How do mortgages work? Everything you need to know

For many Canadians, becoming a homeowner is their dream. Saving up for a house can take years of hard work and determination; it is probably the most expensive purchase most people will ever make.

To make your homeownership dream a reality, you'll probably need a mortgage.

Whether you're a first-time home buyer or looking to take on an additional property, it's important to understand what a mortgage is, how it works, and which options might be right for you.

A mortgage is a loan that you can borrow from a bank, credit union or private lender to finance the purchase of a home or other real estate property and that is secured against the property. 

Your mortgage will be a legal contract between you (the borrower) and the lender. It will outline the details of your loan, including your payment frequency, the length of your mortgage term, your interest rate, the amortization period, and other important information you need to know.

When looking for a mortgage, you can compare a variety of options offered by different lenders. In addition to banks and credit unions, you can also consider getting a mortgage from an insurance company, mortgage company, trust company or a loan company. Who you pick will be based around which mortgage works best for you; beyond the mortgage rate, think about things like the length of the mortgage term, the amortization period and the payment schedule that will work best with your financial plan. You can compare different mortgage options using the Scotiabank Mortgage Calculator to find the best mortgage to suit your needs.

Once you choose a lender, you can start the pre-approval process to see if you qualify for a mortgage. While different lenders have different qualification criteria, the pre-approval process typically involves a review of your:

• Income: What are your sources of income?
• Assets: What do you currently own (cars, real estate, investments/savings)?
• Debt: What do you currently owe (credit card bills, student loans, etc.)?
• Down payment: If you are buying a home, how much do you have saved for a down payment?
• Credit history: How responsible are you with repaying your debts? Something that can negatively impact your credit score is having applied for credit with different lenders recently. Another thing to avoid is applying for additional credit in the period after you have your mortgage approved, but before funding (buying your home). This can jeopardize your mortgage approval, because taking on additional debt can negatively impact your credit score. Learn more here about improving your credit score.   

Before applying for a mortgage, it's helpful to know what type of mortgage product you're interested in. Some options include:

STEP. The Scotia Total Equity^® Plan (STEP) is a flexible borrowing plan secured against your home. STEP lets you mix and match different kinds of Scotiabank credit products (like multiple mortgages and lines of credit) based on your needs, all with one easy application. Learn more about STEP. *

Open mortgage. An open-term mortgage allows you to repay your mortgage at any time during the term without a prepayment charge (though administrative fees may apply). This can be a good option if you're interested in paying off your mortgage as fast as possible. Open mortgages typically come with an interest rate that's higher than those associated with closed mortgages.

Closed mortgage. With a closed-term mortgage, a prepayment charge applies if you want to repay it before the end of your term. Some closed mortgages do allow for prepayment privileges, which permit a limited amount of extra money to be put towards the principal amount of your mortgage each year. The benefit of a closed mortgage is that it typically comes with a lower interest rate.

Portable mortgage. A portable mortgage is one that you can transfer from one home to another, and it may allow you to keep your current interest rate, terms and conditions. If you know that you're going to move before the end of your mortgage term, this is an important option to keep in mind when looking at mortgage options.

A mortgage can be low or high ratio. A low-ratio mortgage is one where the down payment is equal to 20% or more of the purchase price of the home. A low-ratio mortgage typically does not require mortgage default insurance. A high-ratio mortgage is one where the down payment is less than 20% of the purchase price. With a high ratio mortgage, mortgage default insurance will be required.

Reverse mortgages. If you're at least 55 years old and you own your home, you might be eligible for a reverse mortgage. With a reverse mortgage, you can borrow money from the equity you've built up in your home. Exactly how much you can borrow depends on your age, the appraised value of your home and your lender, but the maximum amount is typically 55% of the current value of your home. Be aware that interest rates on a reverse mortgage are usually higher than most other types of mortgages.

Your mortgage interest rate is the fee you will pay to the lender in exchange for borrowing money. The higher your interest rate, the more expensive your monthly payments will be. The interest rate offered to you can depend on several factors including:

• The type of lender you choose (e.g. bank, mortgage investing company)
• The specific lender you choose
• The current posted mortgage interest rate offered by your lender
• Length of mortgage term
• Type of interest (e.g. fixed, variable)
• Your credit history
• If you are self-employed

Want to make sure your mortgage will fit into your budget? Try our mortgage payment calculator.

When getting a mortgage, you can choose between a fixed interest rate or a variable interest rate.

With a fixed-rate mortgage, your mortgage payments will stay the same for the entire mortgage term. A fixed mortgage rate can be higher than variable interest rates, but provides stability with a consistent payment schedule over the mortgage term. This can help when you are budgeting because you know what to plan for each month. 

With a variable rate mortgage, your interest rate can increase or decrease throughout your mortgage term as your lender’s prime lending rate changes. How this impacts your payment amount or amortization period will depend on your lender. 

Not sure whether to go with a fixed or variable rate mortgage? The STEP lets you split your borrowing into multiple mortgage and line of credit components. This can be a useful strategy to manage interest rate risk.

The amortization period is the amount of time it takes to fully pay off your mortgage, assuming regular payments including principal and interest are made on time. Amortization periods can be up to 30 years.

With a longer amortization period, your mortgage payment amounts are lower, but you also pay more in interest over time.

A shorter amortization period results in higher mortgage payments, but less money going toward interest over time.

