mortgage agreement will be in effect, including your interest rate and terms and conditions. At the end of the term, you may either pay off the mortgage in full, renew it or possibly renegotiate your mortgage agreement (for example, decrease your amortization period). Terms are generally for six months to 10 years.
  • Open Mortgage – A mortgage which can be prepaid and any time, without requiring the payment of additional fees. Due to the added flexibility of open mortgages, generally the interest rate charged for this type of mortgage is higher. 
  • Closed Mortgage – A mortgage agreement that cannot be prepaid, renegotiated or refinanced before maturity. Interest rates for closed mortgages are generally lower than open mortgages which may make them a better choice if payout is not expected in the short term.
  • Fixed Rate Mortgage – A mortgage for which the rate of interest is fixed for a specific period of time (the term). Payments are set in advance for the term. This provides you with the security of knowing precisely how much your payment will be throughout the mortgage term. Fixed rate mortgages can be open (may be paid off at any time without penalty) or closed (prepayment penalties may apply if paid off prior to maturity).
  • Variable Rate Mortgage – A mortgage for which the rate of interest may change if other market conditions change. This is sometimes referred to as a “floating rate” mortgage. If interest rates go down, more of the payment is applied to reduce the principal; if rates go up, more of the payment is applied to payment of interest. Variable rate mortgages may be open or closed.
  • Conventional Mortgage – A mortgage that does not exceed 80% of the purchase price of the home. Mortgages that exceed this limit must be insured against default and are referred to as a high-ratio mortgage.
  • High Ratio Mortgage – If you do not have 20% of the lesser of the purchase price or appraised value of the property, your mortgage must be insured against payment default by a Mortgage Insurer, such as CMHC.
  • CMHC (Canada Mortgage and Housing Corporation) – Mortgage insurance insures the lender against loss in case of default by the borrower. Mortgage insurance is provided to the lender and the premium is paid by the borrower.

 

Amortization

An amortization period means the number of years you will need to pay off your entire mortgage. It is an important decision that can affect how much interest is paid over the life of your mortgage. Historically the average amortization period for mortgages was 25 years.

The following table illustrates the interest cost over different amortization periods on a $150,000 mortgage, assuming a constant annual interest rate of 5.45%.

 

AmortizationChart

Note: The amortization period you select can be re-evaluated every time you renew your mortgage.

 

Prepayment Penalties

A prepayment penalty is a fee that's charged when a borrower retires a mortgage before its scheduled pay-off date or maturity.

How is the Prepayment Penalty Calculated?

The prepayment penalty methods below are common methods used by financial institutions. It is important you review and speak to your credit union about your specific mortgage agreement to determine how a mortgage prepayment penalty will be calculated. Two common methods used to calculate a prepayment penalty are as follows:

    Three Month Interest Penalty – An amount equal to three months interest on your outstanding mortgage balance.

    Let's say you have the following mortgage

       (A) Mortgage: $200,000
       (B) Annual Interest Rate: 6%

    To calculate the prepayment charge based on three months interest, you'll need to use this formula:  A x B / 12 months x 3 months.

       Multiply the outstanding mortgage amount by the annual interest rate
       Divide that number by 12 to get the interest payable for one month
       Multiply that number by 3 months

       $200,000 x 0.06 = $12,000
       $12,000 / 12 = $1,000
       $1,000 x 3 months = $3,000

    $3,000 would be the prepayment penalty when calculated using the Three Months Interest calculation.

    Interest Rate Differential (IRD) – The difference between the interest payable on your existing mortgage versus the interest rate payable on a replacement mortgage for the remaining amount of time left in the mortgage term. The penalty amount is based on the difference between two interest rates.  The first is the interest rate for your existing mortgage term. The second is today’s interest rate for a term that is similar in length to the time remaining on your existing term. Please note, some financial institutions use a discount interest rate off their posted interest rate when they set up the mortgage term. The discount rate may be used to determine the IRD.
    For example, if you have three years left on a five year term, your lender would use the interest rate it is currently offering for a three year term to determine the second rate for comparison in the calculation.

    Let's say you have the following mortgage

       (A) Mortgage: $200,000
       (B) Annual Interest Rate: 6%
       (C) Today's Interest Rate for Term of Similar Length (lender may round to nearest term) : 4%
       (D) Number of Months Left in Term: 36 months

    To calculate the prepayment charge based on the interest rate differential, you'll need to use this formula: A x (B-C) / 12 months X D

       Subtract Today's Interest Rate from the Annual Interest Rate (B-C)
       Multiply that answer by the outstanding mortgage balance (A)
       Divide that number by 12 to get the interest differential for one month
       Multiply that number by the number of months left in the term (D)

       6% - 4% = 2% or 0.02
       0.02 x $200,000 = $4,000
       $4,000 / 12 = $333.33
       $333.33 x 36 months = $12,000

    $12,000 would be the prepayment penalty when calculated using the Interest Rate Differential calculation.

    Your mortgage contract may state that the prepayment penalty will be the greater of the two amounts that result from the calculations used above.

       

      Prepayment Privileges

      How can I reduce or avoid prepayment penalties and still pay off my mortgage quickly?

      • Make full use of your prepayment privileges: Prepay as much as you are allowed within your mortgage contract each year.  Make sure you are clear on what your mortgage contract will allow you to prepay and take full advantage of it.  The interest savings can make a significant difference.
      • Wait until the end of your term to prepay: If your prepayment penalty will be a large amount, consider waiting until the maturity date, when you can make a lump-sum prepayment without triggering penalties.
      • Ask Questions: Ask your Diamond North Credit Union lender for suggestions on how you can pay your mortgage down quicker.  There may be opportunities to make lump sum payments, increase regular payments or change your payment frequency.

       

       

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