Chapter 5

Your Price Range, Mortgage and Pre-Approvals

How much can you afford?

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All lenders are different. Each has a different process for determining creditworthiness, and a different policy for assessing risk. However, they all use common benchmarks as a starting point in deciding how much mortgage debt you can handle. These benchmarks are called debt-to-income ratios and you can calculate them yourself using this debt service calculator from CMHC.

|Gross Debt Service Ratio (GDS)

The GDS measures how much of your total income goes to housing. The calculation is simple.

First, figure out your gross annual income. This is the total amount of money you earn each year, before taxes. Let’s say you have gross earnings of $100,000 per year.

Second, add up your total annual housing costs. This includes mortgage principal, interest and property taxes and heat. The CMHC includes 50 percent of your condo fees and lenders must also include secondary financing. Let’s say your total housing costs are $25,000 per year.

Divide your total housing costs by your gross annual income. The resulting percentage is your GDS. In this example, the GDS is 25 percent. Typically, lenders will not allow your GDS to go above 30 or 35 percent, and the federal government has set an absolute maximum of 39 per cent on high-ratio mortgages.

GDS=Annual Mortgage payments + Property Taxes
Gross Family Income

|Total Debt Service Ratio (TDS)

The TDS measures how much of your total income goes to housing and other debts.

Let’s continue with the previous example, where our fictional first-time homebuyer has a $100,000 gross annual income and $25,000 per year in total annual housing costs.

Add together the monthly payments due on your credit cards, line of credit, car loans and personal loans, along with any other monthly debt payments. Let’s assume you have $700 per month in monthly debt payments, for a total of $8,400 per year.

Add together your housing costs ($25,000) and debt servicing costs ($8,400) for a total of $33,400. Divide this total by your gross annual income, to get your TDS. In this example, TDS is 33 percent. Typically, lenders will not allow your TDS to go above 43 percent.

TDS=Annual Mortgage Payments + Property Taxes + Other Debt Payments
Gross Family Income

|Using a Mortgage Calculator

Now that you understand debt-to-income ratios, the online mortgage calculators will make more sense. Enter your personal financial figures into this Ratehub Mortgage Affordability Calculator to get a general idea of how much mortgage you will qualify for.

|Borrowed Down Payments

In Chapter 4, we explored the possibility of borrowing a down payment for your home. Now that you understand debt-to-income ratios, you can see how this is possible. If you have a good income and no debt, your GDS and TDS will be low. Taking out a personal loan for a down payment will increase both ratios, but you may still be under the threshold to qualify for a mortgage. For more information on borrowed down payments, see Chapter 4.

How to increase the amount of mortgage you can qualify for

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Perhaps you’ve calculated your TDS and GDS and found that your dream home will put you over the thresholds. Or maybe you’ve used an affordability calculator and you’ve been disappointed at the amount you’ll probably qualify for. What now?

|Pay off your debt

The more debt you have, the higher your TDS will be. The fastest way to lower your TDS (and qualify for a bigger mortgage) is to pay off your debt as quickly as possible. In some cases, using part of your down payment savings to pay off unsecured debt will increase the mortgage amount – even though you’re putting less down on the house.

|Increase your income

If you are planning well in advance, you may have time to increase your income before you set out to purchase a home.

If you are employed, you can ask for a raise or take a promotion that comes with an increase in pay. Overtime, if consistent, can also serve to increase your qualifying income.

If you are self-employed, most lenders will ask to see your Notice of Assessment from Revenue Canada, dating back at least two years (and possibly three). In the years before you purchase your home, consider leaving tax deductions on the table to keep your total income higher. Lenders will typically look at Line 150 on your NOAs, and writing down your income with tax deductions will lower that number. Some banks, however, will add back up to 15 percent of your gross income to account for deductions. Your accountant will be able to provide you with advice on these issues.

|Adjust your expectations

Sometimes, it makes sense to adjust your expectations. In Toronto’s hot housing market, first-time homebuyers often find themselves looking at condominiums instead of a single-family home. If you have your heart set on a single-family home, you may have to compromise and buy outside the city, and commit to a daily commute. At TorontoProperty.ca, we’ve helped many people find more affordable homes outside the city with excellent commuting options, too.

Understanding your mortgage options

Types of Mortgages

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Before you sit down with a lender, spend some time considering what type of mortgage you want. There are many mortgage products on the Canadian market, and we’ve listed the standard mortgage options you’re likely to encounter as you set out to buy your first home. Read this list, and then consider what will work best for you.

Conventional Mortgage

To get a conventional mortgage, you must have a 20 percent down payment. It is a traditional, straightforward mortgage.

