If you are a first-time homebuyer, you’ll probably need a mortgage to make your homeownership dreams a reality, which may lead you to the question: how does a mortgage work? But more particularly, how do monthly mortgage payments work and how often do you need to pay? Mortgage payments work in various ways because each type of mortgage has a different length, payment schedule and interest rate. So, it’s essential to choose the right mortgage for you.
If you work with a mortgage advisor, they can guide you through buying a home. The problem? How can you explain to your mortgage specialist what you want and need in a mortgage if you aren’t sure what your options are? Let’s explain how a mortgage works and how you can decide what is best for you.
Key Takeaways
- A mortgage is a loan which allows you to borrow money to purchase a home and pay it off over time.
- The type of mortgage you choose affects the interest rate and length of the loan.
- Your mortgage payment frequency determines your payment amount and the date you will be mortgage-free.
- Working with a mortgage professional can help you during the homebuying process.
How Does a Mortgage Work?
Before you get to know your mortgage payment process, it’s crucial to understand how a mortgage works. A mortgage is a loan that helps you buy a home so that you’re only initially responsible for a down payment instead of the full purchase price.
When you find a property you want to purchase, you will have to be approved for the mortgage amount. From there, you’ll go through the process of putting in an offer and negotiating to have the offer accepted or denied. And eventually — you will become a homeowner.
Over time, you will make payments on your mortgage and eventually pay off the loan, at which point you will own your home outright.
However, there are many factors that influence the length of time it takes to pay off your loan balance, including the interest rate, how large your down payment is, the amortization period, and how often you make payments.
Interest Rates
When learning about how a mortgage works, interest rates are important. The interest rate is the cost of borrowing money for your home and how the lender makes a profit. Every time you make a payment on your mortgage, the lender or bank will take part of the monthly payments and apply it to the principal balance of the loan, and the other part will be applied to the interest. Higher interest rates mean higher monthly payments.
For example, if you buy a home for $500,000 and you pay 20% as a down payment, your mortgage amount will be $400,000. Let’s say your interest rate is 5%. This would make your monthly payment $2,326. If your interest rate were to rise to 7%, your monthly payment would be $2,802, a difference of $476 per month.
As you can see, the current interest rate will affect the amount of your monthly payment, so the lower the interest rate, the lower your monthly payment will be. Interest rates can change at any time. However, you are able to lock in an interest rate for a certain amount of time, known as a fixed-rate mortgage.
Types of Mortgages
A key aspect of understanding how does a mortgage work is to understand fixed and variable interest rates. In general, there are two different types of mortgages, which reflect the different options for interest rates: fixed or variable. The interest rate for a fixed-rate mortgage does not change for the borrowing period. In contrast, internet rates for variable rates mortgages adjust over time in response to market changes.
Fixed-rate mortgages are the most popular choice for Canadian homebuyers. In the first three weeks of November 2023, 79% of Canadians opted for a fixed-rate mortgage. Fixed-rate mortgages are popular because once you’ve got your set rate, you have consistent payments for the chosen term length. The only reason fixed-rate mortgages aren’t always the best choice is they tend to have higher interest rates than variable-rate mortgages.
Variable-rate mortgages, although less common, are historically less expensive throughout a mortgage because the interest rate is generally lower. Although, the uncertainty with price increases can be enough to stop any homeowner from taking the risk.
If interest rates are low, it might be the right time to lock in a fixed rate. However, if you anticipate the rates may drop in the near term, then a variable-rate mortgage might be a good option.
Open and Closed Mortgages
You will also need to choose between an open mortgage or a closed mortgage. An open mortgage allows flexibility to pay off your mortgage at any time. A closed mortgage has more strict requirements, and you cannot pay off your mortgage before the term ends without penalties.
