What Is a Mortgage?
Given that the price of the average home is much higher than the average individual can afford, it is necessary for most home buyers to obtain a loan to buy a home.
A mortgage is a loan that is obtained by a borrower from a mortgage provider in order to buy real estate such as a house, commercial building, or land. The borrower repays the loan to the lender in periodic regular payments that consist of Principal and Interest payments over a period of time. The loan is secured by the property purchased by the borrower.
Mortgage Interest Rates and Terms
Mortgages are designed with an interest rate over a specific timeframe.
The most popular terms are 15-year or 30-year fixed-rate mortgages. However some mortgages can be as short as 5 years.
1. Fixed-Rate Mortgage
The interest rate can be fixed throughout the life of the mortgage, called a Fixed-Rate Mortgage (FRM).
2. Adjustable-Rate Mortgage
The interest can vary during the life of the mortgage, called an Adjustable-Rate Mortgage (ARM).
The interest rate is usually fixed at a lower rate for an initial period of time in order to attract borrowers. Then after a certain period of time, the rate increases or changes according to interest rates in the market. However, there are limits on how much the interest rate can rise during the life of the mortgage.
3. Interest-Only Mortgage
Normally, periodic mortgage payments constitute principal and interest payments. However, some mortgages are structured to pay interest only. As such, the outstanding mortgage balance is not paid down at all. These are called interest-only mortgages.
These are primarily structured for sophisticated real estate investors who either plan to re-sell the property and pay down the debt or they plan to replace the interest-only mortgage with better financing in the future.
In an interest-only mortgage, the borrower only pays the interest on the mortgage over a period of time. Then, he is required to repay the principal as a lump sum at a future specified date.
Interest-Only Mortgage Terms
Most interest-only mortgages are normally for terms much shorter than for conventional mortgages. They are usually for a period of 5 to 10 years.
After that period has elapsed, the mortgage becomes a conventional mortgage with mortgage payments made up of both principal and interest payments.
Interest-only loans are structured such that the borrower pays interest at a fixed rate for 5 to 10 years. Then, after the initial period expires, the borrower pays both principal and interest, and that interest rate begins to change.
Of course, after this initial period, the borrower has other options he could pursue, which include:
– If market conditions have changed and the borrower believes he can get better mortgage terms, and it would be more beneficial to replace the mortgage with a better mortgage, he can do so. He can refinance the mortgage to a mortgage that requires lower interest payments.
– He can choose to sell the house and pay off the mortgage entirely.
– If he has the financial ability to pay off the mortgage without selling the house, he can do so.
An interest-only mortgage enables the borrower to reduce his monthly mortgage payments and save cash.
On the other hand, the borrower is not paying down any of the principal on the mortgage and therefore is building no equity in the house.
As such, interest-only mortgages are most common with sophisticated real estate investors who need to save cash that can be allocated to other real estate investments. And these investors expect to either sell the houses or refinance the mortgage in the near future to restructure their finances.
4. Reverse Mortgage
A reverse mortgages is a mortgage that applies to a borrower who already owns a home. It is a mortgage designed to convert a portion of the equity that this homeowner holds in his home into cold hard cash.
In simple terms, the homeowner uses his home as collateral to receive a loan. This generally applies to homeowners over the age of 62 who have built up significant equity value in their homes over time. During the homeowner’s retirement years, with his lower income, he may need cash to cover personal expenses. This loan can come in handy.
The homeowner can receive the loan as a cash lump sum, monthly payment, or as a line of credit. The outstanding loan balance is due when the homeowner sells the home or when the homeowner dies.
5. Government-Backed Mortgage
In order to encourage home purchases, some government agencies guarantee home mortgages, which reduces the risk to the lender and encourages the lender to fund more home purchases.
In the United States, these agencies include the government-sponsored Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).
In Canada, the agency is the federally-owned Canada Mortgage and Housing Corporation (CMHC), which backs about 90% of all insured residential mortgages.
The Mortgage Application Process
Let’s say you want to buy a house and you need to apply for a mortgage in order to fund your purchase. Here’s what to expect:
You will walk into your local bank branch or lender’s office and complete a mortgage application form. Or you can fill out the form online.
Regardless of the route you take, you will then be asked to provide supporting documents in order for the lender to assess your creditworthiness. The lender will conduct a credit check on you.
The lender will assess whether you can afford the property and loan as such:
– Your monthly mortgage payments shouldn’t exceed about 30% of your Gross Income. This requirement was ignored by lenders in 2006, which led to the 2008 housing crisis.
– You should be able to pay for the down payment and closing costs of the home.
Supporting Documents
Lenders will normally request documents that detail the following:
1. Proof of Identity
– Copy of your driver’s license or passport
– Tax identification number such as Social Insurance Number (SIN), Social Security Number (SSN), or equivalent in your jurisdiction. This will be used for a credit check.
2. Proof of Income
– 2 years of federal income tax returns
– Bank statements of all income accounts such as savings and investment brokerage accounts
– 2 years of employee income statements
3. Assets
– Asset accounts including your chequing, savings, and investment accounts
– Notarized letter from a relative who may be assisting you with funds for the home purchase
4. Proof of Employment
– Employer name and contact information. The lender may want to contact your current or previous employer to verify your employment information and history.
– Business owners and self-employed professionals will usually need to provide their corporate tax returns and corporate bank statements as proof of income and assets.
What Happens Next?
Your lender will verify your information and establish whether to approve your mortgage application by analyzing a few ratios and numbers.
Credit Score
Your credit score is a number produced by the major credit bureaus such as TransUnion and Experian that indicates your ability to repay a loan. The score is calculated using your bill payment history. A high credit score implies a lower risk of default and therefore justifies a lower interest rate.
A credit score over 620 is considered good.
Debt-to-Income
Your lender will want to know if you have other debt (student loan debt, credit card debt, car note, etc.) and how much more of a debt burden the mortgage will add to your existing finances. This is calculated as a debt-to-income ratio.
A maximum debt-to-income ratio of 36% is considered good.
Required Down Payment
Generally, lenders will fund up to 80% of the price of a home. As such, you will be expected to make a down payment of 20% of the home price.
However, this down payment requirement is usually reduced to as low as 5% if you obtain mortgage insurance, which protects the lender if you default on the mortgage.
Mortgage Approved
If your mortgage application is approved, your lender will offer you a mortgage loan up to a certain amount and at a specific interest rate.
Even before you find the house you intend to buy, you can apply for a mortgage in order to be pre-approved and ready with the funds when you do find your dream home.
Mortgage Rates
Your interest rate will depend on your credit score, lender, type of mortgage, and market conditions at the time of your home purchase. Interest rates vary from week to week.
You cannot predict future interest rates. So most home buyers aim to lock in a predictable fixed interest today over the life of the mortgage.