First Time Home Buyers Guide: 2020 Edition
In 2018, 457,600 Canadians purchased a home, that’s a lot of people for one year! Purchasing a property is one way of investing your money explaining why buying a home is a popular endeavour for many Canadians. Not only does investing in a home help you save money for the future, it provides you with a long-term living situation. No wonder so many Canadians are purchasing properties!
While there are many benefits to purchasing a home in Canada, it’s a big commitment both from a financial and lifestyle perspective. Educating yourself on the process of purchasing a home and all of the necessary requirements and restrictions can help you make informed decisions related to your first home purchase. Afterall, the home buying process is extremely daunting if you have never been through it before, it helps to learn a little before committing to anything. My Rate Compass realized the need for Canadian consumers to educate themselves on home purchases and has created the below guide to answer all your queries!
Everything You Need to Know About Mortgages
What is a Mortgage?
A mortgage is a type of loan that is used to purchase property. Some basic features of mortgages include the purchased property is always used as collateral and regular payments to the lender are required. Mortgages sometimes cover the cost of property taxes and insurance premiums in addition to the cost of the property.
Mortgages are quite substantial in size monetarily, they can even be worth millions of dollars! Because of the large size, there’s a higher chance that the borrower could default. In the event that a borrower does default on their loan, the lender has the right to seize the property, sell it and use the proceeds to pay off the mortgage. Lenders use the property as collateral to protect themselves from the borrower defaulting.
The payments to the lender consist of both principal and interest payments, with interest payments being larger at the beginning of the mortgage term. As the mortgage term goes onward, interest payments get smaller while principal payments get larger. You pay the same amount every period, simply the breakdown of principal and interest payments differ.
Components of a Mortgage
As you can probably imagine, mortgages are more complex than simply obtaining a loan with the property used as collateral. Given that a property purchase is likely the largest purchase you will make in your life, there are plenty of conditions, options, requirements and restrictions involved. Let’s explore these components further below.
Fixed versus Variable Interest Rates
A fixed interest rate means that the interest rate applicable to your mortgage will stay consistent throughout the mortgage’s life regardless of external activity. A variable interest rate changes as your bank’s prime rate changes. More specifically, the interest rate fluctuates based on the decisions the Bank of Canada makes. The Bank of Canada makes their decisions based on the state of the economy, so your mortgage interest rate essentially fluctuates based on external activity. Generally speaking, when the prime rate increases, your mortgage variable rate will increase. When the prime rate decreases, your mortgage rate will decrease.
Deciding between a fixed and variable interest rate is one of the most challenging decisions when obtaining a mortgage. It’s a tough decision to make because no one knows what will happen in the future and the future has a great impact on interest rates. If you feel that economic conditions will be favourable in the future, its best to go with a variable interest rate. On the other hand, if you feel the economic conditions will be unfavourable, it’s better to go with a fixed interest rate.
Furthermore, fixed interest rates are ideal if you want a more stable and reliable loan payment schedule. Choosing a variable interest rate is ideal if you think the prime rates will be lower in the future and you are able to handle fluctuating payments. Keep in mind that you can change between fixed and variable interest rates when refinancing or renewing your mortgage.
Open versus Closed Mortgages
An open mortgage means you can pay off your mortgage balance early without a penalty. Closed mortgages only allow for a certain lump sum payment each year in addition to the regular payments. Although, some closed mortgages don’t allow lump sum payments at all.
Borrowers tend to choose closed mortgages because they have lower interest rates. Closed mortgages have lower interest rates because the lender doesn’t have to worry about the lost interest if a borrower pays off a loan early. However, if you expect that you will have the money to make large lump sum payments towards your mortgage, then an open mortgage is a better option. Lump sum payments go towards the principal balance only, you will end up paying less interest overall this way.
An amortization period is the duration of time you’ll be required to pay the principal and interest payments towards your mortgage. When an amortization period is long, your monthly payments will be lower, but you will pay more interest and vice versa. Note that an amortization period is not the same as a mortgage term. Mortgage terms will be discussed below.
