A residential investment property is one of the largest purchases that most investors will make in their career. A residential mortgage is how the vast majority of investors are able to afford such a large purchase. Shopping for mortgage loans can be confusing, but the knowledge you’ll pick up along the way can save you a small fortune in the long run. You’re much better off having a general understanding of how it all works, than simply relying on your bank or broker.
We’re here to help you understand the ins and outs of residential mortgage loans, in the most practical ways possible. The little bit of time that you invest in learning about your residential mortgage will pay huge dividends for decades to come!
Definition of a Residential Mortgage
Let’s start with a mortgage definition. A residential mortgage, or any mortgage loan for that matter, is a loan that is used to give you access to a large sum of money that is required to purchase property, allowing you to pay it back over time in much more affordable chunks.
You’ll pay interest on this loan, meaning the total amount that you end up paying for the property will be greater than the initial property’s value. Property values tend to appreciate over time, and mortgages are some of the most affordable loans you’ll encounter, and in the long run, it will save you a fortune compared to renting, so despite the additional costs, it’s still a very worthwhile endeavour in most cases.
There is also a cash deposit, also called a down payment, that is required. This is based on a certain percentage of the value of the property, which can vary depending on the terms of your mortgage.
Simple mortgage meaning: Money that you borrow to purchase real estate. A residential mortgage is used to purchase residential property.
The down payment that you make on your mortgage goes towards the total cost of the investment property. There are minimum and maximum down payments that will vary based on where you are located, and the price of the property. For a less expensive property, you may be able to have a minimum down payment of just 5%, but for a more expensive property, it can be upwards of 20%.
If you aren’t able to meet a certain threshold for the down payment, you may need private mortgage insurance (it’s called mortgage default insurance in Canada). It’s most commonly used by first-time residential investors who aren’t able to secure a full 20% down payment on their investment property. It means you can pay less money upfront, but the cost of the insurance itself can be expensive, so you’re better off trying to round up the money, or going with a more modest property in some cases. Nonetheless, it gives you the option of putting less money down when you can’t afford to pay 20% of the cost of your new investment property up front.
Where to find the money for a residential mortgage down payment?
Coming up with 10-20% of the cost of a new property is never an easy task, especially for people who are currently renting and are used to their current budget. It’s common to have to save up money for a while in order to be able to afford the down payment, but it’s not always easy.
Planning ahead, even for several years, will go very far. Once you decide you want to own an investment property, it’s time to start saving. In fact, if you’ve been saving before you’re ready to own an investment property, you’ll be ahead of the game.
Buying a used car instead of a brand new one is one of the most significant ways to save a big portion of down payment, but many smaller purchases will add-up over time, too. Going out to dinner a bit less, spending less on new clothing, etc. These smaller things, over the course of a few years, can make a significant difference.
Housing costs are some of the biggest expenses that people face, so choosing a more affordable place to rent while you save up for an investment property will also get you to that down payment quicker.
Repaying a residential mortgage
Your monthly mortgage payments will be determined by the size of your mortgage, the length, and the terms that you and the lender agree to.
Your mortgage contract will dictate the exact repayment terms, and as with any contract, it’s important to look closely before signing anything. Some mortgages will allow you to increase your monthly payments, or to make the occasional lump sum payment in order to pay less interest over time and to pay off your mortgage sooner. Paying an extra $100 per month can save you tens of thousands of dollars of interest over the course of your mortgage, for example.
Because of this, some lenders will penalize you for early repayments. If you know you will be coming across a sum of money and will want to pay off your mortgage early, keep that in mind when you are choosing which type of mortgage to sign. We will be comparing the different types of residential mortgages before the end of this page.
Interest and principal on a mortgage
The principal is the amount that you owe on your mortgage before factoring in the impact of the interest rate. It’s the total amount of money that you borrowed for your mortgage and the amount that you need to pay back.
The interest rate is the fee that you pay in exchange for borrowing the principal on the mortgage.
Your monthly payments will go towards the principal and the interest. Other costs can include mortgage insurance and taxes.
Sometimes, a mortgage will be stacked with a larger portion of the payment going towards interest at the beginning of the term, with more of each payment going towards the principal towards the end. Having more interest upfront allows the interest to compound, and compounding interest can be very powerful (in your favour, but also against you).
