Mortgage Types and Terms: What you need to know
Depending on your situation you will find a variety of mortgage option available. There are two main types of mortgages:
1) Fixed term mortgages
2) Variable Rate mortgage:
With each of these types of mortgages there are also:
1) Closed mortgages
2) Open mortgages
Let’s look at these in a little more detail:
Fixed Mortgages: OPEN and CLOSED
A fixed mortgage is normally set for a specific time periods from 6 month up to 10 years.
A fixed mortgage has a set interest rate for the term you agree on. At the end of the term you choose, the mortgage comes up for renewal. You then begin to renegotiate with the same lender or a different one, it is your choice.
Mortgages are normally amortized over 25 to 30 years in Canada
This means if you like 5 year fixed terms you would have 5 terms in a 25 year amortization period. You will be in negotiations at least 5 times during the life of the mortgage, unless you make pre-payments which we will cover later in this chapter.
An OPEN fixed term is normally for a 6 month to 1 year term. These are normally used when you intend to pay off the mortgage fast or sell it quickly once you own the house.
Interest rates are normally higher for these types of fixed mortgages as the lender knows you will only be in the mortgage a short time so they charge a premium interest rate to make it worth their while lending you the money.
I only recommend these when you have short term plans or are planning on flipping the house and selling quickly. With that in mind I normally always suggest the variable rate option instead as they are cheaper and charge a lower interest rate. If there are delays in your plans you can save money. You can also transfer the old mortgage to your new home in some cases.
The big advantage of an OPEN fixed term mortgage is that there is no penalty for paying off the mortgage sooner than the term you took. Let’s say you pay the mortgage off half way through the term. Normally you will be charged a penalty of at least 3 months interest.
With and OPEN fixed term there are no extra penalty charges. The disadvantage is that due to this feature the interest rates are always higher than a CLOSED fixed term mortgage.
A CLOSED fixed term is set for a specific period say 5 years and during this term your interest rate will not change. Your payment stays the same through the whole 5 year term.
The CLOSED term means, if you break the mortgage before the 5 year term is up the lender will charge a 3 month interest penalty or can charge an Interest Rate Differential penalty or IRD penalty.
IRDs are the biggest problem we have in the mortgage industry. Each bank can set their own Posted rate and this is what the lenders will calculate the penalty from.
The only time an IRD penalty is charged is when the current interest rate is less than your contracted 5 year interest rate. The bank will then use this formula to calculate their loss since you are paying out the mortgage early. They will then charge you the IRD penalty.
Let’s say you have a 5 year mortgage and you have 3 years left owing on the mortgage when you sell your current home. The interest rate is 5.70% on the 5 year term
Say you still owe $200,000 on the mortgage and the current interest rate is now 4% (so 1.7% lower than your current interest rate). This 4% is the POSTED rate of the lender you are working with.
The simple math is:
$200,000 remaining balance X interest rate difference 1.7% X 3 year remaining or $10,200.
So the IRD would be $10,200 compared to a simple 3 months interest penalty if your contract term rate is less than the current rate posted by your lender.
You can see how this can become expensive quickly if the new rates are lower than your current contract rate.
Variable Rate Mortgages: OPEN AND CLOSED
Variable rate mortgages are available in OPEN and CLOSED terms and usually in 3 or 5 year terms.
A variable rate mortgage means the interest rate will fluctuate (go up and down) in relationship to the Bank of Canada Prime Interest rate.
The Bank of Canada sets the prime rate every 6 to 8 weeks. Normally the rate will move in .25% increments but it can move in higher increments if the government sees fit to do this.
Each time the Bank of Canada moves the prime rate your bank will adjust your interest rate. They will send you a letter to state how much the rate has changed and what your new mortgage payment will be until the next rate change happens.
You want to use variable rate mortgages with lenders that allow you one free conversion back to a fixed term. This clause allows you to call the lender anytime during the term of the mortgage and request it be converted back to a fixed term.
You are required to convert back into a term equal to or longer than what is remaining on your current term.
The only risk with these mortgages is that when prime rates begin to increase the fixed rates have already begun increasing. Since fixed rates are based on the open Bond market they will reflect a rising interest period sooner than variable rates.
This means when you make the request to change to a fixed term. The fixed rates will have already been on the rise and will not be what the current fixed rates are. This has been what has happened in the past and will likely be the case in the future.
OPEN Variable Rate Mortgages:
These mortgages are based on the prime rate PLUS. Currently OPEN variable rates are at prime plus .80 to 1.00%.
The mortgage is OPEN which means no penalty is owed if the mortgage is paid out early.
CLOSED Variable Rate Mortgages:
These mortgages are based on the prime rate MINUS Currently CLOSED variable rate mortgages are at prime minus .50 to .60% off (currently).
The mortgage is CLOSED which means you will have a 3 month interest penalty similar to the fixed term mortgages. The good news is there is no IRD penalty as with the Fixed mortgages.
What other conditions and options are available with your new mortgage
Each lender has similar terms and conditions with their mortgages. The important items to watch for when looking at lenders and their mortgage options are as follows:
All lenders will allow you the privilege of making extra payments on your mortgage. They will have a variety of terms that you must meet to do this but in most cases as long as your payments are made on time as promised you can make extra payments.
Any extra payment you make will be credited to the principle mortgage balance. None of the money will be used to pay interest.
The lenders usually allow anywhere for 10 to 20% of the ORIGINAL mortgage balance to be paid each year.
You can pay anytime during the year and you can do it in a number of ways. You can increase your regular payment by 10 to 20%. Some lenders will allow you to double up each payment you make or you make bulk payments throughout the year.
You want to ensure any lender you use has a pre-payment feature similar to the one described above.
Transfer and Portable Option:
This option allows you to transfer your mortgage to another home once you have sold the current home that the mortgage is registered too.
If you transfer your mortgage to another home you can avoid any penalty on the old mortgage. It also can help you conserve your lower interest rate you may have. This option can save you thousands of dollars in penalties.
You are allowed to port the old mortgage to the new house. You can add more money to the old mortgage, but you must requalify to do this.
You can then blend your old interest rate with the current new interest rate which means you come up with a new rate somewhere in between the two rates.
Transferring your old mortgage can save you a lot of money in penalties and interest. It is well worth looking into once you own your own home and want to look at buying a new one.
Regular Payment Options:
Most lenders will allow you to make a variety of different choices for your regular payment. You can pay monthly, semi-monthly, bi-weekly or weekly. You can also use accelerated bi-weekly or weekly payments.
Accelerated payment options mean you will make extra payments each year. All of these extra payments will be credited to the principle balance of the mortgage.
With Bi-weekly accelerated payments mean you will make two extra payments per year. Weekly accelerated payments mean you will make 4 extra payments per year.
To really understand how much money you can save on your mortgage and other tips to help you save on your new mortgage please get a copy of my book called “How to Save Thousands on your mortgage”
You can visit my website at www.savethousandsonmortgage.com and download a copy. It’s FREE and if you implement the tips you will save thousands on your next mortgage.
There are many other terms and conditions with a mortgage but these are the main ones you need to focus on. They can help save you a lot of money if implemented with your new mortgage.