Canada offers mortgage default insurance, also known as CMHC Insurance, which is mandatory for mortgages with down payments between 5% and 19.99%. Mortgage default insurance protects lenders from borrowers who default on their loans. The cost of mortgage default insurance is between 2.8% and 4% of the mortgage’s total value. However, with the insurance, lenders are able to offer lower interest rate because of the reduced risk. The cost of the insurance is essentially cancelled out with lower interest rates. Since mortgage default insurance is mandatory, it’s automatically set up on mortgages with down payments between 5% and 19.99%.
The maximum length of an amortization period depends on whether or not mortgage default insurance is applicable on your mortgage. Amortization periods can be up to 25 years in Canada with insurance. Without insurance, they can be as long as 30 years.
A mortgage term is the length of time which the conditions of the loan are in legal effect. A mortgage term is usually expressed in years and can range anywhere from six months to ten years. In Canada, mortgage terms tend to be five years on average. Both the borrower and the lender are required to follow the legal conditions of the mortgage for a specified period of time. When a mortgage term ends, the remaining balance of the loan must be refinanced, renewed or paid in full.
Individuals usually plan their mortgage terms around interest rates. The interest rate you receive on a mortgage depends on the mortgage term. Also, individuals can play around variable and fixed interest rates using mortgage terms. For example, if you think variable interest rates are going to be high for the next three years, you can get a fixed interest rate mortgage with a term of three years. At the end of the three years, you can reassess the situation and alter the interest rate type you have when refinancing or renewing.
Whenever you change how often and how much you pay towards your mortgage, it’s known as an accelerated payment. As an example, if you change your payment frequency from monthly to bi-weekly that would be considered an accelerated payment.
Some lenders will allow you to increase the payment amount by a certain percentage. The increase goes towards your principal only, the goal is to pay off your mortgage faster. This is also considered an accelerated payment. There is typically a cap on how much you can increase your payments, the percentage cap is often around 20%.
It’s possible to pay off a mortgage early, although, you may be subject to a prepayment charge. Most lenders only allow for a certain amount of additional payments every year. If you exceed that amount, you might incur a prepayment charge. Lenders charge this fee because it’s meant to replace the lost interest. Usually the additional payments you can make are around 20% of your total mortgage but check with your lender to determine how much extra you can pay towards your loan without penalty.
Sizing of a Mortgage
Mortgages are substantial in size monetarily, before obtaining one you will need to plan and budget accordingly. Before you shop for homes, you will want to determine how much you can reasonably afford on mortgage payments. One third of your monthly income for all housing costs, including mortgage payments, property taxes and maintenance fees, is a good benchmark for your budget.
If you’re contributing over 50% of your income towards housing, you are likely overspending. At this point, saving for retirement and other things will become challenging. Buying a home should be affordable and comfortable, not stressful for your wallet!
Getting pre-approved for a mortgage means that a lender assesses you as a mortgage candidate and determines how much they would approve you for a mortgage ahead of time. Once you get pre-approved for a mortgage, you can start shopping for homes worth the amount that you are pre-approved for. When you find a home, the process of securing financing will be much smoother because you’re already pre-approved.
Pre-approved mortgages are great because it will prevent you from bidding on a home only to find out you can’t get approved for a mortgage. Pre-approval also helps you stick to a realistic budget when shopping for homes. Keep in mind that pre-approved mortgages expire, the offer won’t be available to you forever.
Working with Mortgage Lenders
In Canada, individuals have several mortgage lender options which consists of banks, brokers, credit unions and private lenders. Banks are the most popular option given that most already work with a bank for their day to day personal finance needs. Although, most banks have high interest rates compared to other lenders. If you want the most optimal rate with a bank, you will have to negotiate which can be time consuming.
Brokers tend to offer lower rates compared to banks. Offering a lower interest rate is possible because they tend to do the work of comparing interest rates and selecting the lowest one for you. Brokers make their money by taking a small percentage of the total loan amount from the lender.
Credit unions can be easier to work with because they usually favour the borrower over making a profit. In addition, you can usually get approved for a higher amount with a credit union when compared to a bank or broker. Although, you will still need to work with the lender to secure a low interest rate.
