Finances

Understanding Credit

Most people need a mortgage to buy a home. Before lenders approve a mortgage, they look closely at your credit report and credit score.  CreditCredit Your ability to buy something without paying for it right away, based on the trust that you will pay for it in the future. is your ability to buy something without paying for it right away. Every purchase you make using credit is recorded, and so is how reliable you are in paying off your credit bills. All of this together becomes your credit score, which is a measure of how risky you are to a lender.

Your credit report and credit score play a big role in whether a lender will approve you. Your credit report is a history that helps lenders determine what kind of “financial risk” you are, and if you are likely to repay your credit on time. Your credit report shows your financial history, including:

• CreditCredit Your ability to buy something without paying for it right away, based on the trust that you will pay for it in the future. cards, loans (including lines of credits and mortgages), and phone accounts
• When you opened each account or loan, and how much you owe
• Whether you make payments on time
• If, and how often, you go over your credit limit
• Any debts sent to collections
• Recent credit checks by lenders
• Other statements and alerts

Before you start shopping around for a mortgage, you should order a copy of your credit report to make sure it does not contain any errors. Every lender will look at your credit report before approving you for a mortgage, so it’s important to make sure everything is in order. Lower scores may mean the lender may decide to do one, or all, of the following:

• Approve you with a higher interest rate
• Approve you for a smaller loan amount
• Need a bigger down payment from you
• Need a co-signer for the mortgage
• Refuse to approve your mortgage

Mortgages

A mortgage is a loan secured by real property (commonly referred to as real estate) that allows you to buy a property. It is also a contract that includes the rights, and obligations, of both the lender and the borrower. Mortgages are often very large and have conditions which say when you have to make payments, and how much you have to pay. A mortgage will also come with a length of time, which is how long it will take you to pay it off if you make your payments. Finally, all mortgages are secured, or guaranteed, by the property you are buying. This means if something goes wrong and you can’t make payments (default on the mortgage), the lender can start the foreclosure process and you could lose the property.

Finally, the size of the mortgage depends on how much money you need to borrow, after subtracting your down payment. The remaining total is known as the principal. As you make payments, your principal gets smaller. But, you also need to pay off your mortgage interest as well.

Types of mortgages

There are many different types of mortgages, interest rates, and payment options. The following section will give you a quick introduction to some of the most common varieties that might be available to you.

Open mortgages

Open mortgages are a type of mortgage that gives you freedom to pay off the remaining balance whenever you want. Additionally, there are no restrictions preventing you from making lump sum payments at any time, to help reduce the principal amount. The downside is that most lenders charge higher interest rates for these privileges, which can mean increased costs. Also, since terms are shorter (usually only 6 months to a year), you can’t lock in a good interest rate for very long. In general, if you know that you will soon be coming into a lot of money, or if your finances are uncertain and you want the freedom to easily refinance, an open mortgage might be something to consider.

Closed mortgages

Closed mortgages are a type of mortgage that limits how much you can pay towards the principal before paying extra penalties. Usually, there are limits on how often you can make lump sum payments (for example, once per term), and there may also be an upper limit that you cannot exceed. However, interest rates are usually lower in closed mortgages, making them an ideal option for people who want stability in their budget.

Quick comparison: open vs. closed mortgages

	Open MortgageOpen Mortgage A type of mortgage that gives you freedom to pay off the remaining balance whenever you want. Additionally, there are no restrictions preventing you from making lump sum payments at any time, to help reduce the principal amount.	Closed MortgageClosed Mortgage A type of mortgage limiting how much you can pay towards the principal before you have extra penalties. Usually, this means there is a cap of the lump sum payments to once per term, and there may also be an upper limit.
Interest rates	Higher interest rates	Lower interest rates
MortgageMortgage Mortgages are loans given to you by a financial institution so you can buy a home. When you take out a mortgage, you agree to pay it back over a set period of time (called a term), usually by making monthly or bi-weekly payments. payment restrictions	You can pay off the mortgage anytime	Can make extra lump sum payments to pay off your mortgage (but usually with limits)
Terms	Terms are shorter (6–12 months)	Terms can range between 6 months –10 years
Refinancing and breaking	Terms are shorter (6–12 months)	There are penalties to refinance or break your mortgage

MortgageMortgage Mortgages are loans given to you by a financial institution so you can buy a home. When you take out a mortgage, you agree to pay it back over a set period of time (called a term), usually by making monthly or bi-weekly payments. Interest
If you decide to purchase a home, the first number that will probably catch your eye is the price of the property. However, the interest rate on your mortgage is just as important as the purchase price, as it determines how much you end up paying in total.