Your mortgage term is the period of time over which the interest rate, payment and other mortgage conditions are set. Mortgage terms typically range from 6 months to 10 years. At the end of the term, the mortgage loan is due and payable unless it is renewed for another term. The mortgage term is usually shorter than the amortization period.

When buying a home, you also want to make sure that you have the proper insurance coverages for you. There are many different kinds of insurance to choose from for protecting your home or your mortgage loan. Some types of insurance are optional and some are mandatory. 

Here are some of the different insurance types to consider and how they work:

Mortgage borrowing costs refer to the total costs associated with getting a mortgage. To determine your borrowing costs, you will need to know the annual percentage rate (APR).

The APR is the cost of borrowing charged on your mortgage loan each year expressed as an annual rate. The APR includes more than just interest. It is a combination of your interest rate, certain fees and extra charges that you must pay in connection with the mortgage loan expressed as a percentage.

When budgeting for your mortgage, you should also consider closing costs. 

• Administrative fees
• Legal fees
• Home inspection fees
• Additional insurance (title insurance, property insurance)
• Property taxes
• Moving costs
• Land transfer fees
• Appraisal fees

Discover just how much you can spend before you start house hunting with online mortgage tools like Scotiabank's What Can I Afford? calculator.

There is no one best type of mortgage or mortgage rate. It's important to find the mortgage product and rate that is the right fit for you.

If you want help navigating and understanding mortgage rates, you can talk with an expert, like a Scotiabank Home Financing Advisor, who can walk you through the process.

Remember that the mortgage rates offered to you by a lender will depend on a number of criteria including:

• Your credit score
• The length of your mortgage term (6 months to 10 years)
• The type of loan you choose (fixed, variable)
• The type of lender you choose (bank or credit union vs. private lender)
• The current prime and posted interest rate
• If you qualify for a discounted interest rate
• Mortgage features such as prepayment privileges, STEP, portability, etc. 

If you have some extra money, you might consider using it to pay off your mortgage faster. Whether or not you can increase your payments without having to pay prepayment charges depends on your mortgage contract.

A prepayment charge is a fee that your lender charges you if you pay more than the mortgage agreement allows or if you try to pay back your entire mortgage before the end of the term. How much you pay in fees depends on several factors including:

• Whether or not your mortgage is an open or closed term
• The amount you want to prepay
• Your allowable prepayment privilege amounts
• The number of months left in your term
• Interest rates
• How your lender calculates the prepayment charges

If you want to pay off your mortgage faster while avoiding prepayment charges, there are some strategies you can consider. These include:

• Lump sum prepayment(s). Depending on your mortgage agreement, you might be able to add extra payments towards your mortgage each year, up to a certain amount.
• Match-a-payment. This option allows you to double your mortgage payment on any and all scheduled payment date(s) without an extra fee.
• Increase payment frequency. You can pay down your mortgage faster by switching from a monthly to a bi-weekly or weekly payment schedule.
• Amortization period. Choosing the shortest amortization period with the largest amount of money you can afford can help you pay off your mortgage faster.
• Increase your payments. Consider increasing your monthly payments, so you are putting more toward your principal balance (if your mortgage contract allows this). At Scotiabank, borrowers can increase their payments annually up to a certain percentage (talk to your Scotiabank Home Financing Advisor to find out more). 

Explore ways to be mortgage free faster with our Mortgage Prepayment Calculator.

There are situations where you might face prepayment charges, such as if you are breaking the terms of your mortgage by moving/selling your home. How can you avoid those charges? When you are getting a mortgage, consider things like how long you plan on staying in your home. For example, if you think you might want to move in two years, then a 5-year closed term mortgage might not be the right fit for you. You want to find a mortgage that suits your future plans. 

Here are some things to consider when picking a mortgage:

• Portability. When a mortgage is “portable," it allows you to transfer it to a new home if you move. This means you get to keep the same interest rate for the remainder of your term.
• Open term. If you opt for an open-term mortgage, you can payout, prepay or change the terms of your mortgage without incurring prepayment charges. Keep in mind that the interest rate on an open mortgage is often higher than on a closed mortgage.
• Flexibility. If you think you will move soon, look for a term with short time commitments (like one that is 2 years vs. 5 years). 

If you want help navigating the mortgage process, you can work with a mortgage broker. A mortgage broker is a licensed professional who acts as an intermediary between you and the mortgage lender.

A mortgage broker can help you to identify the right mortgage product based on your financial situation. They can negotiate for the best rate on your behalf with a mortgage lender, help you with all necessary paperwork, and answer any questions you might have along the way.

The mortgage lender you pick usually pays the mortgage broker’s commission. However, there are some scenarios where you might have to pay the broker's fees. When you're interviewing candidates, be sure to ask how they are paid and choose the broker with the experience and expertise that feels right for you.

Buying a home is complicated, and it’s a big help to have someone on your side to explain all of your options. Your lender has experts in mortgages to walk you through the process, including advisors who can help you manage your financial needs, and home financing advisors who provide comprehensive mortgage advice.

You can meet with an advisor at any stage of your home-buying process, and they will help you formulate a plan and guide you through the different types of mortgages to help you find the right one for you. They can also start the pre-approval process when you’re ready.

Your advisor can continue to assist you throughout your time as a homeowner, helping you make sure your mortgage continues to work within your financial plan as your goals evolve over time.

Buying a home is an exciting decision, but there's a lot to consider. You can get help from experts to guide you throughout the process by reaching out to a mortgage specialist or home financing advisor.