Fine Print 101— Definitions For A Surprisingly Long List Of Key Mortgage Terms And Insight Into How They Might Impact Your Mortgage Choices

Introduction

Today’s introduction will be short and sweet, as I think the title above and definitions below largely speak for themselves. My goal today is to provide a glossary or cheatsheet you can use when learning how to speak mortgage in order to guide you towards making the most informed decision possible about the best mortgage for you and yours. My fervent thanks once again to my friend and mortgage guy, Russ Morrison of The Morrison Mortgage Team for his input in creating and shaping this article.

• Posted Rate: the interest rate lenders advertise to borrowers for mortgages with different features and for different rates of time. Lenders provide posted rates for both fixed-rate and variable mortgages.
• Discounted Rate: the actual rate your lender charges you on your mortgage because you’re special rather than the rate they quote to the unwashed masses. You’ll likely need to haggle to get this rate, which is one way having a mortgage broker can help.
• Amortization Period: the amount of time using a set interest rate and a fixed payment schedule before your mortgage is paid off and you can sleep better at night. In reality, you will likely negotiate a number of different mortgages for smaller chunks of time (“terms”) at different rates and for different amounts before your mortgage is finally a thing of the past. You may need to reduce payments upon renewal or add to your debt to finance renos or junior’s quest to be a plastic surgeon. Conversely, you may be able to make additional payments ahead of schedule in order to get your debt paid down faster. As a result, your amortization schedule is a moving target that calculates how long until you are debt-free and adjusts with each payment, if you keep making your regular payments under the terms of your current mortgage if rates never change.
• Term: the length of any mortgage agreement, generally expressed in years, with five years being the most common. For most younger mortgagees, the term of your mortgage will be significantly shorter than your amortization period. For example, if you have a 30-year amortization period and a five-year term, you are currently on pace to take out six separate five-year term mortgages before you’re done, unless your amortization schedule changes, which it almost certainly will. When your mortgage term expires, you will need to either renew with that lender, shop around for a new lender who offers you a better mortgage or pay down the remaining balance. Before the existing mortgage expires, there are usually penalties that apply if you wish to pay down more of your mortgage than allowed under your mortgage agreement.
• Payment Frequency: how often you make payments towards your mortgage. Most mortgage amortization periods are calculated based on you making monthly payments. In reality, you have several other options which call for smaller, but more frequent payments that can often shave several years off your mortgage freedom date. Each of the first four options below have you paying the same amount each year as would be the case under a monthly payment scheme, but your mortgage balance declines faster the more frequently your regular payment. Under each of the two accelerated payment options, you are effectively paying an extra month’s worth towards your mortgage each year, which further shortens your amortization period. The bottom line is the longer the remaining amortization period in your mortgage, the more you’ll save by making more frequent payments and accepting an accelerated payment schedule. Your payment frequency options include: 
  • Semi-Monthly - Payments twice per month or 24 payments per year.
  • Bi-weekly -  Payments every two weeks or 26 payments per year.
  • Weekly - 52 payments per year.
  • Accelerated Bi-Weekly - 26 payments per year but each payment is equal to what you’d pay under a semi-monthly payment schedule.
  • Accelerated Weekly - 52 payments per year. Each payment is equal to what you’d pay under a bi-weekly payment schedule.
• Closed Mortgage: the most common type of mortgage, a closed-rate mortgage offers a lower rate than an “open mortgage” but charges you penalties if you want to make extra payments above those allowed in the mortgage agreement, or if you want to pay it down before your mortgage term elapses. Most of the options and features below are designed to provide more flexibility within closed mortgages, but there is seldom a free lunch—you generally pay for this flexibility through a higher interest rate. A closed-rate mortgage, as well as an open mortgage, can be fixed or variable.
• Open Mortgage: a mortgage that allows you to do what you want, when you want, including paying it down ahead of schedule, renegotiating along the way or getting a new mortgage from a different lender. You pay for this flexibility through a higher interest rate. If you’re looking to potentially move, then this might be the mortgage for you.
• Fixed-Rate Mortgage: a mortgage where the interest rate used to determine your regular mortgage payments does not change over the term of your existing mortgage, such as one, five or 10 years. Under a fixed-rate mortgage, your minimum required payments won’t change during that period, which offers protection to borrowers on tight budgets or who are worried about future interest rate increases.
• Variable Rate Mortgage: a mortgage where the interest rate charged on the balance of your mortgage is calculated according to a formula based on the lender’s posted prime lending rate, discounted by a set percentage (i.e. prime minus 0.75%). In other words, your interest rate isn’t guaranteed and can either increase or decrease during the term of your mortgage. Although each bank’s prime lending rate often moves in lockstep with the Bank of Canada’s prime lending rate, this isn’t always the case or lenders may not always decrease their rates as significantly as the Bank of Canada. In any event, when your interest rate changes, your regular payments change as well to keep you on target to pay down your mortgage based on the amortization period you selected. This can mean increased payments when the rates increase or decreased payments when rates go down. During times of lower rates, small increases to rates can mean significant increases to regular payments. For example, for every $100,000 owing on your mortgage, your payments will increase or decrease by approximately $12 a month if the prime lending rate increases by 0.25%.

