What is a mortgage? How does a mortgage work?
In this post, we will discuss the essence of a mortgage, its key differences vs. a regular loan, and the key components of a mortgage.
First, let's define mortgage and its key attributes as this is important in our analysis of the factors contributing to paying mortgage faster.
A mortgage is a loan secured by real property
That is a straightforward, simple definition, but there is more to a mortgage than this. This definition must be broken down into its core components.
A loan. This is the amount of money advanced to a borrower.
Secured. This means that a Charge (a legal document that outlines the terms of the loan) is registered on the title of the property to secure the loan. If the borrower defaults on the loan, the lender has the right to exercise its interest in the security through several methods.
Mortgage differs from a common loan (credit) for the following attributes:
A mortgage is given for a part of the property value. Thus, you need a downpayment ranging from 5 to 20%.
The borrowers do not get the money in possession at any stage of the process. The money is transferred from a bank that gives you a mortgage to a layer and to the property seller's bank account. This is done to protect the bank from the money being misused by the borrower.
Mortgages are given for 15 to 30 years which is way longer than any normal loan.
You have to pay off the mortgage and the accumulated interest on the mortgage every month.
The bank puts a Charge (a legal document that outlines the terms of the loan) on the title* of the property to secure the loan. If the borrower defaults on the loan, the lender has the right to exercise its interest in the security through several methods.
You have to sign a contract in which the bank puts restrictions on the types of activities you can do with the property as well as a few obligations. Failure to abide by these rules may result in the bank considering the borrower to be in default and forcing the sale of the property. For example, the borrower must:
Repay the loan and interest (obviously),
Insure the property. The bank wants to make sure you are able to repay the debt even if your property burns down.
Maintain the property. The bank wants you to keep the property in good saleable condition, including repairing any portion of the property that requires it. This way, if your work or family situation changes the bank wants you to be able to sell it and repay the debt.
Not to commit waste. Waste is a legal term that includes actions or conduct that could result in damage to the property or a loss of property value. Committing waste will result in the lender considering the borrower to be in default. This may include significant renovations, such as the addition of another storey to the building. This is due to the fact that if the borrower runs out of money during the renovation and it remains incomplete, the value of the property will be diminished.
Pay Property Taxes. The reason why the bank wants you to pay your taxes is that in case you are forced to sell it, the government will take the taxes first, and only then, what is left will go against your bank loan.
Read properly the contract when obtaining a mortgage as there may be other restrictions like the inability to rent your property to a third person or restrictions to do certain types of business.
*Title is a term that refers to the ownership of a bundle of rights that its owner has in a property. If something is registered “on title” it means that it is officially registered against the ownership of the property through the Land Titles Office. If you would decide to sell your property, the registrations "on title" of the property must be first discharged.
Financial Components of a Mortgage
There are several components to a mortgage, but at its core, a mortgage payment is made up of the following financial components:
The Face Value of a Mortgage
The face value or the face amount of a loan is the total amount of the mortgage that is registered against the property. This is the amount that the borrower has to repay according to the mortgage contract.
The Amortization Period of a Mortgage
The mortgage contract will include the amortization period for your mortgage. The amortization period refers to the total number of years that it will take to fully repay the amount borrowed. To repay the mortgage exactly by the end of the amortization period, the bank will calculate a monthly payment that blends coverage of the monthly interest and a portion of the principal.
The Term of a Mortgage
The amortization period is broken into terms as no bank will enter into a mortgage contract with you for the full duration of the amortization period (20 to 30 years). The mortgage contract will indicate the time that the contract will be in force with your lender. After the term expires, the outstanding mortgage amount must either be paid in full (referred to as paying the lender a balloon payment) or renewed with the current lender. These are the only two options that a borrower has.
Paying the mortgage in full can be done in several ways.
Paying off the balance of the mortgage with the borrower's funds. This obviously happens rarely (unless you won a lottery or inherited a large sum of money).
Refinancing with the current lender (renewal) or with a new lender. In the case of moving the mortgage to a new lender, the mortgage is paid out through a balloon payment made by the new lender to the old lender.
It is of interest to note that the term is not used in the calculation of the payment amount. The term is only of interest to the date of the contract expiry.
The Interest Rate of a Mortgage
The mortgage contract also stipulates the amount of interest charged to the borrower, including how this interest is to be calculated. The interest is set for the full term with the current lender. As the amortization period of a mortgage sometimes spans 15 to 30 years, no bank will want to have a contract with you for the full period of a mortgage. Rather, you can choose anywhere from1 to 10-year terms; 3 and 5-year terms are the most common. During the term of your contract, the interest rate is locked. However, when the term is up, you have to make a new contract with the current or new lender (refinance). At this moment, the interest rate for the new contract will change according to the current economic situation and the prime rate from the government.
Slight variations in the rate will lead to changes in the payment amount as well as the total interest you will pay to a bank. So, it is wise to try and lock good rates for a longer period of time. If you are renewing in times of high-interest rates, it may make sense to renew for shorter periods or look for lenders with softer contract termination terms, so that you may cancel the contract earlier and don't need to pay a lot to exit the contract.
Payment Amount of a Mortgage
The contract will lay out the amount of each payment during the term, based on the face value, interest rate, payment frequency, and amortization.
Obviously, mortgages are more difficult as there is much more to them. Don't worry; this is Mortgages 101. In the following posts, we will discuss mortgages in more detail: fixed vs. variable rates, refinancing, mortgage repayment plans and options, what you need to qualify, and many more.