You will be required to make a number of option choices when setting up your mortgage. This will include selecting an open or closed mortgage and a fixed or variable rate. You will also be asked to choose the length of term and amortization period and a payment frequency. The choices you make will determine how long it will take to pay off your mortgage and the amount of interest you will ultimately pay.
Open or Closed
An open mortgage can usually be paid off at any time without penalty. With a closed mortgage, there is a penalty if it is paid out completely before the end of the term, or if extra payments exceed allowable limits. The penalty to pay off a closed mortgage is the greater of three months interest or the interest rate differential. A person might select an open mortgage if they are coming into a substantial sum of money or if they were planning to sell their home in the near future.
Fixed or Variable
With a fixed rate mortgage the interest rate stays the same for the entire term. With variable rate mortgages the rate changes when the bank ‘prime’ rate changes. Variable rates usually go down in a weakening economy and up when the economy shows signs of recovery. The choice between fixed and variable often depends on a person’s tolerance for risk. Some people will choose a variable rate if fixed rates are expected to drop because variables come with an option that allows you to lock into a fixed rate later on (without penalty). This strategy could backfire, however, if fixed and variable rates both went up instead of down.
Choice of Term
The term is basically a contract period. It is the length of time you will be under contract with a particular lender. Every mortgage contract comes with a specific set of conditions and guarantees. With a fixed rate mortgage, the interest rate is guaranteed until the term ends. At the end of the term you must negotiate a new contract agreement with either the same lender or a different one.
Most banks and lending institutions offer terms ranging from 6 months to 10 years. Generally speaking, the longer the term the higher the interest rate. The 5 year term is very popular because it is the most competitive and heavily advertised rate category. When interest rates are low, and expected to rise, many people choose a longer term (7 or 10 years) to avoid the possibility of having to deal with higher rates 5 years down the road. It should be noted that rate forecasting is an inexact science, much like predicting where the stock market will be at a future point in time. In truth, nobody knows for sure where rates will be years from now. Today’s rates are at, or near, 60 year lows so choosing a longer term at this particular point in time would seem to make good sense.
Choice of Amortization
Amortization is the length of time it would take to pay a mortgage off completely if the rate and payment remained the same over that entire period of time. This seldom happens, however, because rates and payments are subject to change at the end of each term.
You can choose any amortization period up to 25 years for CMHC insured mortgages, as long as you qualify to carry the payment. However, if you have a down payment (or equity) of at least 20%, you can choose an amortization of up to 35 years. The shorter the amortization the higher the payment. We encourage first time buyers to be somewhat conservative when selecting an amortization period. If you have never had to pay property taxes, utility bills, or home maintenance expenses, you may be inclined to overestimate the payment amount you can comfortably afford. If you select a longer amortization than you qualify for, you can set your payment higher than required to shorten the amortization. If you encounter unexpected expenses or want to go on a vacation you can then reduce your payment back to the required minimum. Once the initial amortization is set you cannot request that the minimum payment be lowered.
Pre-payment privileges allow you to put extra money down on your mortgage each year as well as increase your regular payment, without penalty. Pre-payment privileges can differ from lender to lender. For some people pre-payment privileges are an important factor in choosing a particular mortgage or lending institution. Banks and other lenders usually offer either 15 and 15 or 20 and 20% pre-payment privileges. The first number refers to the percentage of the original mortgage amount you can put down each year and the second number refers to the allowable percentage increase to the regular payment. No-frills mortgages often have a low interest rate but restrictive pre-payment privileges (such as 5 and 5). You would likely not choose a no-frills mortgage if pre-payment privileges were important to you.
The payment frequency choices include weekly, bi-weekly accelerated, bi-weekly non-accelerated, semi-monthly, and monthly. For the purposes of this discussion we will focus on the two most popular choices – monthly and bi-weekly accelerated.
After choosing a term and amortization, you will be asked to select a payment frequency. If you choose monthly, the payment is set such that the mortgage would be paid in full at the end of the amortization period. If you choose bi-weekly accelerated, the amortization period is automatically reduced because you will actually be paying more on your mortgage each year – probably without even noticing. This is because there are 26 bi-weekly payment periods in a year and only 12 monthly payment periods. This simple strategy can knock years off your mortgage and save thousands in interest.