One of the common conditions in an offer is financing. I always thought that the financing condition was only based on getting a mortgage. Since we had been pre-approved, I never thought we’d have to use this condition in our offer. I was wrong.
Pre-approvals
I highly recommend getting pre-approved for a mortgage before you start looking for a house. It was one of the first things we did after meeting with our realtor for the first time and didn’t take long. If you are self-employed or have a lower credit score, it’s best to start the process as soon as possible in case you have any trouble. Not only was it comforting to know that we could get a mortgage, but it helped confirm our budget.
If you’re putting less than 20% down, like we are, there is another financing worry: having your house appraised.
CMHC
In Canada, CMHC (the Canadian Mortgage and House Corporation) must insure any mortgage that is more than 80% of the purchase price (i.e.: where the downpayment is less than 20%). We decided to put 15% down, so we fall into this category.
Once you purchase a house, CMHC enters the purchase information into their computer system and it spits out a yes or no (this ‘system’ is mysterious to me so I only sort of know how it works.). Apparently a no is very rare and can spit it out for a bunch of different reasons, including that the house isn’t worth what the buyer has offered, or there isn’t enough information to determine its value.
When it spits out a no (like it did for us), CMHC then sends an appraiser to see the house. The appraisal visit can take several days to schedule, so if your offer expires in 48 hours (like ours does), it can be very stressful. Genworth is another company that insures mortgages, so sometimes the bank can get them to do the appraisal if CMHC can’t.
The appraisal itself doesn’t take long – maybe 20 to 30 minutes. We were at our home inspection when the appraisers (yes, more than one) showed up, so we got to see what’s actually done. They walk around with a clip-board, take some photos, and act mysteriously. We tried to be as nice as possible to them and mention that our offer expired in 10 hours…
The appraiser eventually writes a report that is sent to the bank. The bank then confirms that the amount offered is, in fact, worthy of a mortgage. Then you’re good to go. If it’s not, then things get complicated.
Now for some math.
Appraisals matter, but it has to do with what your loan-to-value ratio is, and therefore what CMHC requires as insurance. Here’s an easy example: If you were pre-approved for a $1 million and want to buy a million-dollar home that’s actually only worth $200,000, it’s an obvious problem.
I tend to think about my mortgage in terms of what I couldn’t cover with my down payment is. However, to understand how appraisals affect your lending ability, you really need to think of it in a different way: what your loan-to-value ratio is.
Here’s a simple example:
Purchase Price: $500,000
Down Payment: $50,000 (10%)
Mortgage Amount: $450,000 (90%)
Mortgage Insurance Premium: $9,000 (calculated here)
The loan-to-value ratio here is high: 90%. This means that you are borrowing 90% of the value of the home (or putting 10% down). Because this is higher than 80%, CMHC requires mortgage insurance. In this case, $9,000. The $9,000 can be added to your mortgage or you can just pay it upfront.
If your house appraises at $480,000, then things get complicated.
Purchase Price: $500,000
Appraised Value: $480,000
Down Payment: $50,000 (6.25%)
Mortgage Amount: $450,000 (93.75%)
Mortgage Insurance Premium: $12,375
Note that the purchase price, down payment and mortgage amount didn’t change. But the loan-to-value ratio has. Now the $450,000 mortgage represents a higher percent of the value of the home (450/480 = 94%, whereas 450/500=90%).
Because your mortgage amount hasn’t change, you’re not going to pay any additional interest over the life of the mortgage. However, you are going to pay more mortgage insurance ($12,375 instead of $9,000) because your risk is higher. And, if you add this amount to your mortgage (which is the norm), you will pay more interest because the total mortgage just went up by this amount.
Where it gets really sticky is if you only have 5% down. In this case, the loan-to-value ratio is 95% – the absolutely highest that it can go. As in the example above, if the appraisal comes back lower than the purchase price, the loan-to-value ratio will increase above 95%. Since this isn’t allowed, the only way to purchase the home will be to make up the difference in cold, hard cash.
Confusing? A bit. But this isn’t a huge problem unless you’re hovering around the 5%-down line. Then you need to back out of the offer and walk away (because the bank will make you). Plus, who wants to overpay for a house anyways?