Every month, your lender will charge you interest on your principal, which means the higher the interest rate the more money you are going to end up paying. Even a few percentage points can add up to thousands of dollars (or even hundreds of thousands of dollars depending on your mortgage amount). Lenders will usually offer better rates on certain kinds of mortgages, and it is a good idea to explore all your options before making a decision.

While shopping around for the best interest rate is important, the rates available are beyond your control. One thing that you do have some power over is which type of mortgage interest you choose, with the three most popular kinds being Variable Rate, Fixed Rate, and Adjustable Rate.

All of these mortgages have terms, in which you can lock into a certain type of mortgage and interest rate for a set period of time, usually between 1 to 5 years. Once that term is complete, your mortgage comes up for renewal, allowing you to make changes before the next term begins.

Variable Rate Mortgages

Variable rate mortgages are mortgages that have an interest rate that changes throughout the term, but your payments do not. At the beginning of the term, your lender will use their current interest rate to calculate your payment each month. If the interest rate drops, more of your money will go to the principal of your mortgage. However, if the rate goes up, your monthly payment will go more towards interest. Lenders tend to offer lower interest rates to people who want to sign a variable rate mortgage.

Fixed Rate Mortgages

Fixed rate mortgages are mortgages that have a set, or ‘fixed’ interest rate throughout the term. This makes it easier to budget with, as you know that your payments will not change, and the same amount of money will be going to the principal every month. Often, this stability comes with a price, as fixed rate mortgages usually come with a slightly higher interest rate.

Adjustable Rate Mortgages (ARM)

Adjustable rate mortgages are mortgages that the lender reviews at set intervals and then adjust based on any changes to the lenders prime rate – their lowest available interest rate. This means if the prime rate drops, your monthly mortgage payments decrease as well. On the flip side, if the prime interest rate increases, then you must make higher monthly payments too. Adjustments can take place without much warning and may happen as often as eight times per year.

Mortgage application and lender approval

Before you can make an offer for a home, you need to know what you can afford. You can apply for a mortgage through a bank or a mortgage broker.  This process usually involves getting pre-approved for a mortgage, in which a lender looks at your finances and finds out the maximum amount of money they will lend you. Once you are pre-approved, you will have 3 important pieces of information:

• How large of a mortgage you could get
• The maximum monthly mortgage payments you will need to budget for
• Which interest rate you will be getting

Essentially, a pre-approval provides estimates about how much you may be able to borrow and what your mortgage payments could be. It also may lock in an interest rate for 60 to 120 days. Typically, a lender will ask you for the following information for pre-approval:

• ID
• Proof of employment
• Proof of your down payment and savings
• Information about debts and assets

While getting pre-approved is exciting, it doesn’t mean you are guaranteed to get that amount of money for a mortgage. The final approval process will depend on the value of the home you wish to buy, as well as the actual size of your down payment. As a result, it may be a good idea to look at properties that are a little bit below your pre-approval limit. This will increase your chances of getting the home you decide to purchase, while also saving money for other expenses such as closing costs, moving, and initial maintenance.

When you make an offer on a home, the lender must approve the mortgage based on:

• Your income
• Your expenses
• Your debts
• Your credit report
• The home’s value

Lenders also check whether you can handle higher interest rates through a stress test. For example, if your debt payments are more than 32% of your income—or if your total debts are above 40%, lenders may deny your mortgage application.  If the lender denies your mortgage application, they can tell you what to improve, such as raising your credit score or saving a larger down payment.