Mortgage Basics

What is a Mortgage?

What is a Mortgage?
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  • Gregory Saget-Rudd
| Apr 24, 2020
Reviewed, Jun 9, 2023
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    Before the homebuying process can begin, it’s essential to understand what exactly a mortgage is and how this loan typically works. A mortgage is a loan that allows potential homeowners like yourself to purchase property without having the entire sum immediately available for purchase—it spreads out your payments into more manageable installments over time.

    In essence, it serves as an agreement between you, the borrower, and your chosen financial organization; in exchange for providing funds upfront towards purchasing your desired real estate property, they’ll receive regular repayments from you over several years. In this article, we break down what a mortgage is, the essential parts of a mortgage, and the different types of mortgages available to home buyers in Canada. 


    Key Takeaways

    • A mortgage is a loan that you take out to buy a home or other type of real estate. 
    • Each mortgage payment can include up to four components known as PITI – Principal Interest Taxes Insurance
    • There are different types of mortgages– open vs closed, as well as interest rates– fixed vs variable.

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    What Is A Mortgage?

    A mortgage is a loan that you take out to buy a home or other type of real estate. Unlike other forms of loans, such as personal loans or credit card debts, mortgages are secured by the property that you’re buying. This means that if you don’t keep up with your mortgage payments, your lender has the legal right to repossess your home and sell it to recoup their losses. However, as long as you make your payments on time, a mortgage can be a valuable asset that helps you build equity and achieve your homeownership goals.

    How Do Mortgages Work?

    When you get a mortgage, a lender is providing you with a specific amount of money to buy the property, which you will then have to pay back over a set period of time, usually between 15 to 30 years. The amount of money you borrow will depend on a few factors: 

    You will also need to pay interest on the loan, which is the fee for borrowing the money from the lender. Over time, as you make your monthly payments, you will begin to build equity in the property, which is the difference between the property’s value and the amount you owe on the mortgage. 

    There are different types of mortgages, as well types of interest rates a borrower can choose from, which will determine what your monthly mortgage payments will look like. 

    How To Choose The Best Type Of Mortgage For Your Needs?

    There are different types of mortgages– open vs closed, as well as interest rates– fixed vs variable.

    Open vs closed mortgage

    If you’re looking for a mortgage, you’ve likely come across the terms, “open” and “closed.” But what do they actually mean? Essentially, open and closed mortgages refer to the flexibility of your repayment options. A closed mortgage means that you’re locked in to a specific rate, term, and payment schedule. While you’ll typically get a lower interest rate with a closed mortgage, you won’t be able to make any extra payments or pay off your mortgage early without facing penalty fees. An open mortgage, on the other hand, allows you to make extra payments or pay off your mortgage in full without any fees. However, the flexibility of an open mortgage typically means you’ll have a higher interest rate. Depending on your financial situation and goals, one option may be better than the other.

    Fixed Rate Mortgage

    A fixed-rate mortgage has a fixed interest rate for the entire mortgage term, meaning the total payment between your interest and principal components stays constant throughout your term. When the mortgage commitment is issued, your fixed-rate mortgage locks in the bond yield, which stays unaffected by the BoC’s overnight target to the key policy interest rate – providing predictable payments to the borrower as long over the whole mortgage term.

    Variable Rate Mortgage

    A variable-rate mortgage provides you with a floating interest rate on the interest portion of your payment. Your lender’s discount is a static variance from the prime at the time you commit to your mortgage. However, over your mortgage term, your variable rate will adjust alongside the lender’s prime rate, usually based on a premium added to the Bank of Canada (BoC) key policy interest rate.

    In a variable-rate mortgage, the interest component of your mortgage payment will adjust alongside your interest rate; your payment may not. There are two variable-rate mortgage types: those with static payments and those with variable or fluctuating payments. Static payment variable rate mortgages are known as variable rate mortgages (VRM). In contrast, variable rate mortgages with a variable payment, where the payment adjusts with changes in the lender’s prime rate, are more accurately called adjustable rate mortgages (ARM). Commonly, they are both known as variable-rate mortgages.

    What Are The Parts Of A Mortgage?

    Every mortgage payment includes at least two parts: 1) A portion of the amount owing on the outstanding principal balance; and 2) Interest on the outstanding amount of the home loan. Additionally, if you made less than a 20% down payment on your property, you’ll also be charged mortgage default insurance. And, finally, some mortgages – especially first mortgages – also include a collection of property taxes, which are then automatically paid on your behalf.

    Principal

    Mortgage principal is the outstanding balance of your mortgage – calculated as the amount borrowed from the lender minus the amount repaid to the lender. As mortgage payments are made, the mortgage principal is reduced.

