The Pros and Cons of Common Mortgages

Buying your first home is an exciting step forward, but paying for it can be an overwhelming experience if you’re not familiar with your options for mortgages. You’ll probably end up getting some kind of mortgage to pay for your home. This article explains the most common types of mortgage as well as the costs and benefits of each option. Check out the sources listed at the end of the article (also linked to in the body) if you have any questions.

Open versus Closed Mortgages

When you buy a house, you typically pay about 20% of the cost of the house as a down payment (sometimes less – more on that later), and take out a loan for the remaining amount due. This loan is a mortgage, and it uses the house you’re buying as collateral. If you take out an open mortgage, then you’re free to pay off the principal (the amount you borrowed, without the interest), in full or in part, at any time. This is known as a prepayment – you’re paying back the loan before it officially expires. If you take out a closed mortgage, then there are restrictions on the prepayments you can make. You may only be allowed to pay a certain amount in prepayments, or you may incur a prepayment fee. It’s important to research your different options very carefully to avoid any nasty surprises down the line. Overall, an open mortgage offers you more flexibility and the ability to pay your principal back at any time. Making prepayments may allow you to take advantage of mortgage refinancing options in some cases, although this will depend on your situation. If you want to pay off your loan quickly and/or reduce your debt overall, then an open mortgage may be the right choice for you.

On the other hand, prepayments are generally perceived as a risk by lenders, because they stand to make less money on interest if the borrower decides to pay back his loan in full very quickly. As a result, interest rates on open mortgages are generally higher than interest rates on closed mortgages to offset this risk. This makes open mortgages a better option if you’re looking for a short-term arrangement – perhaps if you want to sell your home soon.

Fixed versus Variable Mortgage Rates

Your mortgage rate is the interest you pay on the principal. A fixed mortgage rate means that the interest, and consequently the payments you make, on your mortgage loan are fixed for a specific period of time (possibly the entire mortgage term). Say your mortgage rate is fixed at 3%. Every month, you’ll pay back a fraction of the principal plus (roughly) 3% of that fraction. Your monthly payment amount does not change, regardless of the state of the market. If you take out a variable interest rate, then the interest rate you pay will fluctuate according to market demand and supply. When business is booming, or if the Bank of Canada lowers interests rates to encourage borrowing and spending, then your interest and monthly payment will fall. Conversely, if the economy slows down, or the Bank of Canada raises interest rates to combat inflation, then you may find yourself owing a higher monthly payment. Check out this video for a more detailed comparison. Some institutions offer a capped interest rate, meaning that they guarantee you that you’ll never pay interest over a certain threshold (say, 5%), but the actual interest can fluctuate within the cap limits. A capped-rate mortgage is a hybrid of the fixed-rate and variable-rate mortgages.

Of course, deciding between a fixed and a variable interest plan will depend on what the fixed interest rate will be. It may be the case that a fixed-rate mortgage is a more affordable option in the long run. That said, variable interest rates have historically been lower than fixed interest rates in Canada, so a variable-rate mortgage is a better choice if you want to reduce the sum of your monthly payments over the course of your mortgage term. On the other hand, there’s a lot of security and stability in a fixed-rate plan. You know exactly how much you need to pay every single month, which helps financial planning. You don’t have to keep track of the prime rate (market interest rate), which may fluctuate unexpectedly. In that sense, a fixed-rate mortgage is a better choice if you’re looking for peace of mind.

Conventional versus High-Ratio Mortgages

For a typical mortgage, you’re required to pay about 20% of the cost of your home as a down payment, and take out a loan on the rest. This 20/80 model is generally considered a conventional mortgage. However, if you make a smaller down payment (for instance, 10% of the total cost of your home) and borrow the rest (90%), you would be taking out a high-ratio mortgage. You would take out a high-ratio mortgage if you don’t have the money to make a full 20% down payment. However, because you’re making a smaller down payment (and are considered more of a risk), your mortgage must be insured against default by a Mortgage Insurer such as CMHC. There are generally restrictions on high-ratio mortgages. In 2012, the Canadian government passed a law forbidding high-ratio mortgages on homes purchased for more than a million dollars – such homes had to be financed with a conventional mortgage (with a 20% down payment). The amortization period for these high-ratio or insured mortgages is capped at 25 years in Canada.

The benefit of a high-ratio mortgage plan, as opposed to a conventional plan, is that it requires a smaller down payment up front. This makes it a good option if you want to buy a house right away, but don’t have the full amount needed for a 20% down payment. In addition, a high-ratio mortgage is automatically insured against default, in case the borrower stops making payments on the mortgage. Mortgage default insurance in Canada will cost you 1.80% – 3.15% of your total mortgage amount.

The bottom line on mortgages

There are many different mortgage plans out there, and it’s extremely important that you research all your options before you make a decision. An open mortgage is more flexible and lets you pay off your mortgage whenever you want, but it also incurs higher interest rates than a closed mortgage, which restricts prepayments. A fixed-rate mortgage offers peace of mind, but has historically incurred a higher interest rate than variable-rate mortgages. Finally, while a high-ratio mortgage requires a smaller down payment and insures you against default, the cost of the default insurance over the term of your mortgage will increase the amount you have to pay overall. Selecting a mortgage plan is a difficult decision, but it has important repercussions for your financial health. Do your research!

If you have more questions, check out the following sources:

Mortgage Default Insurance or CMHC Insurance (RateHub)

Variable or Fixed Mortgage Rates (RateHub)

Types of Mortgages Available to Canadians (LoansCanada)

Glossary of Mortgage Terms (TD Trust Canada)

Buying your first home: Three steps to successful mortgage shopping (Financial Consumer Agency of Canada)