The spring real estate market is gathering momentum. So here are a few things you should know about mortgages to avoid getting fleeced.
First of all, remember that a mortgage is a loan using your home as security. Lenders offer to provide the difference between what you pay for the home and the amount you shell out personally for a down payment.
The minimum down payment without being required to purchase mortgage default insurance is 20 percent of the purchase price of the home. So, on a $500,000 purchase, your down payment would have to be $100,000, and you would take on a mortgage of $400,000, or 80 percent of the value of the home. That $100,000 is said to be your “equity” in your home.
Here’s the catch, though. You’ll recover that equity only if you can sell your home for an amount greater than or equal to your purchase price. That’s why, for most average home buyers, financial planners place a great deal of emphasis on increasing your equity by paying down the mortgage as fast as possible.
When clients who are shopping for a home ask me about mortgages, I tell them I have six key rules to follow:
1. Make the biggest down payment you can
At the very least try to match or exceed the 20 percent threshold beyond which mortgage insurance isn’t necessary. Mortgages for more than 80 percent of the purchase price must be insured, and the insurance premium is added to the monthly payment.
2. Get the lowest interest rate you can
The mortgage market is ultra-competitive. Don’t be afraid to bargain (yes, even with the big banks). It’s amazing how quickly a prospective lender will price-match a lower rate if you are a good risk.
Consider variable rate mortgages, which typically have posted rates 30 to 50 basis points (that is, up to one half percentage point) lower than fixed-rate mortgages, only if you have a monthly cash cushion to withstand a sudden rate increase.
3. Reduce the amortization period as much as possible
This is the period over which the mortgage is scheduled to be paid off in full. The longer the amortization, the lower the monthly payments will be, but the smaller the monthly principal repayment and the higher the total interest paid will be. It’s a great deal for the lender—not so much for the home buyer.
Cut your amortization, even it’s only by a year to begin with. And keep reducing it at the end of every term (that is, the length of time your agreement with a specific mortgage lender is in effect), while maintaining or increasing your monthly payment.
4. Make prepayments
Lenders will often sweeten the deal by offering prepayment privileges—giving you the ability to pay off a lump sum of your principal amount without penalty every year up to a certain maximum percentage of the outstanding mortgage amount.
It reduces your principal amount immediately, so that more of your subsequent monthly payments also goes toward principal repayment, while your interest costs shrink dramatically. Another way to pay down principal faster is to establish a schedule of weekly or bi-weekly payments instead of monthly payments.
5. Watch for fees and penalties
Check for fees and penalties the lender may include for prepayments (including any that might apply if you sell your home before the mortgage matures and wish to pay off the mortgage in full).
6. Ask for help
Mortgage math can get complicated and downright confusing when you try to compare various rates and amortization periods, increase payment amounts, apply pre-payments, or increase payment frequency to weekly or bi-weekly. Online calculators can give you the basics, but your financial adviser is likely to have more sophisticated tools at hand to help you.
Courtesy Fundata Canada Inc. © 2014. Robyn Thompson, CFP, CIM, FCSI, is president of Castlemark Wealth Management. This article is not intended as personalized advice. This article has been edited from its original version.