Choosing A Term You Can Live With
What term should you take? That’s a good question. Before you look at the issue of term specifically, there are things you should consider:
When you’re looking at term and interest rates, look also at what you can live with in terms of payment amounts, because trying to predict where interest rates are going is a tough job. There are many forces that affect Canadian interest rates – economic, political, domestic, and international.
Even the best economists cannot pinpoint this, so how can we. You can twist yourself into knots worrying what will happen. When the rates dropped in 1992 to their lowest in 35 years, no one thought that they will get that low again. They dropped even further. Since then we have enjoyed low rates and we don’t think of rates going in the double digits again. That’s wrong to assume as well. Who would have thought in 1978 that rates only 3 years later would go as high as 21.5%? Please check the graph below for a historical account.
Predicting interest rates is very much a gamble and one should be prepared to keep a close eye on the market.
Here’s a suggestion: If you feel that rates are at a point you can live with and you want to guarantee that rate as long as possible, go with a long term (5 years, 7 years, and 10 years). If interest rates appear to be rising, take advantage of the lower rate for as long as possible, and remember, if you sell your property, you can take the mortgage with you to the new property or have someone assume the mortgage. It could prove to be a great selling feature if you have an assumable mortgage at very low rate.
If rates appear to be falling, you can choose a shorter term (6-month convertible or variable-rate mortgage) that offers the flexibility to lock-in to longer term at any time, just in case the rates start going the other way.
Fixed vs. Variable Rate Mortgages
With a fixed-rate mortgage, the interest rate is set for the term of the mortgage so that the monthly payment of principal and interest remains the same throughout the term. Regardless of whether rates move up or down, you know exactly how much your payments will be and this simplifies your personal budgeting. In a low rate climate, it is a good idea to take a longer term, fixed-rate mortgage for protection from upward fluctuations in interest rates.
A variable-rate mortgage (also called adjustable-rate) provides a lot of flexibility, especially when interest rates are on their way down. The rate is based on prime and can be adjusted monthly to reflect current rates. Typically, the mortgage payment remains constant, but the ratio between principal and interest fluctuates. When interest rates are falling, you pay less interest and more principal. If rates are rising, you pay more interest and less principal, and if they rise substantially, the original payment may not cover both the interest and principal. Any portion not paid is still owed, or you may be asked to increase your monthly payment. Make sure that your variable-rate mortgage is open or convertible to a fixed-rate mortgage at any time, so that when rates begin to rise, you can lock-in your rate for a specific term.
Closed and Open Mortgages – What’s the Difference
An open mortgage allows you the flexibility to repay the mortgage at any time without penalty. Open mortgages are available in shorter terms, 6 months or 1 year only, and the interest rate is higher than closed mortgages by as much as 1%, or more. They are normally chosen if you are thinking of selling your home, or if expecting to pay off the whole mortgage from the sale of another property, or an inheritance (that would be nice).
A closed mortgage offers the security of fixed payment for terms from 6 months to 10 years. The interest rates are considerably lower than open, and if you are not planning on any one of the above reasons, then choose a closed mortgage. Nowadays, they offer as much as 20% prepayment of the original principal, and that is more than most of us can hope to prepay on a yearly basis. If one wanted to pay off the full mortgage prior to the maturity, a penalty would be charged to break that mortgage. The penalty is usually 3 months interest, or interest rate differential (I.R.D. – please refer to glossary for detailed explanation).
Buy first or sell first?
Which comes first–the purchase or the sale–is the greatest dilemma facing homeowners planning to move-up.
If you choose to buy first, make sure the offer to purchase is conditional on selling your current house. That way, if you sell your house, both deals proceed; if not, the deal is off, and you won’t be stuck with two homes. Selling first though will give you considerable peace of mind.
Knowing how much money you’ll get on the sale will help you establish a price range for the new house. Selling first allows you to negotiate the purchase more vigorously, too, since unconditional offers carry a lot more weight with sellers.
Market conditions are another important consideration in deciding which route to follow. In a seller’s market, you’ll probably do better selling after you’ve bought, but in a buyer’s market, it makes more sense to sell.
If you obtained an insured mortgage after April 1’st, 1997, the premium you paid on the mortgage is now portable to another property (if you closed before this date, it is not portable, meaning that if you bought another home and your mortgage needed to be insured, you must pay the applicable premium again.
The Amortization Period is the number of years it would take to repay the entire mortgage amount based on a set of fixed payments. The longer the amortization, the more interest is paid over the life of the mortgage. Therefore, when choosing the amortization period, careful planning should be done to meet your cash flows. Remember, the amortization can be easily shortened after the closing, by simply making arrangements to increase your payments.
MORTGAGE FEATURES – To Help You Become Mortgage-Free Faster
Monthly, bi-weekly, or weekly payments?
