A good friend of mine renewed his mortgage recently. Over a dinner conversation, he asked for my opinion. 3.75% for 3-year, closed term sounded like a good deal but after a couple of questions. I realized that my friend signed up for a mortgage product that he didn’t fully understand and it wasn’t the right product for him. I didn’t want to be the one that broke the news to him but as a friend I must let him know what he got himself into. My friend is a smart and well educated IT professional, so I was very curious why he didn’t know fully know what he signed up for.
As it turned out, my friend was not alone. Majority of people have general understanding about mortgage products but they don’t fully know all the details. When signing a contract with a bank, one should always know the details because you will be getting a short end of the deal if you don’t. After explaining his options to my angry and disappointed friend, I got the inspiration to write this post.
As someone who have been in financial services industry for many years, I can understand why most people don’t know mortgage product in full details. It is because:
- Banker is probably the worst product communicator. Product communication is not a topic that banks typically invested in. As such, it is not surprise that the product managers are not great at communicating the product features in plain an easy to understand language. There are marketing managers in the banks, but their focus is not about explaining the products to customer, but rather to market the products in a way that appeal to you, the borrower/customer.
- The language of mortgage agreement is difficult to understand. Bank’s agreements (lending and deposit) are drafted and reviewed by all lot of people work in control functions in bank. These people would be in law, compliance, risk, privacy, AML, fraud, product and many others so call experts. With so many opinions and communication styles jamming into an agreement, it is not difficult to see how the agreement is a nightmare to read and never make reading list for anyone.
- The mortgage agreement is often very long. The average Canadian bank’s mortgage agreement and schedule is typically over 20 pages long, legal size and in 10 font text. Now, try reading that while your banker or lawyer looks impatiently at you. Most people would just sign the agreement and trust that their banker or lawyer knows looks after their interest.
Though mortgage agreement is yawn-worthy read, it is probably one of the biggest debt you will have, so it is worth your time and pain to read it carefully before signing on the dotted line. If your banker or lawyer gives you the “hurry up” look, politely tell them to chill out and you need all the time to understand the biggest debt you have before signing it.
So, what is a mortgage?
In a nutshell, a mortgage is a legal agreement in which property is used as security for the repayment of a loan. If all of the agreed upon terms of the mortgage are met, the borrower will own the property outright by the end of the mortgage contracted period. Whew! That’s easy.
Now, let’s look at how a mortgage is built. Every mortgage has 3 parts:
- The principal mortgage amount – how much you borrow from the lender
- The interest rate – what is the interest rate that the lender will charge you during the contracted period
- The amortization period – the length of time it will take you to pay back the mortgage. If you are a Canadian and you have less than 20% of the purchase price as down payment, then the longest amortization period is 25 years. However, if your down payment is 20% or more of the purchase price, the maximum amortization period could be up to 30 years
Terms and Rates (or Nuts and Bolts)
Interest rate and term of the mortgage are the 2 items that typically end up costing you if you are not careful. There are two type of interest rate: fixed and variable rate.
- Fixed rate is just likes it name: the rate if fixed for the contracted period. If you sign up for a 5-year fixed rate mortgage at 4.5%, this means you will pay 4.5% annual interest on your mortgage debt for the next 5 years. Easy right?
- Variable rate is the opposite of fixed meaning your mortgage interest rate can go up or down during the contracted period. Variable rate mortgage can fluctuate because it is anchored against prime lending rate. Your variable mortgage rate would be prime rate minus (-) or plus (+) a certain percentage (%). For example: Your 3-year variable mortgage was 2.5% because your mortgage variable rate was Prime rate – 95% (Prime rate was 3.45% when you signed the mortgage agreement). Fast forward couple of months later, the Prime rate drops to 3.2% (a 0.25% drop or increase is typical), your mortgage rate is now 2.25% (3.2% – 0.95% = 2.25%).