High-Ratio Mortgage

To get a high-ratio mortgage, you must have a 5 percent down payment. If you take out a high-ratio mortgage, you must also buy mortgage default insurance, which protects the lender if you can’t make your payments. Insurance premiums can be as high as 4.5 percent of the purchase price, and you must also pay provincial sales tax on your premiums. For more details on mortgage default insurance, see Chapter 3.

In the fall of 2016, the federal government instituted new rules to make sure Canadians will be able to make their mortgage payments when interest rates start rising. When you apply for a high-ratio mortgage, the lender will apply a “mortgage rate stress test.” Even if the bank is offering you a very low mortgage rate, you must qualify for your mortgage at the Bank of Canada’s conventional five-year fixed posted rate, which is higher. You can learn more about the 2018 stress test here.

Portable Mortgage

If you choose a portable mortgage, you can take it with you when you move, though the government requires you to re-qualify each time you move. This can be a good option if you’ve secured a low interest rate and later decide to move. Be sure to read the fine print.

Assumable Mortgage

If you take out an assumable mortgage and later decide to sell your home, the buyers can take over (assume) the mortgage. An assumable mortgage can be a selling feature if you’ve locked in a low interest rate and current posted rates are higher. For this reason, assumable mortgages are popular when interest rates are rising. These types of mortgages can also be helpful if you decide to sell mid-way through your mortgage term; if your buyer assumes your mortgage, you can significantly reduce or even eliminate the fees associated with breaking a mortgage.

Vendor Take-Back Mortgage

A vendor take-back mortgage allows the seller to help the buyer by loaning some or all of the mortgage financing required to purchase the property. In some cases, the seller will also pay closing costs, such as land transfer taxes or appraisal and survey fees.

These types of mortgages are practically unheard of when markets are stable and interest rates are low. In a buyer’s market, or when interest rates are high, sellers will offer VTB mortgages at lower rates to entice buyers.

Blanket Mortgage

A blanket mortgage covers at least two pieces of real estate, and possibly many more. This type of mortgage is typically used by developers and investors, so you’re unlikely to need one as a first-time home buyer. It is possible, however, that a co-op or co-ownership building has a blanket mortgage, and that you’ll be entering into this agreement should you choose to buy into that building. Be sure to consult with your lawyer and an accountant if you find yourself considering a home with a blanket mortgage.

Fixed Rate Mortgage

As the name suggests, the interest rate on a fixed-rate mortgage is “fixed” for a term, usually between one and five years. Your payments will remain the same for the duration of the term, with the same split between principal and interest. Your rate is locked in for the term, so you’re protected if interest rates go up. In exchange for this stability and predictability, the interest rate is slightly higher than other mortgage options. Most Canadians choose fixed-rate mortgages.

Variable Rate Mortgage

The interest rate on a variable-rate mortgage changes based on the prime rate, for a term usually ranging between one and five years. Your payments will remain the same for the duration of the term, but the split between principal and interest will change. When interest rates are low, more of your payment goes to the principal; when interest rates are high, more of your money goes to interest. Variable-rate mortgages typically feature a lower interest rate, but in exchange for the lower interest rate you give up a measure of stability and predictability.

Adjustable Rate Mortgage

The interest rate on an adjustable-rate mortgage changes with prime, just like a variable-rate mortgage. However, with an adjustable-rate mortgage, your payment amount will change along with your interest rate. This means that when interest rates are low, your mortgage payment will stay low; if interest rates rise, your mortgage will go up. Interest rates on adjustable-rate mortgages are typically lower than those on fixed-rate mortgages. These types of mortgages are best for people who have lots of flexibility in their budget and are comfortable with sudden mortgage payment increases.

Convertible Mortgage

A convertible mortgage allows you to transition from a variable-rate or adjustable-rate mortgage to a fixed-rate mortgage, typically without paying any fees. Some convertible mortgages allow you to transition from a short fixed-rate mortgage into a longer fixed-rate mortgage. These types of mortgages allow you to take advantage of lower rates, but also convert and “lock in” when interest rates start to rise.

Cash-Back Mortgage

If you secure a cash-back mortgage, you’ll get extra money from the bank that can help with closing costs, pay the moving company and maybe even finance some renovations in your new home. However, these mortgages have a steep price tag. You’ll pay a higher interest rate, which could cost you tens of thousands of dollars over the life of the mortgage. Most, if not all, cash-back mortgages also have clawback features that will cost you dearly when you sell your home. Be sure to read the fine print.

Open Mortgage

An open mortgage offers a great deal of flexibility. You can make large lump-sum payments, or you can pay it off entirely at any time. In exchange for this flexibility, you will typically pay a higher interest rate. However, an open mortgage can be a good option if you are expecting an inheritance or another substantial sum of money in the near future.

