Are you considering buying a home? This is a big decision, given the potential size of the loan and the long period involved, perhaps one of the biggest financial decisions you’ll make. This type of loan is usually referred to as a “residential mortgage loan” (we’ll say “mortgage” from now), and as you could imagine, there are several considerations to take into account.
We’ll cover this topic in two parts and by the end, we hope to help you understand various aspects of this important decision, including, mortgage terms; costs associated with a mortgage; how much house you can afford, and so on.
What is a mortgage?
In a residential mortgage loan, you pledge your house to a lender as security for the loan to purchase that property. This pledge is referred to as a “mortgage” or a “lien”. Should you not meet your mortgage payments, the lender then has a claim on the house and can “foreclose” (take possession) of the property. In the case of a foreclosure, the lender may evict the occupants of the home and sell the house, using the income from the sale to repay the outstanding loan.
The lender’s right to do this (and one of the documents you will sign) is contained in a legal document called a “mortgage deed”. It contains the terms of the mortgage loan, for example, the amount of the debt, length of the loan, the interest rate basis, and obligates you to personally repay the debt according to those terms.
The lien on the property reduces the risk to the lender; therefore, they are more willing to offer a lower rate on mortgages than other types of personal debt.
Quite sadly, the residential mortgage market in the Caribbean remains traditional. Transparency, in particular, for buyers and borrowers is lacking; an absence of transparency usually works in the favour of sellers and lenders. However, most lenders have fairly standard approaches to obtaining a mortgage and the process among them should be similar.
The main features are as follows:
Most mortgages are simple 20-25 year (30 years would be rare) amortizing loans, which are loans in which the principal is repaid over the life of the loan according to an amortization schedule (make sure you are provided with a copy of this schedule), typically through equal monthly payments. Each payment represents a portion of principal and interest.
You will have to make a downpayment on the property, and the exact amount will vary by lender and credit quality of each borrower; therefore it could likely vary between 10-25% of the purchase price.
Fixed vs Variable interest rate loans
Mortgages are either fixed interest rate or variable rate loans, although variable rates loans are the most widely offered.
In a fixed rate mortgage, the interest rate remains the same over either the entire life of the mortgage or the period stipulated by the lender. This could benefit you because the loan payment does not change over the period agreed i.e. there is certainty. Of course, you could benefit if interest rates rise in the future because your rate is fixed at the previously lower rate, but they can also be disadvantageous if rates fall (unlikely in our local markets at this stage).
In contrast, the interest rate on a variable rate mortgage could change as market interest rates move over the life of the loan; therefore, your loan payment is likely to change in the future. This can be good for you if interest rates are declining, as the mortgage rate will adjust downwards. Of course, the reverse is also true. If interest rates rise, your loan payments and the cost of the loan will increase.
Mortgage market reference rate
One of the responses to the criticism of lack of transparency in the mortgage market was the creation of the Mortgage Market Reference Rate (MMRR) by the Central Bank of Trinidad and Tobago (CBTT).
The MMRR is essentially an interest rate benchmark that the CBTT calculates and announces quarterly. Your mortgage loan is priced from the MMRR plus a margin determined by each lender. The margin is supposed to take into account your creditworthiness, size of the downpayment you make, and location of the property.
If the MMRR declines and you have a variable rate mortgage, you should expect your loan rate to reduce at its next re-pricing date. If the MMRR increases, this signals that your mortgage rate could increase, but it is left up to the lender whether to implement the rate increase.
The MMRR is an important indicator, which you should monitor. It is announced the first working day in March, June, September and December.
A prepayment is simply a lump sum payment that you may want to make sometime during the life of the loan. It is applied entirely to reduce the principal balance of the loan, which would lower your total interest cost.
There does not seem to be a clear market practice about prepayments, but it is easy to understand why lenders may not want to encourage them. They may in fact include a penalty to discourage borrowers, or alternatively, your mortgage agreement may allow for prepayments with no penalty once appropriate notice is given. Nonetheless, given the competitive mortgage market, lenders may be prepared to waive prepayment fees.
Personally, we find the reason for a prepayment penalty in our market to be a little unclear, especially if you do not have a fixed interest rate mortgage. While this potential penalty is not a current payment, it is something you need to bear in mind and make sure you understand the rules.
Transferability / Switching
As the mortgage market becomes more competitive, lenders frequently try to encourage borrowers to switch from their current lender. This is in your favour, as you are likely to get better terms and an ultimately cheaper mortgage. Before you commit to a loan you should be certain about the rules for transferability. You want the most flexibility possible.
Eligibility criteria used by lenders
In the post How Much is Enough Debt? – Part 2 we discuss two of the more common guidelines lenders follow in order to determine how much to lend you. They are repeated here for your convenience:
- Debt Service Ratio (DSR), which is your total monthly loan payments (principal plus interest) divided by your gross income. If you have a low ratio (e.g. 15% or 20%), this means a small portion of your income is currently servicing debt. This translates to the lender that you have room to borrow more. Typically lenders like borrowers to have ratios less than 40%.
- Loan to Value Ratio (LTV), which measures whether the lender has an appropriate buffer built into the security (your home) that it takes as collateral. Typically lenders like LTV ratios of 75% but it depends on various factors, e.g. the quality of the home, ease of sale, etc. Let’s say you are buying a house for $100,000 and they want a LTV ratio of 75%, this means they will not want to lend you more than $75,000.
Mortgage must do’s
There are a few things that prospective buyers should do/try. Here are a couple suggestions:
- Comparison shop. Don’t assume your regular banker is giving you the best deal. This commitment is too important and expensive. Small differences in rates or fees can make a difference.
- Negotiate. Don’t let a lender dictate the terms. Push back and ask for what you want. Don’t take “No” for an answer from the officer in front of you; ask to speak to someone more senior. Remember, lenders love residential mortgage loans. Make them work for yours.
- Push back on fees. Most fees are ridiculous. Ask why you are being charged a particular fee and don’t hesitate to ask for a waiver. But be selective; you will not get all waived.
- In Trinidad, you will receive a Disclosure Statement, which the lender is required to provide. It outlines various details about the loan terms and fees. Read it carefully and ask questions about anything you do not understand. Lenders are now required to ensure that all relevant information is presented to you in an easy-to-read format.
- Understand the prepayment rules and make sure you have the ability to make periodic repayments. If you have a fixed rate loan, the chances are you will have to pay a penalty for prepayments during the fixed period, but this should not generally apply to variable rate loans. Regardless, make sure you know the conditions, how much, and when you can make repayments.
- Understand the rules about your ability to switch the loan to another lender in the future.
- Know how much you can afford. We cover this in Part 2 of this post (Read on!).
We hope you enjoyed the post, and we’d love to hear your thoughts or questions in the comments below!