To help choose, consider your personal needs. An open mortgage will result in the ability to pay off your mortgage at any time but will typically hold higher interest rates. A closed mortgage limits your ability to pay down your mortgage on an accelerated timeline but has more desirable interest rates. Most Canadians choose the conservative option, which is a closed mortgage with a fixed interest rate.
Ultimately, your mortgage needs to be tailored to your financial needs. Robert McLister, founder of RateSpy.com says that although rate sites are great for providing education, it helps to reinforce best practices by speaking to a professional. “Ask them to outline all the got ya’s of the rate you’re interested in, so there are no surprises after closing.”
Amortization Period
Once you buy a home, you must repay the mortgage lenders the initial cost plus interest and mortgage fees you’ve borrowed to become a homeowner. Typically, the repayment period ranges from five to 25 years, with the most popular mortgage term being 25 years. You can choose the length of time you have to pay off your mortgage, which is called amortization. The longer the amortization, the smaller your monthly payments, but the higher your total interest paid.
Angela Calla, accredited mortgage professional and host of The Mortgage Show, says that mortgage specialists typically set you up with your minimum monthly payment and longest amortization period. This way, homeowners are protected from potential unexpected expenses in the first few years of adjusting to their new cost of living.
If homeowners are willing to increase their payments and pay off their mortgage sooner than the initial timeline, they can look at available prepayment privileges. Extra payments will also help reduce your high interest costs and put more of your repayment toward the initial loan amount.
Mortgage Terms
Once you have your amortization period, you also need a mortgage term. Although it can be confusing, there is a difference between the two. Your mortgage term is the length of a contract, which outlines your interest rate and payment schedule.
The length of your mortgage term can vary, from as little as six months to up to ten years, with a five-year term being the most popular choice. So, for example, you could have a 25-year mortgage with a 5-year term. In general, shorter mortgage terms have lower interest rates, however because they need to be renewed more often, you may have to renew at a higher interest rate, increasing your monthly payment in the future.
You will likely need multiple mortgage terms before your mortgage is paid in full. Once your mortgage term ends, you can renew and decide, yet again, what type of mortgage rate works for you.
Mortgage Payments
When your home purchase closes and you officially become a homeowner, it doesn’t take long for the payments to start flowing. Your first mortgage payment is usually due at the start of the first full month after closing.
Before you make any payments (or sign your mortgage), your mortgage broker will ask you what type of payment schedule you prefer. Then, each month, the buyer is responsible for making the payments. Part of that payment goes towards the initial borrowed amount (mortgage principal). The remainder of the payment will go towards interest.
You can make payments:
- Monthly
- Bi-weekly
- Accelerated bi-weekly
- Weekly
- Accelerated weekly
Many homeowners choose to pay their mortgage per their payment schedule at work. For instance, if you receive bi-weekly paychecks, you may want to pay your mortgage bi-weekly.
Canada’s most popular payment options are monthly, bi-weekly, and accelerated bi-weekly. However, there are differences in your overall payment total, depending on when you make your payments.
For example, if you choose monthly payments, you’ll make one payment per month. Choosing bi-weekly payments means your mortgage lender will multiply your monthly mortgage payment by 12 and divide by 26. You will then make a payment every two weeks, or 26 times per year.
Accelerated bi-weekly payments are calculated by factoring in one extra monthly payment per year and dividing that in half in order to determine your accelerated bi-weekly payment amount. On a 25-year mortgage, this will automatically bring down your amortization period to 21 years and five months.
So, although you’ll be paying slightly more monthly for your loan payments with accelerated bi-weekly payments, you can save thousands of dollars on interest, and your mortgage loan will be paid off quicker.
Final Thoughts
“It’s all about balance,” says Calla. Your mortgage broker should help you develop a strategy that suits your needs as a borrower. Calla says that for homeowners, it’s vital to protect their equity, build wealth and avoid accumulating debt.
Buying a house is an exciting chapter in your life. The best way to tackle that chapter is by researching, speaking to professionals, considering your budget, and understanding how does a mortgage work.