Closed Mortgage

Most first-time home buyers will secure a closed mortgage, which offers lower interest rates and less flexibility. Depending on the terms of your mortgage, you will only be able to repay a certain amount per year over and above your set payments. If you come into money and choose to pay your mortgage in full, you will pay a penalty for doing so.

What is the mortgage term?

The term is the length of time that you’re locked into the mortgage deal with your lender.

If you select a five-year term, you will be committed to making mortgage payments under the same terms and conditions for five years. Shorter terms usually attract lower interest rates; the longer your term, the higher the rate.

At the end of the term, your mortgage will come up for renewal. If you like the lender, the terms and the interest rate, you can stay where you are. You are also free to take your mortgage business elsewhere.

To change anything about the deal, you will have to “break” the mortgage and pay a hefty fee. For example, if interest rates go down and you want to take advantage of the lower rates on offer at a different bank, you’ll have to weigh the potential savings against the penalty you’ll pay for breaking the mortgage. Ratehub has calculators that will help you estimate the penalty for breaking your mortgage and the amount of interest you’ll pay on your new mortgage.

When you break the mortgage, you’re not following through on your commitment and will be penalized by the lender. Typically the lender will charge you three months’ interest or “penalty interest” called the Interest Rate Differential. This differential is based on a formula set by your lender, and is designed so the lender breaks even on the deal. You’ll want to do the math before breaking the mortgage, to see if it’s worth it2.

What is the amortization period?

The amortization is the length of time it will take you to pay off your mortgage in its entirety. In Canada, the maximum amortization period is 35 years. (Federally regulated mortgages have a maximum 30-year amortization, while some provincially-regulated lenders still offer 35-year amortization schedules). High-ratio mortgages insured by CMHC have a maximum amortization period of 25 years.

A long amortization period will lower your monthly mortgage payments but increase the amount of interest you pay on your mortgage loan. A short amortization period will increase your monthly mortgage payments but can significantly reduce the amount of interest you pay. Use this RateHub calculator to see the difference that short and long amortization periods will make to your bottom line.

The components of a mortgage

When you select a mortgage, you will put several of these components together. Your mortgage puzzle will eventually look something like this:

  • A conventional, 10-year, fixed-rate mortgage at 6.85%, amortized over 30 years.
  • A conventional, five-year, fixed-rate mortgage at 2.84%, amortized over 30 years.
  • A high-ratio, three-year, variable-rate mortgage at 2.89%, amortized over 25 years.
  • A high-ratio, one-year, adjustable-rate convertible mortgage at 1.65%, amortized over 15 years.

Getting pre-approved for a mortgage

The first concrete step toward buying your first home is to get pre-approved for a mortgage. A pre-approval is a conditional guarantee that the bank will give you a mortgage. It establishes the maximum amount of money available to you and serves as a powerful negotiating tool once you’ve identified a home you’d like to buy.

Using your newfound knowledge, you can confidently shop for the mortgage product that best suits your needs. Once you’ve decided what you want, sit down with the lender to get pre-approved. The mortgage broker or specialist will want to see your financial records, including some or all of the following:

  • Pay stubs and a letter of employment, if you’re an employee
  • Two to three years of Notices of Assessment, if you’re self-employed
  • Account statements showing your savings for a down payment and closing costs
  • A gift letter from family stating how much money they will put toward your down payment
  • Identification, such as a driver’s licence or social insurance number

The lender will ask for your permission to pull your credit report, and with all of this information in hand he or she will evaluate your financial situation and pre-approve you for the maximum mortgage loan you can reasonably expect to get.

The pre-approval may come with an interest rate guarantee as well sometimes called a “rate lock.” This can protect you against rising interest rates. It may be valid for up to 120 days, depending upon the lender.

Once the pre-approval is complete, you will receive a copy to take with you.

Why should I get pre-approved for a mortgage?

There are many benefits of getting pre-approved for a mortgage.

First, you will know precisely what your maximum mortgage can be, so you won’t waste time looking at houses you can’t afford. Real estate agents and sellers will take you seriously because they know you’re prepared to buy.

Your pre-approval is also a powerful negotiating tool: when you are able to make a firm offer (instead of an offer “conditional on financing”), it shows the seller that you are fully prepared to close the deal. In Toronto’s extraordinarily hot real estate market, this can make the difference between getting the house and not getting the house. Sellers like to know that potential buyers already have financing in place.

Is pre-qualification the same as pre-approval?

No. A pre-qualification is a superficial review of your financial position and a rough estimate of what you might qualify to borrow if you apply for a mortgage. To pre-qualify for a mortgage, you need only tell a lender how much you earn, how much you have saved, and give a cursory account of your assets and liabilities. The lender takes no steps to verify what you’ve said, and makes no guarantees as to the accuracy of the estimate he provides. When you’re in the market for a house, a pre-qualification does not offer the same benefits as a pre-approval.