One strategy to consider is to structure your regular payments as if your variable interest rate was perhaps 0.50% to 1% higher than is actually the case. That way, you’re paying your mortgage down ahead of schedule so long as rates don’t change, and your regular payments won’t increase until the actual interest exceeds this threshold. Some lenders also offer variable rate mortgages where your payments stay the same even if rates go up, which means no effect to your current cash flow, but the amortization period for your mortgage gets pushed back. Be sure to know whether this applies in your case if this is a concern.

• Hybrid or Combination Mortgage: a mortgage that is really two smaller mortgages, one portion of which is a fixed-term mortgage and the other is variable. This may be a way of hedging your bets if you have a larger mortgage, really like the idea of a variable rate mortgage, but you want to minimize the impact if rates do end up rising more than you expect.
• Convertible Mortgage: a variable mortgage that allows you to change your mind and switch to a fixed-rate mortgage midstream. Expect this flexibility to be priced into your original fixed interest rate and don’t expect to get your lender’s best interest rate when converting to a fixed-rate mortgage, and expect to pay a fee if exercising this option. Your rate will depend on what the lender is offering at that time, and it is often the case that you’ll need to actually lock in at a higher fixed-rate than the variable rate you’re paying at the time you make the decision, particularly if locking in while rates are rising.
• Interest Rate Cap: some lenders issuing variable mortgages may be willing to cap the maximum interest rate they charge even if rates rise far more than expected. This may be something to explore if you want to go variable but would like to limit the downside. As you might expect, there will likely be a charge for this extra protection.
• Breaking Your Mortgage: paying down your mortgage before the current term of your mortgage expires (“prepaying”) when the amount you’re prepaying exceeds the maximum amount you can prepay under the terms of your mortgage. As you might expect, there is a price to pay, which leads us to . . .
• Prepayment Penalty: If you need or want to “break” your mortgage, then the prepayment penalty for this will cost you. For a variable mortgage, this cost is typically the interest otherwise owing on your remaining mortgage balance over the next three months. For a fixedrate mortgage, the penalty is whatever is higher: interest otherwise owing over the next three months or, if interest rates are currently lower than your current rate, you will have to pay the “Interest Rate Differential” (IRD.)
• Interest Rate Differential (“IRD”): If breaking a fixed-rate mortgage when rates have decreased, your penalty is the IRD over the remaining term of your mortgage after you’ve made all allowable penalty-free prepayments (see “prepayment privileges”). More specifically, the IRD looks at the difference between the rate you agreed to pay originally and what someone could get if taking out a mortgage today for a time period equal to the number of years left in your current mortgage, and then factors in the remaining balance of your mortgage. For example, if you’re 36 months into a five-year mortgage with $200,000 left after all allowable prepayments, this means looking at the difference between two-year mortgage rates and essentially either the rate you’re actually paying on your five-year mortgage ( the “discounted rate”) or, in some cases, the “posted rate” at the time of your original mortgage on $200,000, which is usually the higher advertised rate for that lender.

As I explained in my last article, some lenders calculate the IRD in a very punitive way, although all lenders aren’t created equal. For example, lenders using the posted rate rather than the discount rate will generally charge a much higher penalty. Put another way, if you were actually paying 3.25% on that $200,000 mortgage just discussed and the current two-year rate was 2.25%, you’d think the IRD would be one per cent (3.25% minus 2.25%). If the posted rate three long years ago was 5.25% rather than the 3.25% you actually agreed upon, some lenders would use a 3% rate (5.25% minus 2.25%) for calculating the IRD. As a result, knowing how the different lenders calculate IRD should be a crucial part of your decision of where to borrow if looking at a fixed-rate mortgage and there is a more than hypothetical chance you might break your mortgage along the way. Not all lenders will calculate their IRD in exactly this way, but the outcome will be very similar in most cases to this example.

• Prepayment Privileges: There are typically two different types of prepayment privileges—the ability to pay down a set percentage of the original mortgage balance each year without incurring a penalty through one or more lump sum payments, and the right to increase your regular payments that year by a set percentage, also penalty-free. Generally, these benefits range from 10% to 20% paydowns of the original mortgage or 10 to 20% increases to your regular payments each year, and it is common, but not guaranteed that borrowers can maximize both benefits. For example, you may be able to both pay down 20% of your original mortgage and also increase your regular payments by 20% that year without paying any extra fees. Unfortunately, however, if you don’t take advantage of that year’s prepayment privileges, you can’t carry them forward to later years. Furthermore, once again, different lenders have different rules and rates for their prepayment privileges:
  • Some lenders use a calendar year (i.e. December 31st) as the deadline for using up that year’s prepayment rights, while others base it on your mortgage anniversary.
  • Some allow as many prepayments as your heart desires above a small minimum, while others may be far more restrictive. Some lenders allow you to make extra payments whenever the mood strikes, while others may only restrict extra payments to as little as one day per year, such as the mortgage anniversary.
• Some offer 10% annual prepayments while others might bump that up to 20% per year.

