The leap from renting to owning
can be hard to adjust to, but for many it’s worth it. If you’ve given it some
thought and decided that buying
a home is a good idea, then you’re probably curious as to what that would
be like. How
does paying a mortgage work? Is paying a mortgage like paying rent?
Unless you live in Toronto or Vancouver, rent prices are probably cheaper than a mortgage would be a comparable property. In Toronto, with an average condo price of $550,000, you could buy a condo and have mortgage payments lower than the average rent of $2,020, but you’d have to have 20% down (that’s $110,000!). If you’re like the average Canadian, you don’t have that much money just sitting around waiting to be spent.
In what ways are mortgages and rent payments similar? They
- Are typically paid monthly
- Must be paid in cash (as in your own money, not credit)
- Shouldn’t take up more than a third of your monthly spending
And here are the ways they’re different.
- Mortgages require a significant upfront payment. Renting might require a month’s rent as a deposit
- A portion of your mortgage payments go towards building equity. Rent goes entirely to your landlord
- You can pay more on your mortgage to reduce how long you have to pay. Rent is a regular, fixed payment
- Mortgage payments won’t increase for the length of the term (except for certain variable rate mortgages). Rent can increase every year
Whether you rent or own, you’ll have to set aside a category in your budget for housing costs.
Rent will be due on the same calendar day every month, determined by your contract. Your mortgage payment date will also be written in your mortgage commitment and then your agreement.
Sometimes rent will be charged weekly, but that is usually reserved for vacation rentals. Many landlords prefer to be paid monthly to cut down on the amount of time they spend processing payments.
With a mortgage, you have a couple different options when it comes to how often you pay. The most common is monthly, but you can pay bi-weekly as well. For bi-weekly payments, you can further break it down into normal or accelerated payments.
Normal bi-weekly payments take the amount you would pay in a year and divide it by 26 (the number of two-week periods). Then you pay that amount every two weeks. That means some months will have three payments. Because they consider the whole year’s payment when determining your bi-weekly amount, the actual amount you pay over a year won’t change. This is good if you get paid bi-weekly and have trouble budgeting your money.
Accelerated bi-weekly payments take your monthly payment and divide it by 2. That amount then becomes your bi-weekly payment. Because of this math, you actually end up with the equivalent of a 13-month year, meaning you pay more per year than you would on a monthly payment schedule. So why would you want to do that?
By increasing your payments you’re decreasing your amortization. You’ll spend thousands of dollars less in interest and shave a few months or years off your mortgage.
When you go to basically any store, in person or online, you can use your credit card to pay. You borrow money from the credit card company and then pay it back when your bill is due.
Credit cards a convenient way to pay, and they come with some really good consumer protections. The downside is that they’re an easy way for people to spend more than they earn and then pay it back slowly over time, greatly increasing the cost of what they buy because of interest charges.
Auto loans, student loans, and personal loans are all ways that you can spend more money than you have. Sometimes you do this for a good reason, but sometimes you do it for bad ones. You can’t pay rent or your mortgage with a credit card.
There technically are companies that actually do let you do this in a roundabout way. First, you pay them with your credit card. They charge you a fee, then write a cheque to the bank or landlord for you. That may seem like a good way to get credit card rewards points, but in every case you end up spending more on the processing fee than you earn in rewards or cashback. It’s better for everyone to just pay out of your bank account.
General advice is that you shouldn’t spend more than 30% of your monthly income on rent. The more you spend on rent, the less you have available for other necessities like food and transportation (obviously). If more than a third of your income goes to rent, you’re either living in a location that’s too expensive or you’re not making enough money. Maybe both.
When you’re buying a house with under a 20% down payment, CMHC guidelines require you to spend no more than 32% of your income on housing related costs. Your gross debt service ratio (GDS) is the amount of your mortgage payment, heating costs, and property taxes divided by your monthly income. If that number is higher than 32%, you may have trouble getting approved for mortgage insurance, and by extension, a mortgage.
You must have at least 5% of the purchase price of a home as a down payment. For properties worth more than $1 million, you need at least 20% down. 5% down on a $500,000 condo (cheaper than average in Toronto) is $25,000 – not exactly a small sum. A $1 million home, cheaper than the average detached home in Toronto, needs $200,000 upfront.
The more you spend on your down payment, the lower your monthly payments will be. That’s because as you approach a 20% down payment, the amount you have to pay in CMHC insurance decreases. Since CMHC premiums are added back onto your mortgage, you end up needing to finance a lot more money, which can cost tens of thousands of dollars in total. But in order to have a large down payment, you either need a down payment gift from a wealthy relative or a lot of money of your own.
Renting doesn’t require a large upfront cost. In Ontario, security deposits (money you get back after you leave if you don’t damage the property) are actually illegal. Rent deposits are allowed, but they can only be up to the cost of one month’s rent.
One argument brought up when talking about the benefits of buying over renting is that you are building equity in your house while you’re paying the mortgage. That’s true, but 100% of your mortgage payment doesn’t go to the principal amount. Instead, a portion goes to paying off that month’s accrued interest first, and the remainder is applied to the remaining balance.
In the first few years of homeownership, more than 50% of your monthly payments go to interest. As time goes on, more and more of your money goes to equity. But there is a long delay between buying the home and having the principal be paid down.
At first you won’t be growing your equity by very much every month. Once you get closer to the end is when you’ll see huge jumps in your equity.
That being said, absolutely no portion of your rent payment goes towards building equity in the place you’re staying. You don’t own it, your landlord does. So while renting is cheaper than owning a home, you have to find ways to invest your money yourself.
Accelerated bi-weekly payments are one way to reduce the length of your mortgage. Another is to take advantage of your mortgage’s pre-payment terms. Spending just $100 more per month on your mortgage can cut a whole year off your amortization!
You can’t ask your landlord to pay more now to reduce payments later. Even if you could, there’s no reason to – you aren’t building equity in a property you rent.
When mortgage rates go up, what happens to you depends on what type of mortgage you have.
If you have a fixed mortgage– nothing happens. You keep paying the same payment.
If you have a variable mortgage – you will have to pay more in interest. Many lenders will simply adjust the amount of your payment going to interest rather than increasing your payment, but some will require you to pay more per month.
Once your term is finished, you’ll have to renew your mortgage (unless it’s paid off). When renewing, you’re at the mercy of the market. If rates have gone up by the time you renew, you’ll have to renew at a higher rate. If rates have gone down, then you get a cheaper mortgage!
With rent it’s very likely that your payment will never decrease. In fact, it could increase every year! How often it increases depends entirely on your landlord, although they can only increase it as much as the local government allows. In Ontario, they can only increase rent by 2% per year. They may choose to not increase rent if you’re been an especially trouble-free tenant.
When deciding if owning a home is right for you, don’t worry too much about how the payments work. What’s more important is that you can afford to pay them! As long as homeownership fits your budget and lifestyle, it can be a worthwhile investment and a satisfying lifestyle change