What the heck is prime lending rate, you ask? Well, the prime rate is based on how much it costs banks to borrow money from the central bank (i.e.: Bank of Canada, Federal Reserve, European Central Bank, etc.). Yes, banks borrow money and a lot of it from central bank. The Prime rate is dictated primarily by the target for the overnight rate which is the key interest rate set by the central bank. When central bank raises the overnight rate, it becomes more expensive for banks to borrow money, thus the banks will raise their prime rates to cover their lending cost. It works the opposite way when central bank drops the overnight rate. On last thing, variable rate is typically lower than fixed rate
If variable rate is typically lower than fixed, so should we all get variable rate? There are many debates on this topic and there is no right or wrong answer on this. The choice of rate should depend on how much risk you can tolerate. Fixed rate is higher and boring but it is a stable option. You will know exactly how much your interest rate will be for the duration of your mortgage contract. In contrary, variable mortgage rate can fluctuate, but your mortgage payment will probably remain the same throughout the term of mortgage. The banks will only increase your mortgage payment in the event that your mortgage payment is no longer enough to cover your interest payment portion. It is unlikely scenario, but it is a possibility.
Even with this information, some of you would probably say no to variable rate option. There is one solution fit all as it depend on your situation and your risk tolerance. I know your probably bore to tears by now, but I need you to hang in there for couple more minutes because I have to tell you about the term of the mortgage. The term is what can cost you big money if you are not carefully considering your options. There are 2 types: Closed and Open term mortgage.
- Closed term mortgage means there are restrictions on what can be paid towards your mortgage during the term. For example, if you have a 5 years fixed rate closed term mortgage. Now you want to pay off or switch your mortgage to another lender before your 5 year term ends, the bank will charge you a penalty for breaking the contract. Typical it is 3 months interest penalty.
- Open term is the opposite of closed meaning there is no restriction on the term of your mortgage contract. Feel free to kick your banker to the curb and switch your mortgage to another lender because your bank can’t charge penalty on an open term mortgage
If open term is so flexible, why doesn’t everyone sign up for open term? Well, bank will charge a higher interest rate on an open term mortgage simply because you can walk away anytime. Flexibility comes with a cost. But there are times when you need that flexibility even at a high cost. For example, you may need to sell your house in a near future but you don’t yet know the exact time and you have to renew your mortgage now. You may want to take an open term to give yourself that flexibility to pay off your mortgage without penalty when you sell your house.
My last word on this subject is to explore your options. Ask your lender to present to you 4 to 5 mortgage rate options. Then carefully look at the payment amount, the total interest you will have to pay during the term and your situation before making any decision.
A Little Example
Take a look at a $300,000 mortgage balance. If you select a 5 year fixed and closed rate at 3.29%, you will pay $45,722 in interest payment and have a mortgage balance of $257,837 at the end of your term. If you select a 5 year variable and closed rate, you will pay $39, 485 in interest payment and have a balance of $255,681 at the end of your term. So, you will pay $6,240 less in interest payment and also end up with a lower mortgage balance of $2,156. Which means you will save $ 8,396 in the same 5 years period. But only you can be a judge of whether that saving ($8,396) is worth the feeling of uncertainly you will have to endure during the 5 years if you are not a risk taker.
Ok, we are almost done. Last thing that I want to highlight is the pre-payment option in your mortgage. Your mortgage may have pre-payment option. The most common ones are the 20+20 or 15+15 option. Essentially, this is the additional payment options that your bank allow you to make as one- off payment or increase your normal payment. Take the 20+20 option:
- The first 20 means you could pay a lump sum up to 20% of the value of the original principal mortgage amount once annually. Typically the minimum amount is $100 and the payment will go directly to the principal balance of your mortgage
- The second 20 means you could increase your normal weekly/bi-monthly/monthly payments up to 20%. The payment will go toward both principal and interest payment of your mortgage typically
Most people choose the second option to increase their normal payment by 20% and this may not be the best option for you. The first 20% option will save you more money because the payment goes toward your mortgage principal balance, while the second option will go to both principal and interest payment. Again, it is all in the fine print. If you are not certain, ask your lender to do a mock-up of your mortgage amortization schedule with first vs second option to see which option will save you more. In some case, I would advocate that the second 20% option may be right for you even if it doesn’t save you more money. The reason is some people like to have the set schedule and so option 2 is much more convenience and easy.
You are the boss of your finance and only you can decide which mortgage is right for you. Ask your lender/banker to present you with more options; you are entitled to know all information so you can make an informed decision. And, negotiate the heck out of it because you will have to pay a lot of money on your mortgage so every saving penny count.
Well, there is more mortgage information that I can share but these are the essential information that any mortgage borrower should know. Almost 2000 words count later, I fear that I may sufficiently put you to bed or comma out of boredom. I wish you all the best in your mortgage negotiation and read the agreement carefully before you sign on the dotted line.