Pre-Qualify & Pre-approval (The Stress Test)
When applying for a mortgage, the lender wants to make sure you can afford it on a monthly basis. The lender does this with two debt ratios: the Gross Debt Service (GDS) Ratio and the Total Debt Service (TDS) Ratio.
The GDS Ratio looks at the percentage of your gross monthly income needed to cover expenses related to the home: your mortgage payments, property taxes, heating and maintenance fees (if applicable). Most lenders are looking for a GDS Ratio below 39%.
The TDS Ratio is similar to the GDS Ratio. It looks at all the same things as the GDS Ratio, however, it also factors in any other debt that you might have. If it’s revolving debt, such as credit card debt or a line of credit, 3% of the outstanding balance is usually used for debt servicing purposes. If it’s an installment loan with a fixed payment (i.e., a car loan, car lease, or personal loan), the payment is used for debt servicing purposes. Most lenders are looking for a TDS Ratio below 44%.
It should be noted that the mortgage payments used in these calculations are higher than you’re actually paying. That’s because the payments are calculated using the inflated stress test rate (5.25% or current rate + 2% whichever is higher)
While the GDS and TDS Ratios include some important homeownership expenses, it’s important to also factor in any other big expenses you may have, such as childcare expenses.
Types of Rate
Fixed-rate mortgage is a mortgage loan where the interest rate on the note remains the same through the term of the loan, payment amounts and the duration of the loan are fixed and the person who is responsible for paying back the loan benefits from a consistent, single payment and the ability to plan a budget based on this fixed cost.
Adjustable Rate Mortgage (ARM) the interest rate floats with the prime rate but the monthly payment will change as rates rise or fall. The amortization of your mortgage (how long it takes to pay it off) will not change.
There are pros and cons to an adjustable rate mortgage. You are forced to pay down your mortgage within the same timing you originally committed to with your lender. The downside is it can be difficult from a budgeting perspective if your mortgage payments keep increasing.
Variable Rate Mortgage (VRM) the interest rate floats with the prime rate but the monthly payments will remain the same unless interest rates rise to the point where you are no longer covering the required interest payments on the mortgage. The amortization of your mortgage will increase with rising rates and decrease if interest rates go lower than when your mortgage payment was originally set meaning you could pay off your mortgage sooner but conversely it could take you longer to pay off your mortgage and cost you more in interest charges.
Prime Rate
A prime rate or prime lending rate is an interest rate used by banks, usually the interest rate at which banks lend to customers with good credit. Some variable interest rates may be expressed as a percentage above or below prime rate.
Prepayment Privilege
A prepayment privilege is the amount you can put toward your mortgage on top of your regular payments, without having to pay a prepayment penalty. Your prepayment privileges allow you to: increase your regular payments by a certain percentage.
Prepayment Penalty
A prepayment penalty is a fee that your mortgage lender may charge if you: pay more than the allowed additional amount toward your mortgage. break your mortgage contract. transfer your mortgage to another lender before the end of your term.
Interest Rate Differential (IRD)
The IRD is a compensation charge that may apply if you pay off your mortgage prior to the maturity date, or pay the mortgage principal down beyond the amount of your prepayment privileges. The IRD is based on:
- The amount you are pre-paying; and,
- An interest rate that equals the difference between your original mortgage interest rate and the interest rate that the lender can charge today when re-lending the funds for the remaining term of the mortgage.
Most closed fixed-rate mortgages have a prepayment penalty that is the higher of 3-months interest or the IRD. Most variable-rate mortgages do not have IRD penalties.
Different Types of Mortgages
Insured, Insurable, and Uninsurable
Insured, Insurable, and Uninsurable
There are three main types of mortgages: insured, insurable, and uninsurable.
An insured or high-ratio mortgage is when you’re required to pay mortgage default insurance that protects the lender. Because of that, most lenders offer their lowest mortgage rates on these products (although this is offset by the mortgage default insurance you’ll pay).
An insurable or conventional mortgage is when you make at least a 20% down payment on a home. In this case, you aren’t required to pay mortgage insurance. This saves you money, but because it’s slightly riskier for lenders you’ll most often pay a higher mortgage rate than an insured mortgage.
An uninsured mortgage is a mortgage that doesn’t meet the government’s guidelines to be insured by any of the mortgage insurers. Examples include home purchases over $1 million and 30-year amortizations. Because of this, uninsurable mortgages tend to come with the highest mortgage rate.
Open vs. Closed
An open mortgage lets you repay the mortgage in full at any point during your mortgage term. Because of this, it tends to come with a higher mortgage rate. Open mortgages only tend to make sense if you expect a huge cash windfall or intend to sell your home in the near future.
A closed mortgage has limitations on how much extra money you can put towards your mortgage beyond your regular mortgage payments. Because of that it tends to come with a lower mortgage rate than an open mortgage.
- The amount you are pre-paying; and,
- An interest rate that equals the difference between your original mortgage interest rate and the interest rate that the lender can charge today when re-lending the funds for the remaining term of the mortgage.
Most closed fixed-rate mortgages have a prepayment penalty that is the higher of 3-months interest or the IRD. Most variable-rate mortgages do not have IRD penalties.
Term vs. Amortization
A mortgage term is the length of time the terms and conditions of your mortgage are guaranteed. If you have a fixed-rate mortgage, your mortgage rate will remain the same for the duration of the time.
The mortgage amortization is how long it will take you to pay off your mortgage in full. The standard length in Canada is 25 years, although there’s nothing stopping you from choosing a shorter or longer term (as long as you can pass the stress test).
