For most of us, buying our first house can be a daunting task. It's probably the biggest purchase we'll have made to date, and it can have a huge financial impact on our lives for decades if we make the wrong decision.
That said, there's a lot to think about and it can be intimidating, especially when it's your first home and you have so many people telling you different things. I remember some of the things people told us when we were looking for our first to buy our first real estate investment back in 2018.
"Always get a fixed rate mortgage because your interest rate won't change so the monthly payment will stay the same."
"Go for a variable because it's cheaper"
"Lock it in for 5 years."
"No, no, go for a shorter term so that you can refinance sooner."
Get an open mortgage, wait no a closed mortgage is better. You'll need mortgage insurance. Have you thoughts about a credit union? Visit multiple lenders. The list goes on...but I was confused to say the least.
While that may have all been good advice and I'm sure that it all came from a good place, now, having bought several residential and commercial properties over the past 5 years, when people ask me for advice, my answer is usually not one that they want to hear.
And that makes sense, right? Not all of us are in the same financial position, have the same goals or have reasoning behind the purchase. We have different incomes, different savings and good or bad credit.
But that becomes problematic for most people because humans instinctively need an answer. So how can we figure out what mortgage is best suited for us and why does it even matter?
Well, the answer as to why it matters is pretty simple, making the wrong call can end up costing you tens of thousands of dollars in only a couple years if you don't get the best mortgage rate. So let's get to finding the best mortgage for you.
STEP #1: HOW TO GET APPROVED
First things first, we need to understand the lending process from a lender's perspective so that we can stack the deck and make sure we get off with the best possible mortgage loan.
So what exactly plays into determining credit worthiness? And what is credit worthiness in the first place?
To put it simply, credit worthiness is just a fancy way of saying how likely you are to default on your debt obligations. Lenders will risk assess you based on a number of factors determine how much they can lend you and what are the terms of the loan.
Having worked in a bank for a number of years, I can tell you that creditworthiness is something that is quite easy to change if you know exactly what factors affect it.
Let's start off by running through the main factors that you can influence before figuring out which mortgage product is best for you.
Factor #1: Credit Score
Since our early days, the words "Credit Score" have instilled fear in all our hearts. That's because your parents and most of the people that have taught you about finance (let's forget about the education system that failed us all) make it seem like your credit score is some type of unknown monster that controls our lives.
Everyone tells you to make sure you never get bad credit but do they even know what affects credit?
In reality, your credit score is made up of exactly what you would think and those things fit into two main categories: current debt obligations and payment history.
As for current debt obligations, that would include all your open debt (a car loan, a mortgage, a student loan, a line of credit or conventional loan, any credit cards and etc...)
Now payment history is a little trickier because "you always need to pay everything off at the end of the month and never miss a payment", right? Wrong!
Before we get into the nitty and gritty, you should start off by figuring out your own credit score with a soft check. I would recommend starting off by simply logging into your online banking portal and finding the credit score section. You should be able to get an idea of your score in no time.
Now, this is a great place to start but it really only evaluates the products that you have with your own bank so if you have any debt products with other lenders, you may want to look at a third party service for a soft check. Something like CreditKarma will do just the trick.
So knowing that a higher credit score improves credit worthiness and your likeliness of approval, let's fix that credit score. Start by paying down high interest balance consumer debt on open loans and then move onto the next highest interest debt.
Typically, you would want to follow this order:
Credit card balance(s)
High interest open loan(s)
Now, it's important to note that both your car loans and mortgages shouldn't usually be paid down faster than the paydown schedule. Just make sure to keep making any car loan or mortgage payment and you'll be good!
The fastest way to improve your credit score is to implement pre-authorized debits on all your debt products with overdraft in your chequing account. That way, you'll never be late on any payments and the overdraft will protect you from any negative balances or any charges bouncing.
Making your monthly payments on debt products when you were previously missing payments is the easiest and fastest way to improve your credit score.
Before you even consider applying for a mortgage, you're going to want to make sure that your score is above a 640 although that typically won't get you approved on a large enough amount to buy a house unless you have co-signer, or the rest of the application is immaculate.
We really suggest that you should focus on getting that score closer to 750 if you can because that will really improve your chances of getting approved.
Now that your bad credit is fixed, let's move onto the other two factors.