Last but not least, you can obtain a mortgage from a private lender. Working with a private lender can be less stressful because they tend to be more lenient about terms and payment structures. They often work with individuals who got declined by traditional lending institutions. While these factors of working with a private lender seem appealing, the interest rates are typically sky high. Interest rates as high as 15% are not unheard of when working with a private lender. Private lenders are able to charge high interest because they’re working in an unregulated market and have higher risk clientele.
The Stress Test
Starting January 1, 2018, the Office of Superintendent of Financial Institutions (OSFI) implemented the stress test. The OSFI requires that all individuals who borrow from Canadian banks undergo the stress test to ensure that they can make their payments if interest rates rise.
This new stress test is also referred to as B-20 and replaced an older stress test system. Using the stress test, individuals must prove that they can afford their mortgage if interest rates increase to the five year Bank of Canada average rate or by two percentage points, whichever is higher. Unfortunately, the stress test has lead to a loss of buying power from borrowers. Borrowers can no longer obtain a mortgage unless they pass the stress test which has made it challenging for some Canadians to buy a home.
Everything You Need to Know About Down Payments
What is a Down Payment?
Unless you’re extremely wealthy, you will likely need to finance your home purchase as opposed to buying it outright. When you purchase a home with a mortgage, the purchase is divided into two categories: the mortgage and the down payment. As we saw above, the mortgage is what you pay the lender over time. The down payment is what you pay the seller up front.
A down payment is a large, upfront payment that goes towards the value of home directly. None of the down payment is an interest payment to the lender. As an example, if the home you want to buy is worth $1 million and you make a down payment of $100,000, the amount you owe the seller is $900,000. The remaining balance, $900,000, will become your mortgage.
Not only do down payments reduce the total amount of your mortgage, they serve as a bargaining tool with lenders. The more you put down, the more power you will have to negotiate lower interest rates and other conditions with mortgage lenders.
A down payment is not cheap, usually people put down 10% to 20% of the total home’s value. If you don’t have that money right now, you might be thinking you can finance the down payment. However, a down payment shouldn’t be financed for two reasons.
First of all, it’s illegal to pay the full price of a property with a mortgage in Canada. It is possible to finance a down payment outside of your mortgage, however, this brings us to the second reason you shouldn’t finance a down payment. Financing a down payment externally means you’ll be managing another type of debt which is risky and expensive in conjunction with your mortgage. The majority of Canadians save up for a down payment because of the risks associated with financing a down payment. Too much debt all at once is never a good idea!
Down Payment Minimums
Down payments have rules in Canada, you can’t put down any amount you want! According to the Canadian government, below are the down payment rules:
- For a home that costs $500,000 or less, 5% of the purchase price is the minimum down payment
- For a home that costs between $500,000 and $999,999, 5% of the first $500,000 of the purchase price plus 10% of the excess amount over $500,000 is the minimum down payment
- For a home that costs $1 million or more, 20% of the purchase price is the minimum down payment
The above are down payment minimums, you are allowed to pay a bigger down payment if you can afford it. Paying a larger down payment is favourable to you because you will be financing less with your mortgage and paying less interest overall. Although, it can be challenging to make a 20% down payment or greater, especially in expensive Canadian cities such as Toronto and Vancouver. Work with your budget when determining a reasonable down payment for your financial position.
What is the 20% Rule?
When you make a down payment of less than 20%, the rest of your home’s purchase will be financed with a mortgage which would be 80% or more of the purchase price. The government of Canada doesn’t like when individuals finance 80% or more of their home. For this reason, they created the 20% rule.
The 20% rule states that individuals who make a down payment of less than 20% are legally required to buy insurance for their mortgage. Mortgage default insurance must be purchased from the Canada Mortgage and Housing Corporation, also known as CMHC Insurance.
Individuals required to get mortgage insurance must pay insurance premiums on top of all the other housing costs. While this is an extra cost to worry about, lenders usually offer lower interest rates with mortgage insurance so the costs basically cancel each other out.
