If you’re in the market for a mortgage, you may be wondering how to decipher all the specialized vocabulary you’re encountering: term versus amortization, fixed versus variable, open versus closed — and what’s an interest rate differential, anyway?
As a mortgage shopper you’re probably focused on the interest rate you’re being offered, but a mortgage has many different features that should factor into your borrowing decision.
Here’s what you need to know before you make the leap.
Key time periods: Term versus amortization
When you sign a mortgage agreement with a lender, that agreement is in place for a period of time, or term, that you select — from as little as six months to as long as 10 years. Then, when your mortgage term expires, you must either renew your mortgage contract, sign a new one or simply pay off the remaining principal you owe. If you renew your contract with the same lender and you’re not looking to increase the size of your mortgage, you won’t need to re-qualify.
In contrast to your mortgage term, your mortgage amortization period is the amount of time (chosen by you) it will take to fully pay off your mortgage — for example, 15, 20 or 25 years. Most homeowners enter into several different mortgage contracts over the amortization period: so over 25 years, you might have five different mortgage contracts, each with terms of five years (the most common mortgage term in Canada is five years).
Key takeaway: “Amortization period” and “term” both describe key time periods in a mortgage: the term is the period that your current mortgage contract is in effect, while the amortization period is the amount of time it will take to fully repay the amount you’ve borrowed.
Mortgage rates: Fixed versus variable interest
With a fixed-rate mortgage, the mortgage interest rate you agree on when you sign the mortgage contract — and thus the amount of your monthly payment — will stay the same for the entire term of your mortgage.
With a variable-rate mortgage, the mortgage interest rate will change as the prime lending rate (set by Canada’s major banks) changes over time. So your monthly mortgage payments will go up or down, too.
How do variable-rate mortgages work?
- The prime rate is the annual interest rate on which lenders base rates for variable loans (including mortgages) and lines of credit.
- For a mortgage, a lender’s variable rate will usually be quoted as the prime rate plus or minus a percentage — for example “prime minus 0.5%.” This means that if the prime rate is 3%, your mortgage would be based on a rate of 2.5%.
- Although the prime rate may fluctuate over the term of your mortgage, the relationship to prime will not.
Key takeaway: With a variable-rate mortgage, if the prime lending rate changes, your mortgage payment amount could increase or decrease, too. Variable rates are usually lower than fixed rates, because they are less risky for lenders. Fixed rates, in contrast, secure your payment amount throughout the term. A fixed-rate mortgage is a bit like an insurance policy against the risk of rates rising. However, fixed rates are usually higher than variable rates.
Paying it off faster: Open versus closed mortgages
If you have an open mortgage, you are free to make extra payments, beyond your regularly scheduled ones. You can even pay off the entire mortgage balance in one go if you like.
If you have a closed mortgage, you’ll have to pay a penalty (called a “prepayment penalty") if you want to change some of the terms of your existing mortgage.
Here are some of the reasons you might be charged a prepayment penalty:
- paying more than you’re allowed to under your set prepayment privileges
- borrowing more money using your home equity (via a home equity line of credit)
- breaking your mortgage contract before it’s over
- transferring your mortgage to another lender before the end of your term
Key takeaway: Open mortgages tend to have slightly higher interest rates than closed mortgages, in exchange for the increased flexibility. However, if you think you might want or need to make changes in your mortgage before the end of your term, you should consider paying the higher rate.
Not to be confused: Prepayments versus accelerated payments
Prepayments, discussed above, are different from accelerated payments, even though both allow you to pay off your outstanding mortgage balance more quickly.
Let’s look at accelerated payments: When you sign up for a mortgage, the default payment option is monthly payments — but you can opt to pay more frequently than that. By making more frequent (accelerated) payments, you will not only repay your mortgage faster but also pay less interest overall.
For example, one option is to make payments on a bi-weekly accelerated schedule. Here’s how this works: you divide your monthly payment amount in half, and then pay that amount every two weeks. Because there are 52 weeks in a year, this gives you 26 payments, speeding up the pace at which you repay your outstanding balance.
Key takeaway: Making mortgage payments more frequently by choosing accelerated payments will reduce both the time it takes to pay off your mortgage and the total amount of interest you pay.
Understanding prepayment penalties
Closed mortgages include prepayment penalties, as discussed above — but the way those penalties are calculated differs from lender to lender. The prepayment penalty will usually be the higher of the following:
- an amount equal to three months’ interest on what you still owe
- something called the interest rate differential
The interest rate differential (IRD) is the difference between the interest rate for your current mortgage term and the interest rate in effect at the time you make the prepayment, calculated over the remaining time left on your current term.
Mortgage lenders will calculate the IRD differently, depending on which interest rate they use. For example, some lenders might use the mortgage rate they advertised when you signed your mortgage, although you agreed to a discounted rate.
Key takeaway: If you’re thinking about a closed mortgage, it’s worth investigating how your lender calculates the IRD in the event you need to break the mortgage and pay a prepayment penalty. The cost of making a prepayment can vary significantly from lender to lender.
Building your mortgage vocabulary
Whether you’re looking for a first mortgage or considering your options on a property you already own, take the time to understand how mortgages work. That way, you’ll be sure to choose what’s best for you, and you won’t be taken by surprise if you need to make a change.
Check out MD’s mortgage calculator to get an idea of monthly mortgage payments if you bought a home. Change variables like your down payment, the interest rate and the home price, and see the impact on your payments.
Use the Scotiabank eHOME online mortgage hub to get pre-approved, search for a home and get a mortgage approval — all in one place, all online.1 For residents, fellows and new-to-practice physicians, the mortgage amount qualified for is based on estimated projected income.2 eHOME is not available in Quebec.
An MD Advisor* can help you with your budget and help you figure out how a mortgage will fit into your financial plan.
*MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec), or an MD Private Investment Counsel Portfolio Manager.
1 All mortgage applications are subject to meeting Scotiabank’s standard credit criteria, residential mortgage standards and maximum permitted loan amounts.
2 The projected income is an average estimated amount based on available industry data and is subject to change. Your actual income may vary. Terms and conditions apply.
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The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.