Factor #2: Debt Servicing Ratios (Total and Gross)
Next, you're going to have to think about a few things that are rarely mentioned, your debt service ratios.
At a high level, these are essentially just quick calculations that are done by lenders to find out how much of your gross income is allocated to making existing recurring payments. They do however vary slightly.
Your Total Debt Service Ratio (TDSR) is the total amount of debt that you have to service and all related recurring expenses as a result of that debt.
Typically, lenders will want your TDSR to remain under 36% and will not approve you for any loan that would raise your ratio over that rate. There are however some lenders who are more flexible such as B lenders who may be open to approving a loan that would exceed to 36% although in my experience having spoken to a number of brokers, they would rarely ever exceed 43%.
On the other hand, your Gross Debt Service Ratio (GDSR) is going to be a smaller percentage of your gross income because it only includes the percentage allocated to servicing home-related debts.
It will include things such as mortgage payments (both the principal and interest), insurance, utilities and typically they will only approve a mortgage up to about 28%.
It's a good idea to know your ratios before trying to get that pre-approval so I would highly suggest using this TDSR and GDSR calculator to have a better idea of your current position.
At this point, you know more than enough about both these ratios but if you are approaching the limits that we mentioned, you may need to play with your income and expenses to improve the ratios (primarily your TDSR if you are a first-time homebuyer).
Factor #3: Employment
Employment (and income but that is covered as part of your debt service ratios) is really the last determining factor.
There is a common idea that self-employed individuals won't be eligible for a mortgage. And while it can be more difficult, it is entirely possible.
A lender will always consider employment stability as a factor in any application since they need to determine the likelihood that the borrower can meet their debt obligations. Knowing that self-employment income is typically more variable compared to a salaried employee, means that there is great risk for the lender.
For a self-employed individual, the lender will require much more documentation in addition to the standard requirements. Income statements, profit & loss reports, balance sheets are not uncommon requirements for many lenders and they will want at least 2 years of documentation.
For the employed applicant, they will require recent paystubs and letters of employment. You will have to be in your current job for at least 6 months in most cases although there are exceptions to the rule depending on the lender.
STEP #2: WHERE TO APPLY
Now that we've cleaned up all our credit and should be able to get an approval, what do we do? Well it's quite simple, reach out to lenders.
While most people would typically feel comfortable walking into their banks and talking to one of the financial advisors, I would typically suggest chatting with two different mortgage brokers who work with different lenders.
By working with a mortgage broker, you'll essentially be able to apply for a mortgage with many lenders at the same time. The broker will take your application and work with their partners to get you the best mortgage rate and terms.
For instance, if you were to go to a TD branch, the advisor is going to prepare a file and will only go to their own TD underwriters. The issue is that TD might not be offering the best rates and terms at that time so you are essentially limiting your options.
A broker will work with several lenders and make them bid on your mortgage application. That way, you'll be able to submit one application but shop around.
By going to two brokers that work with different mortgage lenders, you're increasing your reach and able to get the best possible rate.
While you could go to every lender separately, I would highly advise against it because it's a huge time commitment but more importantly, each one of the lenders is going to want to pull your credit score. Having several hard checks in a short period can be quite detrimental to your score, which could result negatively through a higher rate or worse terms.
STEP #3: CHOOSING THE RIGHT MORTGAGE SOLUTION FOR YOU
So now it comes time to make the big decision. Fixed? Variable? Variable with fixed payments? Long term? Short term? Lending fees?
But what does this all mean and how do I choose the right mortgage option? Well again the answer isn't always clear and won't be the same for everyone.
Let's start off by covering the different types of mortgages. The key difference between these mortgage products is how they treat interest rates. And that includes both the initial rate and the rate over time.
A variable rate can fluctuate over time as a result of changes in the overnight rate from the Bank of Canada which affects your lenders prime rate and subsequently your variable mortgage rate. For instance, a variable rate could be your lenders prime rate + 0.5% so when the prime rate changes, so will your variable rate. Typically, upon signing, the lower interest rate will be variable.
A fixed rate on the other hand will always be higher initially but it provides stability as this rate will not fluctuate with changes in the lenders prime rate.
Recently, we've seen a number of rate hikes from both the Federal Reserve in the U.S. as well as the Bank of Canada. Most recently just a couple days ago. These rate hikes were long predicted by economist as a measure to combat the near double digit inflation rates that we have been seeing throughout 2022.
