Capped rate mortgages: What, and why?

So, you've decided to buy a brand new home. But the home won't be ready for occupancy for a couple of years. What happens to your mortgage pre-approval? Enter the capped rate mortgage.

As a new-home purchaser, it is critical that you receive a bank pre-approval of your mortgage, in the form of a written commitment, for the money that you will need to buy the property. The mortgage commitment should provide, among other things, details regarding the amount of money, the length of the loan, the interest rate, and any special terms. The commitment should also provide for a very important item – how long the lender will guarantee the rate that has been committed to you. This is called a capped rate.

The capped rate mortgage in action

Let me explain. Let us assume that on Jan. 1, 2015 you are buying a property with a closing date of Dec. 31, 2016 and your rate commitment or “cap,” as shown on your commitment, is for a period of 14 months at 2.25 per cent. What this means is that, as long as the deal closes on or before the date that is 14 months from the date of the commitment, the bank will honour the rate that they have agreed to.

Sometimes deals get delayed past the time of the capped rate guarantee. What happens? Simply put, the lender no longer is legally bound to honour the original rate that was originally offered. In our example, if the rates increased to 3.5 per cent and the closing was delayed until June 30, 2016, the lender would have the option of telling you that the new rate was now 3.5 per cent.

There are more issues relating to this scenario, as you will have to decide if you still want the mortgage, and the lender will have to decide if it would still be prepared to give it to you. That is correct! Remember: if rates rise, the money needed to carry the same amount of mortgage also rises, so if you were tight on your financing before the rate increase, you may no longer qualify for the mortgage.

The moral of the story is to ensure that you negotiate a capped rate for as long a period as possible. Quite often, the mortgages offered by the builders on-site have built-in extension protection. Ask for this as part of your purchase agreement.