Canadian Government Savings Plans and Your Home Purchase
Registered Retirement Savings Plan (RRSP) and the Home Buyers’ Plan (HBP)
If you’re planning to purchase a home and have a Registered Retirement Savings Plan (RRSP), the Home Buyers’ Plan (HBP) allows you to withdraw money from your RRSP to put towards your home without any tax implications. Normally, when you withdraw from an RRSP, you will be subject to harsh taxes. The HBP works around these tax implications of withdrawing from an RRSP to allow Canadians to finance a home purchase.
Effective in 2019, you’re allowed to withdraw up to $35,000 from your RRSP under the HBP. All of the withdrawals from the RRSP under the HBP must be done within one calendar year, in other words, between January and December of one year. The drawback of the HBP is the amount you withdraw must be replaced within 15 years. In a way, this is another payment to consider when purchasing your first home if you use the HBP.
In addition to an RRSP, the Canadian government offers a tax-free savings account, TFSA for short. A TFSA is beneficial because all of the investment income earned within the account is tax free, similarly to an RRSP. To help you save for a down payment and the other costs of property ownership, consider using a TFSA. TFSAs don’t have the same harsh withdrawal tax implications as an RRSP does, you can withdraw from a TFSA anytime you’d like.
An RRSP and a TFSA are both amazing savings tools for home ownership and other savings goals. The particulars of these accounts are beyond the scope of this article. To learn more about special Canadian government accounts, visit this website.
Other Costs to Consider When Buying a Home
If you haven’t realized it already, mortgages and property ownership is a big commitment. Not only are you responsible for the mortgage payments, you are required to pay for any additional housing costs during and after the purchase. Fortunately, many of these extra housing costs are measurable, you merely need to build a fund to cover the costs when they come up. Below are some extra costs you can expect to incur when buying and owning a property.
An appraiser assesses the value of the property you’d like to buy to ensure that you’re paying a reasonable price. As a first-time home buyer, you’ll likely want to hire an appraiser because you aren’t as experienced and want to guarantee that you get your money’s worth. Appraisals typically cost $300 to $500 each.
“Title” refers to legal ownership of a property. Purchasing title insurance is not absolutely necessary, but it can protect you against losses related to title ownership. For example, having title insurance would protect you from forgery, fraud and identity theft. Title insurance can be purchased from a title insurance company or your real estate lawyer and it costs between $250 and $350.
Land Transfer Taxes
Every province (excluding Alberta and Saskatchewan) requires land transfer tax payments once the sale of your new property closes and the property is officially yours. The amount of land transfer tax you pay depends on the cost of the property and the debt you took out to purchase it. Fortunately, first time home buyers are often eligible for a discount.
In Toronto, you are required to pay a municipal land transfer tax in addition to the provincial land transfer tax. So far, they are the only city to implement municipal land transfer tax in Canada. If you’re buying in Toronto, be sure to consider this fact because it can drastically increase your purchase price!
Once you own a property, you are required to pay property taxes every year. If you live within a municipality, you will pay property taxes to your city or town. If you live outside of a municipality, you will pay property taxes to the province or territory you live in.
How much you pay in property tax is determined by various factors. The general municipal tax rate (if applicable to you), the current tax rate, education tax rate and the value of your property all influence your property tax amount owing. Once you own a property, keep an eye out for a property tax bill to determine how much you need to pay every year.
Property taxes are most often paid in instalments, however, it’s possible to include the property tax amounts in your mortgage payments. If this is the case, the lender would make the property tax payments on your behalf.
Changing Interest Rates
The Bank of Canada has implemented five interest rate increases over the last year and a half which has made variable interest mortgages more costly. Other conditions of the Canadian housing market have made it challenging and expensive to purchase a home right now too, such as the unreasonable price of condos and the stress test implementation in 2018.
Thankfully, real estate boards in Toronto and Vancouver have been putting pressure on the federal government to revise or remove the stress test. Without the stress test, home buyers would have more purchasing power with lenders and therefore could obtain a mortgage easier.
There is concern from economists that the Bank of Canada will continue to increase interest rates which will negatively impact mortgage interest rates. Although, other economists are expecting the Bank of Canada to lower interest rates. Either way, there is a lot of stress and uncertainty surrounding the Canadian housing market at the moment which will impact mortgage interest rates in some way.