Now, having gone through the fifth rate hike of the 2022 with the current overnight rate sitting at 3.25% up from just 0.25% back in January, both variable rates on existing mortgages and posted fixed rates for new mortgages have skyrocketed.
In general, this is the historical trend. When a central bank increases the overnight rate, mortgage rates will increase as well. That doesn't necessarily mean that it will be a proportional increase or decrease (if rates were to drop).
Lenders have seas of economists who's job is to know what the central bank is going to do before they officially make the move. For instance, most economists warned of each one of the rate hikes in 2022. They have been pretty accurate to say the least.
Since fixed rates are held for the duration of the term, lenders take into account future changes to the overnight rate when approving mortgages because they need to make sure that they are in the black over the term of the loan.
If you already have a fixed-rate mortgage, these rate hikes won't affect you during your current term, however, they could affect you when it comes time to renew your mortgage. It would also impact you on any current Home Equity Lines of Credit (HELOC) or future HELOCs since they are always variable.
If you're currently tied to a variable-rate mortgage, then you will most likely see an increase to your payments and a higher percentage of your payments covering the interest rather than the principal. The lender will make an adjustment at their next opportunity as set out in the terms of your mortgage.
But as mentioned, the opposite is also true. Lenders will make adjustments to your variable rate if the central bank announces a rate drop.
Even with the recent rate hikes, it doesn't necessarily mean that you are or have been worse off with a variable rate or that it will continue to be the case.
For instance, if you obtained your mortgage when there wasn't any changes in the rates and it took a number of years for rates to change after you got your mortgage then you would most likely be better off since your payments have been lower for a few years and may have only caught up to the equivalent fixed rate mortgage later in the term.
A number of studies have shown that variable-rate mortgages have historically been cheaper when compared to fixed-ratemortgages.
We remain in an uncertain economic situation. Many people believe that we are on the brink of an economic recession and that the rapid ongoing rate hikes are pushing many people and businesses to their financial limit.
While the central bank remains adamant that we have not seen the end of the rate hikes, the question becomes, how long will this continue?
Unfortunately no one knows but the government has announced that they are aiming to have inflation back to a more reasonable 3% by the spring. If that is in fact the case, it is possible that they may start stepping back on the rate hikes of 2022 in favour of drops in 2023.
While a recession along with a drop in inflation rates would lead many to believe that the overnight rate will drop, this isn't necessarily the case. For instance, in the early 1980, the U.S. economy was in a deep recession but the average fixed-rate mortgage remained as high as 18.45%.
With all these unknowns, how can you make the right decision. Well it will depend on a number of factors, such as your thoughts on the current state of the economy, whether you think there will be additional interest rate hikes, your job stability, current income, family situation, savings and etc...
Understanding that a sole property owner working for a private company with limited savings should have a lower risk tolerance and most likely opt for a fixed-rate mortgage should be evident but other than that, it can be difficult to determine the best solution for you.
Its also important to understand the penalties linked to these mortgages if you were to sell or pay off your mortgagebalance early. Variable-rate mortgage penalties are typically much lower since they are usually only 3 months of interest. Fixed-rate mortgage penalties are much higher but we recommend using this calculator to determine the possible penalty before making any decisions.
With all that in mind, what should you do? If you're looking at buying a property in the next 180 days, I say get a pre-approval for a fixed-rate mortgage ASAP. Nothing bad will come of it and worst case, rates drop between now and then, but you can reapply to secure a new mortgage approval at the lower rate. This would be the best option if you want to air on the side of caution.
Alternately, if you have more room to manage risk, opting for a variable-rate mortgage can be wise. You'll be able to pay off the loan with a relatively minor penalty to switch to a fixed-rate if rates continue to rise and test your financial limits or profit from a potential drop in rates in 2023.
If there are any changes in your financial situation or any significant economic changes like an interest rate hike, revaluate your options.
All that in mind, it's very difficult to be certain of your decision during these times but when it comes time to sign on the dotted line for that dream house of yours, you'll be able to rest assured knowing that you made an informed decision and that you won't be "skinny dipping when the tide goes down".
If you still have questions, please don't hesitate to contact us directly and one of our investment specialists will be more than happy to answer any of your questions. Alternatively, they'll be able to explain how ReDeal can help you reach your financial goals by investing on autopilot.