There are many factors you have to decide on before finalizing your mortgage decision. The key factors are amortization, term of the mortgage, open or closed mortgage, prepayment privilege, interest rate options, interest averaging, payment schedules, and assumability, and portability. A brief explanation of the first four items will be discussed in this Part I. The next column, Part II, will discuss the remaining five issues to consider.
Amortization
Amortization is the length of time over which the regular (usually monthly) payments have been calculated on the assumption that the mortgage will be fully paid over that period. The usual amortization period is 25 years, although there is a wide range of options available in 5, 10, 15, 20, 30 and 40 year periods as well. Naturally, the shorter the amortization period, the more money you save on interest.
Term of the Mortgage
The term of the mortgage is the length of time the mortgagee will lend you the money. Terms may vary from six months to ten years. If the amortization period was 25 years, that would mean that you have several different mortgages, possibly 5-10 separate terms before you have completely paid off the loan.
At the end of each term, the principal and unpaid interest of the mortgage become due and payable. Unless you are able to repay the entire mortgage at this time, you would normally either renew the mortgage with the same lender on the same terms, renegotiate the mortgage depending on the options available to you at that time, or refinance the mortgage through a different lending institution. If you renew with a different mortgage lender, there could be extra administrative charges involved. Due to considerable competition among lenders, frequently there is no administrative fee if you are transferring a mortgage to another institution. In some cases another institution will absorb the legal fees and costs as well, as an inducement for you to bring the business away from a competitive lender.
Some people take out short-term mortgages, eg for six months, anticipating that interest rates will go down and that at the end of six months there will be a lower interest rate. The problem is that if rates have gone up instead of down at the end of the six months, your monthly mortgage payment will increase and you may not be able to afford, or want to pay, the increased rates. The other option you have is to negotiate a long-term mortgage, eg for five years, so that you can budget for the future over a five-year period with certainty about the interest rates. The lender is not obliged to renew the mortgage at the end of the term. If the lender decides to renew, an administration fee of $100 to $250 is often charged. However this is frequently waived by negotiation or due to competitive realities.
Open or Closed Mortgage
An open mortgage allows you to increase the payment of the amount of the principal at any time. You could pay off the mortgage in full at any time before the term is over without any penalty or extra charges. Because of this flexibility, open mortgages normally cost at least a percentage point more than standard closed mortgages. A closed mortgage locks you in for the period of the term of the mortgage. There is a penalty fee for any advance payment. A straight closed mortgage wil normally have a provision that if it is prepaid due to the property being sold or the death of the borrower, either a three-month interest penalty or the interest rate differential for the balance of the term, whichever is greater will be applied. Alternatively, the penalty could be waived entirely, if the new purchaser of the property takes out a new mortgage with the lending institution. Most closed mortgages have a prepayment feature with penalty. This is discussed below.
Prepayment Privilege
This is a very important feature to have in your mortgage if your mortgage is a fixed mortgage. If it is an open mortgage, you can pay in part or in full the balance outstanding on the mortgage at any time without penalty. If on the other hand you have a closed mortgage which does not have any prepayment privileges, you are locked in for the term of the mortgage, eg three years, without the privilege of prepaying without penalty.
You may therefore wish to have a mortgage which, though called a closed mortgage, is in fact partly open and partly closed, permitting prepayment at certain stages and in a certain manner, but not at other times. For example, you may be permitted to make a prepayment of between 10% and 20% annually on the principal amount outstanding. This could be made once a year at the end of each year of the mortgage anniversary date, or at some point during the year, depending on the terms with the lender. Another variation would also give you the option of increasing the amount of your monthly payment by 10% to 20% once a year. You can see the incredible difference this would make in terms of saving on interest and reducing the amortization period. Every time a prepayment is made, or every time you increase your monthly payments, the balance owing, and thus the monthly cost of interest, is reduced. The net effect is that a larger portion of each payment will be applied toward the principal, since monthly (or other agreed-upon regular) payments usually remain the same.
Make sure that you completely understand your prepayment options, as they could save you a lot of money. It is important to make a realistic assessment of the right package of your needs. For example, ask whether the prepayment percentage you can apply is based on the original mortgage taken out, or the outstanding balance. It makes a big difference.
