This piece was originally published in November 2016, and was updated on July 6, 2022.
What is a mortgage? It’s a question we’ve all asked at some point, and it’s one that we can answer. A mortgage is a major financial commitment, so the more you know about them, the more prepared you’ll be if you decide to get one for yourself.
Read on for a short answer to the ‘what is a mortgage’ question, as well as some further information about how a mortgage works.
What is a mortgage?
A mortgage is a loan used to purchase property, like when buying a house, for example. Mortgages are normally taken out by individuals, who borrow money from mortgage providers like banks and credit unions. Mortgages are generally the largest loan that people will take out in their entire lives, and most take decades to pay back. Mortgages range in size from $10,000 up to many millions of dollars. By the end of 2021, the average value of new mortgages was roughly $372,000.
Mortgages are what’s known as secured loans. A secured loan has some sort of asset that can be used to pay back the loan if the borrower can’t. In the case of a mortgage, that asset is the property that’s been purchased. Because there is less risk in a secured loan, they generally have much lower interest rates. As a result, mortgages have some of the lowest interest rates of any type of credit, certainly much lower than credit cards or personal loans.
So what is a mortgage? It’s a big loan that you take out to buy a house. However, if you really want to understand how a mortgage works, there are some more details to cover.
How do mortgages work?
Mortgages are complex, and it takes an expert to understand every part of them. This is why some people pay too much when they take out a mortgage, as less informed borrowers are easier to take advantage of. Luckily, you’re in the right place – Ratehub.ca is all about giving you the information you need to choose better. Knowing just the basics of how mortgages work goes a long way.
Let’s start by breaking down the key components of a mortgage. These include the mortgage rate, down payment, amortization period and payment frequency.
Your mortgage rate, or interest rate, is the percentage that your lender will charge for lending you money. If you were to borrow $100 at a 5% interest rate, your lender would add an additional $5 to your outstanding balance each year. That’s a simplified example, but it’s essentially the same process used in a mortgage.
Mortgage rates either come as fixed or variable rates. The difference between them is that variable rates can go up and down, while fixed rates are locked in for the term of your current mortgage contract, which is typically 5 years.
As well as the overall market, there are lots of elements that go into determining what interest rate you’re eligible for. These include your cash down payment, your credit score, whether you choose a fixed or variable rate and many more. Comparing the best mortgage rates in Canada when you take out a mortgage is the single best thing you can do to get a lower rate, which will save you money over time.
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A down payment is a lump sum of cash that you need at the start of your mortgage. A cash down payment is mandatory for all property purchases in Canada, with the minimum ranging from 5% to 20% of the asking price. A higher down payment is generally better, if you can afford it. This is because your down payment reduces the amount you need to borrow, which reduces the amount of interest you’ll be paying over the long term.
When purchasing a property, the total loan value is equal to the asking price of your home, less the down payment, plus mortgage default insurance, often called CMHC insurance. Mortgage default insurance protects your lender if you can’t make your repayments. You’ll have to pay for mortgage default insurance on your mortgage if it’s classed as a high ratio loan. This includes mortgages with down payments less than 20%.
The amortization period of a mortgage is the total length of time in which you will pay off your mortgage. The typical amortization period for a mortgage in Canada is 25 years. Extending your amortization period is one way to reduce the amount of your payments, but results in an increase in the total amount of interest paid on your mortgage. In contrast, the shorter your amortization period is, the faster you’ll pay off your mortgage and the less interest you will pay.
To see the full effect of differing amortization periods, use a mortgage payment calculator and look at an amortization schedule. An amortization schedule will show you how each of your payments reduces your loan balance, how much of your payment goes towards interest, and how much goes towards reducing your principal.
Note: Your amortization period is different from your mortgage term. Your mortgage term is how long you sign with a particular lender, and it’s normally 5 years (although it can range from 1 -10 years). After your term, you’ll need to renew your mortgage with a new term, either with the same or a new provider.
The payment frequency is how often you make your mortgage payment. Typical frequencies are monthly, bi-weekly and weekly. Some providers also offer accelerated payment options to pay off your mortgage faster. If you make more frequent payments, you’ll be able to pay off your mortgage faster.
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Closed vs. open mortgages
In addition to variable or fixed-rate mortgages, mortgages can be either closed or open. A closed mortgage is best if you don’t plan on paying off your mortgage in full in the short term. If, however, you want to pay off the mortgage before the specified date, you’ll have to pay a penalty. By agreeing to keep your mortgage for the full term, you’ll receive a lower interest rate than in an open mortgage. With an open mortgage, you have the flexibility to pay off the mortgage at any time without a penalty.
The cost of this increased flexibility is a higher mortgage rate. Since closed mortgage rates have a lower interest rate, you may be curious as to why anyone would choose to have an open mortgage. Individuals who select an open mortgage may expect to receive a large amount of money in the near future that will enable them to pay off their mortgage. This could be from an inheritance or from selling their home. If, however, you don’t expect to receive a lump sum of money anytime soon, a closed mortgage is better because you’ll receive a much lower interest rate.
Where to learn more about mortgages
So what is a mortgage? Now you know. But the best thing you can do to get a better deal on your mortgage is to learn as much about mortgages as you can. At Ratehub.ca we provide lots of great resources on mortgages, as well as other financial products, at no cost to you. Head over to our first-time homebuyer education centre to get started.
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