Once you have the mortgage amount, rate and amortization period, your monthly payment can be calculated. Now is the time to decide how often you want to make your payments, because by selecting the right payment frequency could literally mean thousands of dollars in savings. For example, on a $100,000 mortgage at 8% interest, amortized over 25 years, the monthly payments would be $763.21. However, by simply switching to bi-weekly payments (every two weeks) with payments of $381.61 (half of the monthly payment), there would be a saving of $30,484 in interest! Weekly payments of $190.80 will save $30,839 in interest, and you will be mortgage free in the 19’th year.
You notice that there is very little difference between weekly and bi-weekly payments, however. If you have other payments throughout the month, bi-weekly may be less stressful and easier to budget. If you are self-employed or commissioned, and your income varies greatly from week to week, it may be easier to pay monthly and use your prepayment privileges to knock the amortization period. Also, not all weekly and bi-weekly payments work the same as above. Let us show you how to manage your mortgage to your best advantage.
Prepayments – Extra Payments against Principal
This is one of the most important features to look for when you are getting a mortgage. Having the prepayment privilege that works to your specific needs could mean a difference of thousands of dollars over the life of your mortgage. Although all financial institutions offer some form of prepayment privilege, the amount and how it can be applied varies from one to another. Some offer only up to 10%, once per year, and on the anniversary date. Then there are others that offer as high as 20% per year, and prepayments can be done throughout the whole year as long as the total does not exceed 20%. Ideally, you should work your prepayment privilege as often as possible throughout the year. Saving aside to make that big prepayment is not the best strategy. We have found that the small, regular prepayments will get you quicker to that mortgage burning party (I hope we’re invited).
(TIP: Put your tax refund to good use. The average tax refund for Canadians in 1995 was $1,000. Even this amount will pay large dividends over the life of the mortgage)
Often times most mortgage shoppers are only looking at rates and overlooking this interest saving feature. That is why it is important to have a mortgage specialist make some recommendations for your specific needs. Not only can we find you the lowest rates, we can also get you the features that will work to your advantage.
Increase Your Regular Payment
The secret to borrowing is borrow early in your life. The reason is that the future value of the dollar decreases. Why we are bringing up this fact is that when you borrow early, your payments are set. As time goes, our incomes increase (hopefully), but our mortgage payments stay the same, provided you locked-in to a long term, fixed mortgage. Therefore, in the future we may be in a position to increase our payment on the mortgage, regardless if you are paying weekly, bi-weekly, or monthly. Any increase in payment is directly going to pay down the mortgage, thus saving you thousands down the road due to the effect of interest not compounding on that amount for the life of the mortgage. Neat little feature.
Again, this feature varies from bank to bank. Some allow increasing payment up to 10%, and others as high as 25% per year, some up to 15% only once in the term of the mortgage. If you increased your payments, should the need arise, you can go back to the original payments as well. A mortgage specialist will run a “Mortgage Reduction” model for you and make some recommendations.
Double-Up on Payments
A few lenders will allow you to double-up on your payments, and the extra payment goes directly in the principal. If you double-up once in the year, you have just achieved the benefits of the weekly or bi-weekly mortgage. This is a neat little feature for someone who prefers the monthly payments but wants the results of the weekly and bi-weekly payments. And some lenders allow you the flexibility to skip a payment if you have made a double payment previously. This defeats the purpose, but when times are tough, a neat little feature to have.
Early Renewal Option
This is a great feature to have when interest rates are on a rise. If you are locked-in to a term and the mortgage will be maturing in months or years down the road, and the mortgage rates are on a rise, you can renew your mortgage before the maturity and lock-in the low rates for a new term. You may not even have to pay anything out of pocket and still save over the term, especially if rates move up considerably.
If you want to take your mortgage with you when you move, you can if your mortgage has a clause that allows you to do that. This option allows you to continue your savings on your lower rate if the going rates are higher, as well as avoid any penalties if you were to break that mortgage. If you need a larger mortgage for the new property, your existing mortgage amount can be increased. As for the associated costs, since a new mortgage document must be registered on title, legal fees and normal appraisal fees would be applicable.
If you are moving and don’t want to take your mortgage with you, or you are selling and not buying, an assumable feature will allow the buyer(s) of your property to take over the mortgage, providing they meet the lender’s qualifying criteria. By doing so, you will not pay any penalties as you are not breaking the mortgage contract. In fact, if your interest rate is lower than those available at the time, your assumable mortgage suddenly became a great selling feature for your property.
A word of caution here: Just because someone assumes your mortgage does not necessarily mean you are off the hook for the responsibility. You must get a release from the Mortgage Company to ensure that you are no longer liable for it. Some mortgage companies automatically offer a release, but with others, you must make the request, and do it through your lawyer.
Mortgage Life Insurance (optional)
Since your home is likely your single largest investment, you may want to protect that investment. Many financial institutions offer mortgage life insurance at an affordable and competitive price, and the requirements for eligibility are usually quite simple to meet. If you or your co-borrower (if you choose joint coverage) die, the insurance company will pay off your mortgage. Also, some institutions now offer job-loss and/or disability insurance to borrowers. The best thing to do in making a decision about how to insure your mortgage is to have an insurance agent work out the figures for a private term insurance and mortgage life insurance.