Why take out a residential mortgage?
Quite simply, because most people can’t afford to buy a property without a mortgage. Even if you have the cash to buy a house upfront, it’s not always the wisest financial decision. There are plenty of good reasons to take advantage of a mortgage loan, even if you don’t need it.
This becomes more of a question about renting vs buying a place to live. There are pros and cons to both, but in the long run, you will save money by purchasing a property compared to renting for decades, unless you plan to be nomadic and move around often enough. Granted, there are additional costs to residential investments that can’t be budgeted for as easy as a monthly rent payment, but in the long run, they pale in comparison to using your monthly payments to build up equity in a property that you’ll eventually own outright.
Comparing types of residential mortgages
There are a number of different types of residential mortgages. These different mortgage structures can be beneficial in certain scenarios, so it’s good to understand which ones would work best for you, depending on your needs, your plans, and your financial situation.
Low-ratio mortgages: These are also referred to as conventional mortgages. This is a mortgage where the debtor has made a down payment of at least 20%.
High-ratio mortgages: This is when the debtor has made a smaller down payment, and will likely require special insurance, as it is seen as a riskier loan.
Open mortgages: This is a type of mortgage that grants you the privilege of being able to make additional payments, and to pay off the mortgage early without any penalties. Because you’re able to end the mortgage at any point, which can drastically cut into the profits of the creditor, an open mortgage is usually more expensive. It’s not a good idea to get one if you aren’t planning on taking advantage of the freedom of early repayment.
Closed mortgages: A closed mortgage prevents the debtor from paying it off early or making additional payments, re-negotiating anything, or refinancing at all before the maturity of the mortgage. The rate will be lower than an open mortgage since the creditor knows exactly how much they will earn throughout the life of the mortgage. The terms could allow for a certain amount of prepayment or x amount of additional payments per year, but those will be capped and you will be penalized for surpassing them.
What is a loan to value ratio?
In the previous section, we looked at high and low-ratio mortgages. The ratio in question is the LTV, or the loan to value ratio. As the name suggests, this ratio represents the value of the loan in comparison to the value of the asset that is purchased with the loan (In this case, real estate.)
This is one of many risk factors that are taken into consideration when a lender is preparing the terms of a loan. With an increased LTV ratio on a loan, it becomes harder to qualify for, because there is an increased risk that the lender can lose money in the event of a default. With a lower ratio, there is less risk for the lender as they can simply foreclose on the property and sell it with less room to take a loss due to the ratio.
Should you make a larger down payment on your mortgage?
There are compelling arguments both in favour and against making a larger down payment. A larger down payment on your mortgage will result in less interest paid overtime, but there is also an opportunity cost associated with this. Depending on the financial markets and current interest rates, a mortgage is usually some of the most affordable money that the average consumer will have access to. By making a smaller down payment, and not paying off your mortgage earlier, it’s true that you will be paying more in interest – but that could still be less interest than you would be paying otherwise. Here’s an example…
Let’s say that a new residential investor is considering making a $40,000 down payment, or a $20,000 down payment. They also have about $20,000 in credit card debt. In this simplified example, the credit card debt is costing them 20% interest per year, whereas the interest on the mortgage is a lot lower. In this case, it makes more sense to make a smaller down payment and to pay off the credit card debt instead.
Another example could be if you’re likely able to get a higher rate of return in the financial markets than you would save by paying off your mortgage early or making a larger down payment, or if you have a business that earns you a higher ROI on your money than you would save on the mortgage.
In other cases, you can run the numbers and determine that you’re better off making a larger payment up front and paying less over time. It really comes down to what you could be doing with the money instead.
Residential Mortgage Lending: Brokers vs Banks
You can apply for a mortgage at any bank of your choice, or you can enlist the services of a mortgage broker who will approach a number of banks on your behalf, to find the best rates for you. Brokers generally have access to better rates since they are participating in the wholesale lending market and they are able to get a “bulk discount” of sorts when dealing with lenders (namely banks.) When you approach a bank on your own, you’re just one individual so you don’t have as much sway.