Learning Objectives

In this chapter, we cover various issues concerning usage of debt. In particular, we look at how mortgage financing works. We then talk about the advantages and shortcomings of investment loans (i.e., borrowing money to invest). Finally, we discuss the benefits of debt consolidation (i.e., combining debts of various sources into one).

Mortgage Financing

Suppose you want to buy a house. After visiting several potential choices, you decide on one house that you like the most. You then negotiate with the seller on the price. Now, you have to decide how much ofthe payment will come from your own money (i.e., down payment) and how much from borrowing.

In many countries, there is a rule governing the minimum down payment that a buyer needs to make. Typically, the minimum is expressed as a percentage of the house's price or appraised value. For Canada, that minimum is 5% (as of early 2011). Obviously, you can make a larger down payment than the minimum if you want. Depending on the amount of your down payment, your mortgage can be classified as conventional or high-ratio. A conventional mortgage is one where the buyer makes a down payment of at least 20% of the purchase price and borrow the rest (or, equivalently, the loan-to-value ratio is 80% or below). On the other hand, a high-ratio mortgage is one where the down payment is between 5% and 20% (or the loan-to-value ratio between 95% and 80%).