What is a Mortgage and How Does it Work in Canada

A mortgage is a loan from a lender – such as a bank or credit union – intended to help home buyers finance the purchase of a home.

A loan is a legal contract between the borrower and lender, stipulating financing terms.

Some characteristics are unique to mortgages, such as:

  • You require a down payment to secure this loan
  • If you need to break your contract, you’ll likely pay penalties
  • You may renew your mortgage agreement several times until you’ve paid the total amount
  • A financial ‘stress test’ is a common qualifying condition for mortgages
  • Your home is likely going to be the most significant purchase you’ll ever make
  • Your property may be used to secure your mortgage

Fixed vs Variable Interest Rate

Interest rates are a percentage-based fee your lender charges when you borrow money from them.

The two general mortgage types are fixed-rate and variable rate.

Fixed-Rate Mortgage

As the name suggests, the interest rate for this mortgage remains fixed for a specific period referred to as the “term.”

The most common term is 5 years.

A fixed-rate rate is usually a more straightforward loan, and the contract structure doesn’t vary much from bank to bank.

These mortgages can have higher interest rates but are designed for borrowers who don’t enjoy surprises from changing rates.

You will know what you are paying at all times – both towards interest and principal.

The rates for fixed mortgages are calculated based on the Government of Canada’s bond yields at the time of signing.

Variable Rate Mortgage

Variable interest rate loans are typically more complex than their fixed-rate counterparts.

With a variable rate mortgage, your payment remains the same while the interest rate fluctuates based on changes in the prime rate.

This means how much you pay towards your principal changes with the rates.

So, if the interest rate decreases, you will pay more towards your principal and conversely, you pay less if rates increase.

Variable rate mortgages are tethered to the Bank of Canada prime rates and offered to customers plus/minus this floating number.

The critical point is your mortgage payment always pays the interest first and your principal second.

The benefits of variable-rate mortgages lie with their flexibility.

Banks typically offer various perks, such as opting into a fixed-rate mortgage at certain times.

Variable rate mortgages also tend to offer lower interest rates than fixed options, but come with the risk of interest rates going up.

Couple moving into their new home

Open vs Closed

If you want to put a lump sum down on the outstanding mortgage amount you owe or end your mortgage contract before the term ends, there are some differences you should be aware of when it comes to open vs closed mortgages.

Open Mortgage

As it sounds, this kind of mortgage offers versatile options for paying down the loan on your terms – without penalties.

An open mortgage might mean making more frequent, higher, or lump sum payments on your debt.

Anything over and above your scheduled payments is considered a pre-payment, and they can dramatically reduce the time spent paying it off.

Additionally, it’s likely to be simpler and cheaper to refinance your mortgage or pay it out in its entirety.

On the downside, open mortgages tend to have higher interest rates – flexibility tends to be more expensive for consumers.

Consequently, open mortgages are not the first choice of most.

Closed Mortgage

Most Canadian home loans are closed mortgages – they offer lower interest rates that make sense for most borrowers.

However, several limitations impact your ability to respond to a changing situation.

There are often extra fees if you need to alter the mortgage contract during the term.

If you need to sell your house or you want to make a lump-sum payment, there are potential limitations on what you can do before penalties kick in.

For example, some lenders might let you pay up to 10 percent per year towards your mortgage before incurring fees.

Most will charge an Interest Rate Differential or 3 months’ interest penalty, whichever is higher, if paying more than the prepayment limit, which includes paying out your entire mortgage.

Term

When you enter into a mortgage agreement, there are opportunities for you to negotiate interest rates paid on loans.

Once done, a ‘term’ contract is signed, stipulating interest rates paid and time allotted.

Most terms range between six months to five years, although seven- and ten-year terms are also available.

Terms are essentially the length of time your agreed upon interest rate is valid for.

When the term is up, you have the opportunity to negotiate with your financial institution or look elsewhere for a better rate.

Amortization Period

A mortgage is a massive financial commitment that usually takes a decade or two to pay off.

One of the decisions you’ll make is the length of time you plan on taking to pay off your loan, based on scheduled payments.

This time is called the amortization period, and the period allotted is generally 15, 20 and 25 years – the common term being 25 years, with some lenders going up to 35 years based on certain conditions being met.

When debating the long and the short, it’s good to remember the trade-offs.

For example, a shorter amortization period saves you money in interest charges and allows you to build equity in your house faster.

You’ll be done paying your mortgage sooner with all the benefits that come with that decision.

On the other hand, long-term gives you lower monthly payments and greater flexibility with your budget.

Saving money this way comes with a price, and a lot of that may be paid in more significant interest fees over time.

Additionally, you may still have the option to make pre-payments on your mortgage if you find yourself in a stronger financial position to reduce your amortization period.

Down Payment

Your down payment is the key to home and hearth.

To qualify for a mortgage, you likely need to provide your financial contribution towards purchasing your house.

Currently, Canada requires that borrowers produce at least 5 percent of the home price as a down payment – up to $500,000.

After the first half million, the required amount is 10 percent on the remaining amount.

Your lender may have different requirements.

Purchase Price of Home Minimum Down Payment
$500,000 or less 5 percent of the purchase price
$500,000 to $999,999  5 percent on first $500,000 and

10 percent on the portion after that amount

$1 million and more 20 percent of the purchase price

Source: Canada.ca

Of course, you can’t talk about mortgages without talking about mortgage insurance.

The rule is if you have less than a 20 percent down payment, you are required to pay this premium.

These fees typically vary from 0.6 percent to 4.50 percent of your mortgage total.

This means the larger your down payment, the smaller your mortgage insurance premium.

You can choose to pay for these costs upfront or have them rolled into your mortgage.

Affordability

Buying a home and affording a home can be two different things.

Most people already know about down payments, but maybe you didn’t consider closing costs – home inspection fees, legal expenses, land title search, and more.

The Canadian Mortgage & Housing Corporation (CMHC) estimates these costs run between 1.5 and 4 percent of the purchase price.

In terms of living costs, a good rule of thumb is total monthly housing expenses – including mortgage payment, property taxes, heating, 50 percent of applicable condo fees – shouldn’t exceed 32 percent of your gross household income.

A budget calculator can help when determining affordability.

You’ll also want to think about your current debts – does making this mortgage work mean only paying the minimum payments?

A final note about affordability; federally regulated financial institutions require buyers to undergo a mortgage stress test.

This test is meant to protect the housing industry and will probably cut into how much you’re qualified to borrow.

In short, you might get more mortgage bang for your buck with a credit union.

Frequently Asked Questions

  • What happens to the mortgage when you sell?
  • Can you get a 40-year mortgage in Canada?

Lindsey is a freelance writer specializing in personal finance and business trends. She has a B.A. in psychology and is currently working towards completing her Canadian Securities Course.

When she’s not exploring the relationship between mind and money, Lindsey likes to play vintage video games, read all books, and go skiing.