A property, for many households, is the most important purchase in a lifetime. However, given the price of the property, the vast majority of purchases are made using a government mortgage loan contracted at a financial institution.
However, few potential buyers and even mortgage holders actually know the operation and calculation associated with this whole process. In a new government home mortgage loans, customers must make several decisions about the variables of a mortgage contract. We will demonstrate the effect of each variable on the mortgage using a fictitious example.
Value of government mortgage loans
Take for granted that we would like to purchase a property worth $ 250,000 and our initial down payment is $ 50,000. The amount of $ 200,000 will have to be financed by a mortgage and will be disbursed by the financial institution, that is, the financial institution will give the money to the seller through the notary. From now on, this amount becomes a debt for the individual, who will have to repay a portion of this mortgage on a periodic basis.
The origin of the word mortgage explains very well the concept. The equivalent of the mortgage in English “mortgage” takes its sources of the French language. The prefix “death” and the suffix “pledge” (collateral for debt) can literally be translated today as a loan as collateral for a property that dies when the debt is settled. Indeed, the financial institution retains the right to the real estate until the last payment of the mortgage. In case of non-payment, she can take possession of the property.
Now that we know we need to borrow $ 200,000, the next step is to get a government mortgage loan rate for the loan. This rate may vary from institution to institution but take a fixed rate of 3.5% per year for our simulation. Mortgages with variable rates (rates that may change over time) will be dealt with in a future article. What is the effect of this fixed rate on our payments?
Term of interest
With the rate comes to a term for interest. For example, a financial institution may display a fixed rate of 3.5% per year for a period of 5 years. This means that regardless of the movement of interest rates in the markets, up or down, your rate will stay fixed for the next 5 years. This will, therefore, provide some stability because you will be certain that your payments will not increase due to fluctuations in economic cycles. You sign an agreement with the financial institution for the next 5 years.
At the end of the 5 years, you must renew with the rates offered at that time. It is here that the term of interest becomes important. If we take a shorter term, for example for a term of one year or 2 years for interest terms, our rate will be smaller compared to the rates offered for 5-year terms. However, the maturity of the term will come sooner, and if rates have risen during this period, we will be forced to renew at a higher rate. For example, if the current term for a 2-year government mortgage loan is 3.5% and the term for a 4-year mortgage is 4%, many may prefer the lower 3.5%. However, if interest rates rise in the coming years,
- Scenario 1: Rate of 3.5% for Year 1 and Year 2, rate of 5% for Year 3 and Year 4
- Scenario 2: Rate of 4% for each of the 4 years
The rise in interest rates has therefore favored the stability that Scenario 2 offers us. However, the opposite would be true if interest rates had fallen years after taking out the mortgage. Scenario 1 would have been a winner. You have to make a decision on interest rates based on the forecast of interest rates for the next few years.
The amortization period is the length of time it will take before our mortgage is repaid in full with the financial institution. The market trend is to choose 25 years for this variable. This will vary our periodic payments. Of course, if a person chooses a 15-year amortization term, the payments will be higher compared to someone who chooses a 25-year term. The maximum term of insurable depreciation previously was 35 years in 2008, reduced to 30 years in 2011, and again reduced to 25 years in 2012. The concept of sustainability of Glenworth / CMHC will be addressed in a future article.
What is the benefit of taking a shorter amortization period if mandatory periodic payments are going to be higher? The answer is in the amount of interest we will save if we pay the balance of the mortgage faster. The following example will clarify everything.