When looking to “break” your mortgage, maxing out on your prepayments just prior to that time reduces the penalty you would otherwise be stuck paying. If timed just right, you might be able to even take advantage of two years of lump sum prepayments rather than just one to further reduce your penalty. I discuss this in more detail in my previous article. Having more flexibility in how much and when you can prepay can save thousands of dollars in some cases.

• Blending Your Mortgage: You need to borrow more money before your current mortgage has expired and you want to roll that into your existing mortgage rather than triggering prepayment penalties and taking out an entirely new mortgage (aka “blend and increase”). The old and new rates and conditions will be combined into a single mortgage and payment with a rate that is somewhere between the old and new rates. Because the banks know that you want to avoid prepayment penalties or want to hang onto an older mortgage at a better rate than currently available (which isn’t today), you may not get the best possible rate for the new portion of your mortgage. Accordingly, it still might be worth determining whether or not it makes sense to break the mortgage instead and start from scratch. You might also look at blending and increasing if you are moving and have the option to “port”  your mortgage or transfer it to your new home.
• Blend and Extend: When your new blended mortgage starts a new mortgage term, such as an additional five years from that point onward. You may lean towards that option for fixed-rate mortgages if rates are currently delightful and/or you worry about future rate increases and want to lock in for a longer period than the remaining term of your original mortgage. The calculation of your new payments and rates will not extend the rate on the remaining term of your original loan past its expiry, so it’s not like you can extend the savings if the original mortgage was at a lower rate. Instead, the rate on your original mortgage and its remaining term will be taken into account when determining the overall interest rate you’ll need to pay for the new term of your mortgage.
• Blend to Term: When your new blended mortgage doesn’t extend the term of your old mortgage. Thus, if you had two years left on your original mortgage, your new blended mortgage will still expire when those 2 years have come and gone. This may be the way to go if the goal is to remain as flexible as possible going forward, such as expecting rate drops, considering a potential move or wanting to be able to canvas the market again in a couple years, particularly if you’re not convinced that you got a great rate on your new borrowing, but don’t want to break your current mortgage and pay a penalty.
• Portable Mortgages: when you move, this mortgage moves with you. Even if you aren’t planning on moving, it’s a great thing to have as much flexibility as possible to deal with as many of life’s little surprises as possible, assuming that the cost of having this feature (i.e. the increase to your interest rate) isn’t too steep. Unfortunately, however, the purveyors of small print now include many “ifs, “ands” and “gotchas” so that many socalled portable mortgages are in fact as portable as the Tower of London. 

Some of the potential caveats, requirements and drawbacks include:

• Requiring that you restart your mortgage term when you port, which isn’t so wonderful if you wanted the flexibility to shop the market when your original mortgage term is due to expire.
  • Either not allowing borrowers to port variable rate mortgages or requiring that you convert them to fixed-rate mortgages at that time. If you have a Home Equity Line of Credit (HELOC), you may also not be able to port that along with your traditional mortgage.
  • Only transferring your existing balance with no right to “blend and increase”, which means having to come up with a bigger down payment on the new place or having to break your mortgage anyway.
  • Going through the entire mortgage application process again from scratch, including proof of income and reviewing your credit scores, which can’t fall below a certain level, and current debt levels. The lender also has to be willing to lend against your new place, which might not happen with certain types of property.
  • Having to come up with bridge financing to cover the down payment on your new place before being reimbursed from the sale of your old one if your lender won’t offer you this option.
  • Limiting the geographic area to which you may port. For example, some credit unions may not allow out-of-province porting.
  • Specifying that you must close on your new place within deadlines as tight as 30 days after you’ve sold your old home
  • You will likely still have to pay a fee to port, and have your new place appraised.

• Assumable Mortgage: A mortgage that allows someone else to take it over midstream “as is” if they purchase your current home. The new borrower would need to qualify. This option can save money if it means not having to break your current mortgage and may be an attractive selling feature to buyers when your current mortgage is less than the current interest rate offered for new mortgages. In some cases, you will remain liable for missed payments if the new borrower defaults, so find out this detail in advance. On the other hand, mortgage guru Russ Morrison has never actually seen anyone assume a mortgage in his 20 years of inhabiting mortgage-land. 

Conclusion

Congratulations for making it through this list alive and best wishes in selecting the perfect mortgage to suit your situation. Despite taking the time to educate yourself on this subject, I still recommend using an independent mortgage broker to walk beside you during the mortgage process. Getting a mortgage is a huge financial commitment for most of us. Having someone to walk beside us along the way, access the best rates, crunch the numbers on our behalf and play devil’s advocate as necessary can go a long way to making sure the choices you make are the right ones. Even better, they’re free!

Colin S Ritchie - Lawyer & Financial Planner colinritchie@colinsritchie.com