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Published March 2, 2022

What Is a Mortgage?

Mortgages are loans used to buy a house or other property. Mortgages require you to make monthly principal and interest payments over a period of several years.

While many Canadians aspire to home ownership, few have the ability to buy a house outright with cash. That’s where mortgages come in.

A mortgage is a loan that’s secured by the property it’s used to purchase. This is what allows you to live in a house purchased with a mortgage, even though you haven’t yet paid off the loan. But, because the property serves as collateral, the house can be repossessed if you fail to make your agreed-upon mortgage payments.

» MORE: How does a mortgage work in Canada?

The meaning of ‘mortgage’

The word etymology of the word mortgage is quite interesting. According to Oxford Languages, a global dictionary publisher, it is derived from the Old French words ‘mort’ (dead) and ‘gage’ (pledge).

Some say that this is because mortgages are pledges that always end in a type of death: the contract between borrower and lender dies when the loan is paid in full, or the borrower’s status as a homeowner dies if they default on the contract to pay back the loan.

How does a mortgage work?

A mortgage is provided by a financial institution, such as a bank, which can then take possession of the property if the terms of paying back the mortgage, as set out in the contract, are not met.

Using a mortgage to buy a home doesn’t mean zero cash is required.When an individual is ready to buy a home or a property they will need to pay some money upfront, which is known as a down payment. Depending on the cost of a home, the down payment can be as little as 5%. The remainder of the cost is then borrowed as a mortgage from a lender (usually a financial institution such as a bank). The buyer will then repay the money borrowed plus interest and fees over an agreed-upon period of time. Typically, this payment period is up to 25 years.

A portion of the mortgage is paid back on a regular basis depending on the agreed-upon terms of the mortgage contract. This means the frequency of the payments could be weekly, bi-weekly, monthly, etc.

The mortgage payment covers both  the principal and the interest on the money borrowed. In the beginning, most of the payments go towards the interest owed and only a small portion goes to the actual principal. For this reason, it’s in your best interest to pay off the property as quickly as possible to avoid accumulating extra interest. However, any extra payments you can make will need to fall under the terms of your agreement.

Usually, a mortgage is paid back over a long period of time (known as an amortization period). In Canada, a total amortization period of 20 to 25 years is very common.

» MORE: What are principal and interest?

Requirements for getting a mortgage

Getting a mortgage is a big step requiring some financial preparation. The first step is to check your credit score and credit report to make sure there are no errors. Lenders will rely on your credit report when deciding whether or not to approve you for a mortgage, so you want to ensure that everything is correct and in order.

Lender will also want to be sure that you can afford your mortgage and keep up with payments, they’ll do this by asking for a letter of employment and examining your debt-to-income ratio. It’s a good idea to create a mock budget with your expenses and figure out your gross debt ratio (GDS) and total debt ratio (TDS) to make sure that you will be within the limits. Your GDS should be no more than 32% and TDS no more than 40%.

You will also need to be able to pass the mortgage stress test. At this time, that means your bank will use an interest rate of either 5.25% or your negotiated interest rate plus 2%, whichever is higher.

If you’re unable to meet the credit score and income requirements of a federally-regulated mortgage lender, sometimes referred to as ‘A’ lenders, a subprime mortgage from a ‘B’ lender may be an alternative option. Be aware that subprime mortgages are considered higher risk for lenders, and often come with significantly higher interest rates, fees and closing costs.

» MORE: Here’s the minimum credit score needed for a mortgage

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How to start a mortgage application

First, make sure that you have all the documents required. This includes your employment information, the down payment information, other financial information, such as your assets and liabilities, as well as details about the home or property you are hoping to purchase. Once you have all this documentation in place, contact a broker or lender to start the mortgage pre-approval process. It’s generally recommended that you be pre-approved for a mortgage before making an offer on a house.

Common types of mortgages

Once you’ve passed the mortgage stress test and are approved for a mortgage, you can choose between several common types.

Open Mortgage: With an open mortgage, you’re allowed to make extra payments (called prepayments) whenever you please. This means you could even pay off your mortgage in full before the end of the term without having to worry about any additional fees or charges. However, open mortgages tend to have higher interest rates and shorter terms that may only range from six months to a year.

Closed Mortgage: In a closed mortgage, you won’t have the same flexibility with prepayments. Some prepayments may be allowed without charges, but there is a strict limit on how many you can make without incurring a stiff penalty fee. However, closed mortgages tend to have better interest rates than open mortgages.

Variable Rate: Variable interest rates fluctuate are tied to a financial institution’s prime rate, so they can rise and fall over the term of a mortgage. Lenders often offer variable mortgages for lower interest rates than fixed mortgages.

Fixed Rate: With a fixed interest rate, your rate is guaranteed to stay the same throughout the full mortgage term. However, these rates are generally higher than variable interest rates.

» MORE: How to choose between fixed and variable rate mortgages

Definitions of common mortgage-related terms

Mortgagor: The individual who takes out the mortgage.

Mortgagee: The lender.

Principal: The total amount borrowed.

Interest: The fee paid to the lender in return for borrowing the money.

Equity: Home equity is a term used to describe the the market value of a house minus the remaining mortgage balance. Equity is accumulated by making a down payment and paying down the principal.

About the Author

Hannah Logan
Hannah Logan

Hannah Logan is a writer and blogger who specializes in personal finance and travel. You can follow her personal travel blog EatSleepBreatheTravel.com or find her on Instagram @hannahlogan21.

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