Adjustments to Property Taxes and Utilities
This is one of the costs that aren’t as predictable and measurable as the others. Once the previous owners move out and transfer their property tax and utility bills to you, there are often adjustments that need to be made and paid. Many of these costs are typically paid or reimbursed during the closing of the home and are factored into the purchase price.
Once all the legal matters are handled and paid for, the home decorating fun begins! Decorating a home is one of the most enjoyable things about owning a home, but everything you put into your home comes with a price tag. Remember, the bigger your home, the larger your home decor costs will be because there is more space to fill.
After you’ve received your mortgage, you may be eligible for life insurance. In the event that you pass away, life insurance will pay out a substantial amount of money to your family. The proceeds of life insurance can be used to pay off the remainder of the mortgage to ensure your family does not struggle financially in the event of your passing.
Life insurance is completely optional, it all depends on your financial goals and lifestyle. If you get life insurance through your bank, the payments are combined with your mortgage payment. Of course, you can go through a third party as well.
New Home Costs
If your home is newly built, you might incur sales tax. Generally, resale homes are not eligible goods for sales tax. Sales tax on homes is quite complex, hiring a professional real estate or tax lawyer may be required on top of the actual sales tax payment.
In addition to sales tax, new homes come with a warranty which sometimes requires an additional payment. The builder may charge enrollment or solicitors fees as well.
Moving and Set Up Fees
After you close the sale of your home, you will need to consider the cost of moving. Potential costs you may incur are packing supplies, professional movers, moving insurance and travel. You may incur fees to set up internet, cable, phone lines and utilities as well.
Not all homes are ready to live in after they’ve been purchased. If this is the case for your home, renovations may be required before you can move in. You may want to renovate simply to improve the home’s quality or adjust it to your needs before you move in too!
Many of the home closing costs have already been discussed, such as land transfer taxes. However, there can be other miscellaneous costs included in the final offer that are entirely specific to the property you want to purchase. If anything doesn’t make sense to you in the final offer, hiring a real estate lawyer is a good idea to clear up any legal jargon misunderstanding and confusion. All lawyers cost money, but it’s worth it if there’s a mistake in the final offer’s pricing. Real estate lawyers tend to cost between $1,000 and $2,500.
Finding the Best Home for You
If you’re reading all about mortgages and buying a property, chances are you’re trying to buy a home. My Rate Compass would like to congratulate you! The journey of purchasing a home is exciting and becoming yet challenging.
Shopping for a Home
Finding your dream home is easier said than done. In reality, you may be looking at listing after listing before you find what you want. To help you during your search, create a list of all the things you need and want in a home. Do you want a furnished basement? Is having a balcony a must? Do you want a spacious backyard? Whatever it is you want in a home, write it down! When you’re looking at listings, you can use the list to narrow down your options quickly.
One of the most important things to consider when purchasing a home is the location. It becomes especially important to research the location if you’re planning on relocating to an unfamiliar area. When considering location, you might want to be close to schools or daycares for your children, easily access public transit for work or be close to nature. Include these items on your list of must haves. Before finalizing anything, take the time to visit the neighbourhood you’re considering moving to. Buying a home is a big commitment that can’t easily be changed, be sure to get it right!
Real Estate Agents
Real estate agents can help you find the home of your dreams through their expertise and ]network. In addition, they can make the process of finding a home much easier and less daunting. If you have questions, they can answer them and give you an informed opinion.
All of these things are great, although, real estate agents usually take a cut of the final sales price. It’s rare to pay a real estate agent directly.
Hiring a real estate agent isn’t necessary, it merely provides you with some extra help and insight during the home buying process. If you don’t want to work with a real estate agent, you can do research online and find listings for yourself. Alternatively, you can do a combination of both, the choice is entirely yours!
Finding the Right Mortgage
To prepare yourself for mortgage hunting, it's wise to take a moment to consider your current financial position and financial goals. Using that information, you can design a budget for your mortgage and begin shopping for homes. The goal is to find an ideal home for yourself while still working within the parameters of your personal finances. Finally, what works for you might not work for someone else, do what’s best for you!
Now that you know everything about buying a home in Canada, you’re ready to hit the neighborhoods in search of home deals. Happy home hunting!