Overheard in Leonard cafeteria: students talking about purchasing a house on Aberdeen.

They were discussing how renting a house was a dumb idea, concluding it would be a much wiser investment to purchase a house rather than paying rent to a landlord and having nothing to show for it. It was a no brainer, they agreed. They would all go to a local Kingston bank tomorrow and apply for a mortgage.  

Little did they know how complex mortgages really are — let me tell you why. 

Gone are the days when house prices represented a small multiple of your annual income. That’s where mortgage loans come into play. 

Down Payments 

The first thing you will need to consider when buying a home is how much of a down payment you can afford. That is, how much cash of your own do you have to purchase a house. 

The size of the down payment you can afford will affect the type of mortgage you can get. In Canada, there are two types of mortgages: conventional mortgages where you pay a down payment of at least 20 percent of the purchase price; or a high ratio mortgage where you can only afford a smaller down payment. 

High ratio mortgages are more risky loans for banks, so they require you to obtain mortgage insurance and to pay the insurance premiums.  

Mortgage Loans 

A mortgage loan is similar to any other loan in that there are four variables; (i) the principal amount of the loan; (ii) the interest rate; (iii) the term; and (iv) the amortization period.   

The Principal

The amount of money that the bank is prepared to loan you is called the “principal” amount of the loan. The principal amount of the loan together with your down payment would form the top end of your housing purchase budget, or the amount of money you have to spend on a house.     

The Interest Rate

Banks are not in the business of lending money without something in return. This “return” is the interest that you will pay to the bank on your loan. 

Mortgage loans have the lowest rate of interest for borrowers because the risk of the bank losing money if you default is very low. 

The Term 

The term of the loan is the period during which the loan is outstanding, at the end of which you will have to pay the bank back the principal amount remaining. 

Most mortgage loans have five-year terms but it isn’t expected that you will repay the principal amount fully during that five-year period.  It would be almost impossible unless you won the lottery or received an inheritance. 

The Amortization Period 

For this reason, mortgage loans are amortized over a longer period than the term of the loan. The amortization period is the period of time that it will take you to pay off your loan completely.  

The longer the amortization period, the lower the amount you will have to pay the bank on an annual basis. But in the end, you will pay more interest as the principal amount is outstanding for a longer period of time.    

So, let’s go back to a house that those overheard students wanted to buy.

Let’s assume the house is listed for $499,000, a realistic price for a house in the University District. .  

Let’s say they have $25,000 lying around to meet the minimum five percent down payment and the bank loans them the balance, plus the mortgage insurance, as this is a high ratio mortgage.

They then obtain a five year variable rate mortgage with a 25 year amortization period and an interest rate of 2.6 percent. 

Their monthly mortgage payments would be around $2,200 

At the end of the five year term they would’ve paid the bank around $60,000 in interest all told and they would still owe about $400,000, that would presumably, take the next 25 years to pay back.   

While $2,200 per month may not seem like a lot to buy a house compared to paying rent, they would also have to pay home insurance, property taxes and some amount for maintenance and repairs.          

Loan to Value (LTV)

When reading mortgage loans, the term Loan to Value (LTV) is frequently mentioned. LTV is the amount of money being loaned against the value of the property. This metric is used by banks to help assess the risk of their loan. The higher the LTV, the riskier the loan. 

Let’s use an example of a property that is valued at $100,000 and compare a 60 percent LTV to an 80 percent LTV.  

If the LTV is at 60 percent, the bank is prepared to lend you $60,000 and if the LTV is 80 percent, the bank is prepared to lend you $80,000.  

In the 80 percent LTV situation, the bank is taking a greater risk. If the value of the property is reduced by 20 percent or more, their principal will be at risk. 

Whereas in a 60 percent LTV situation, the bank has a much greater cushion. The property would have to lose 40 percent or more of its value for their principal to be at risk. To account for this higher risk, the bank will charge a higher interest rate for an 80 percent LTV loan than a 60 percent LTV loan.

Now you can confidently walk into a bank to talk to them about a mortgage loan.