Buying a home is often the biggest decision we ever make and the cost of it is usually the most crucial factor in that decision. As such, it is important to know what options are available for financing your residential home purchase and what choices you have if you can’t obtain financing through your first choice.
Where to start when looking for home financing
Unless you are fortunate enough to be able to afford a cash purchase, you will most likely need a mortgage to buy a property. A mortgage is a loan secured against the value of a property; the property is used as collateral in the event that the borrower defaults on the loan.
The details of the mortgage can vary greatly. Interest rates can be fixed for a certain period of time (usually between one and five years) or can be variable, which means the rate is relative to the Bank of Canada’s prime lending rate from which registered banks (usually) derive their commercial lending rates. The maximum loan amount and interest rate are generally determined based on the credit rating, income and fixed expenses of the borrower; people with better credit and more disposable income will be able to borrow more.
Although there are interest-only mortgage products, in most situations, with each payment the borrower pays off some of the principal (the amount borrowed) and some of the interest accrued at the agreed rate. Payments are often either monthly or bi-weekly and occur for the full length of the mortgage term, typically 3-5 years. This is not to be confused with the amortization period, which is the number of years the total principal loan is divided into (typically 20-25 years). When the Term of a mortgage expires, the borrower must renew the mortgage, which gives both parties a chance to re-negotiate the terms of the mortgage and, for the borrower, a chance to shop around again for a better deal. If your down-payment is less than 20% of the purchase price of the property (known as a high-ratio mortgage), you will be required to pay mortgage insurance in addition to your regular mortgage payments, which helps protect lenders against the increased risk of default.
Before starting your property search, it is advisable to get pre-approved for a mortgage. This is where a financial organization analyses your finances, income and expenditure and confirms how much you can borrow and at what rate. This gives you a much clearer picture of what you can afford to buy and will help you and your realtor find a location and house type most suited to your needs and budget. If you want to lock in your interest rate against short-term future increases, you can opt to go for a full Mortgage Approval, which is a bit more onerous, but it will commit the lender to lend you a certain amount of money, at a specific rate, for a short period of time (usually 120 days).
What is the mortgage stress test?
Since January 1, 2018, all mortgage applicants at federally regulated institutions in Canada have had to pass the OSFI mortgage stress test in order to qualify for a mortgage. This federally-mandated condition demands that borrowers must qualify at the contracted interest rate plus 2% or the Bank of Canada’s five-year benchmark rate, whichever is greater. This stress test was in effect for new insured mortgages previously but the new rules mean it now applies to uninsured mortgages (where buyers have a down payment of 20% or more) and also for mortgage refinancing and renewals if you are switching to a different lender.
There have been a number of articles written describing the effect that these rules have had on the real estate market. Many have argued the stress test has added to the struggle for many first-time buyers as it has reduced buying power in an expensive market, leaving intense competition for the few lower-priced homes. It has also been highlighted that the stress test affects the ability for borrowers to shop around when renewing their mortgage by potentially taking that option away. We spoke with Shubha Dasgupta, founder and CEO of Pineapple, about the effects of the stress test and he emphasized the impact it has had on buying power and the changes it has made to the mentality of buyers: “The stress test greatly affected borrowing as it reduced purchasing power by about 20%. An often less talked about impact was also in the way banks and lenders raise capital. This made it more difficult and more expensive; these costs were then passed along to the consumer in the form of higher interest rates. As some time has passed, consumer mentality has changed and we have all become more normalized to the changes which makes things a little easier to work with.”
While there are some vocal critics of the stress test, it seems that it is here to stay for the time being and that means it is something that buyers need to take into consideration when searching for a property.
Check back next week as we look at the mortgage application process in more details and explain many of the options available to you when you apply for a mortgage.