    Interest

    Interest is paid on top of your mortgage loan payments as the cost of doing business with your lender. Your interest rate indicates the annual cost to borrow money from your lender. The rate is expressed as a percentage of your total loan balance and is paid on at least a monthly basis, along with your principal payment, until your loan is paid off. Because your mortgage balance decreases over time, you’ll pay more in interest at the beginning of your home loan.

    Taxes

    Your lender may collect property taxes along with your mortgage payments, particularly if you’re a first-time homebuyer to ensure your taxes are paid on time. You can also choose to have your lender collect these taxes for you. The tax funds are then kept in a special ‘escrow account’ by your lender until your property tax bill is due, at which point they’re paid on your behalf.

    Homeowners’ insurance

    Lenders often require homeowners’ insurance be in place to cover damage from fires, storms, accidents and other catastrophes. You can choose to insure your home and belongings for either their replacement cost or actual cash value. Replacement cost is the amount it would take to replace or rebuild your home or repair damages with materials of similar kind and quality, without deducting for depreciation. Actual cash value is the amount it would take to repair or replace damage to your home after depreciation. 

    Mortgage insurance

    Also known as ‘mortgage default insurance’, this is mandatory insurance you must have when buying a property and making less than a 20% down payment. This insurance protects your lender in the event you stop making payments and default on your mortgage loan. This insurance empowers Canadians, who may otherwise not be able to purchase homes, to be part of the real estate market. Without it, mortgage rates would be higher, as the risk of default would increase.

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    3 Tips to reduce the interest paid on your loan

    The simplest way to reduce the interest paid on your mortgage loan is to contribute a larger down payment. The larger the sum you put down, the smaller the amount of your purchase price you will be charged interest on. 

    A second way is to always shop around when it’s time to renew your mortgage. Once your mortgage term is up, it is crucial that you research as many lenders as possible to make sure you are getting the lowest interest rate out there. Don’t just renew with your current lender!

    Finally, another way to reduce interest paid is to pay off your mortgage faster The bigger dent you make in your principal, the better.

    Common mistakes people make when taking out a loan 

    One common mistake people often make is not budgeting for the additional costs and fees that come with the loan. These may include closing costs, appraisal fees, and property taxes. Failing to include these expenses can result in financial strain and make it difficult to keep up with mortgage payments. 

    Another mistake is not understanding the different types of mortgage loans available and choosing one without fully evaluating the options. It’s essential to seek guidance from a reputable lender or financial advisor to ensure that the mortgage loan is the right fit for your long-term financial goals.

    As mentioned above, one of the most common mistakes people make when taking out a mortgage loan is not shopping around for the lowest mortgage rate. Always remember that doing thorough research will always pay off; save money by approaching as many lenders you can!

    How refinancing can help or hurt your financial situation

    Refinancing your loans can be a great financial move if done correctly, but it can also potentially hurt your financial situation if you’re not careful. Refinancing involves taking out a new loan to pay off an existing loan, often with better terms or interest rates. This can lead to lower monthly payments, reduced interest rates, and even flexibility in the loan terms. However, if you choose to refinance with a longer term, you may end up paying more interest in the long run. It’s important to weigh the pros and cons before making any decisions and to carefully consider your current financial situation and future goals. Overall, refinancing can be a useful tool in managing your finances, but it’s important to do your research and make an informed decision.

    FAQ

    What is mortgage default insurance?

    Mortgage default insurance is a type of insurance that is designed to protect lenders against the possibility of a borrower defaulting on their mortgage payments. It’s important to note that this insurance is not designed to protect the borrower – it is solely for the benefit of the lender. In most cases, lenders will require borrowers to take out mortgage default insurance if they are providing a loan to someone who is making a down payment of less than 20% of the purchase price of the home.

    How do I choose between a fixed or variable mortgage type?

    Deciding on a variable or fixed rate is a question of personal choice and risk appetite. And while variable mortgages have proven to be more cost-effective over time than fixed mortgages, some people prefer the certainty of having the same payment throughout the mortgage term.

    It is recommended that you take time to speak with a mortgage professional to discuss your current financial situation as well as your short and long-term plans for yourself and your home.

    What is the difference between mortgage term and amortization?

    When it comes to mortgages, there are two important terms to understand: mortgage term and amortization. The mortgage term is the length of time a borrower commits to a specific interest rate, payment schedule, and lender. This can range from as little as six months up to 10 years or more. On the other hand, amortization refers to the length of time it takes to pay off the entire mortgage, which can be as long as 25 to 30 years. While these terms may sound similar, they can have a significant impact on your monthly payments and overall financial outlook. It’s important to understand the difference between them to make the best decision for your unique situation.

    Final Thoughts

    In conclusion, getting a mortgage can be an overwhelming process that requires knowledge and expertise. That’s why it’s important to do your research, keep track of all the documents you need, and speak with an experienced expert before making any decisions. If you have questions or would like assistance with understanding what is a mortgage and how to go about applying for one, we highly encourage you to get in touch with one of our mortgage experts today.


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