What Is a Mortgage? A Beginner's Guide to Home Financing

Buying a home is an exciting milestone, but for most Canadians, it also means navigating the world of mortgages. If you’re new to home financing, the process may seem overwhelming at first. However, understanding what a mortgage is and how it works can empower you to make informed decisions on your journey to homeownership. In this guide, we’ll break down the basics of mortgages, explain key terms, and provide tips to help you get started with confidence.

1. What Is a Mortgage?

A mortgage is a loan that helps you purchase a home. Since homes are expensive and most people can’t pay the full cost upfront, a mortgage allows you to borrow money from a lender—such as a bank, credit union, or mortgage broker—to cover the cost. In return, you agree to repay the loan, plus interest, over a set period.

Key Components of a Mortgage

• Principal: The amount you borrow.
• Interest: The cost of borrowing the money, expressed as a percentage.
• Amortization Period: The total length of time you have to repay the mortgage (commonly 25 years in Canada).
• Mortgage Term: The length of time your current mortgage agreement lasts (typically 1-5 years).

Learn more about mortgage terms and amortization in this article on our site.

2. How Does a Mortgage Work?

When you take out a mortgage, you’ll make regular payments—usually monthly, bi-weekly, or weekly—to pay down the loan. These payments are divided into two parts:

• Principal Repayment: Reduces the amount you owe.
• Interest Payment: Covers the cost of borrowing.

As time goes on, more of your payment goes toward the principal and less toward interest, especially if you have a fixed-rate mortgage.

3. Types of Mortgages in Canada

There are different types of mortgages to suit various financial situations and preferences. Understanding the differences can help you choose the best option for your needs.

Fixed-Rate Mortgage

• The interest rate remains constant throughout the term.
• Provides predictable payments, making it ideal for budgeting.
• Learn more about fixed vs. variable mortgages.

Variable-Rate Mortgage

• The interest rate fluctuates based on the lender’s prime rate.
• Payments may vary, but the potential for lower rates can save you money over time.

Open vs. Closed Mortgages

• Open Mortgage: Allows you to pay off your loan early without penalties, offering flexibility.
• Closed Mortgage: Offers lower rates but restricts early repayment, often coming with penalties for breaking the agreement.

4. The Role of a Down Payment

In Canada, the down payment is the portion of the home’s purchase price you pay upfront. The minimum down payment required varies based on the price of the home:

Homes Priced Up to $1 Million

• 5%: On the first $500,000 of the purchase price.
• 10%: On the portion of the price between $500,000 and $1 million.

Homes Priced Between $1 Million and $1.5 Million

• 10%: For the entire purchase price.
• Homes in this range now require a higher minimum down payment than those priced under $1 million, reflecting the new rules.

Homes Priced Over $1.5 Million

• 20%: Minimum down payment required for homes exceeding $1.5 million.
• Homes at this price point are not eligible for mortgage default insurance.

If your down payment is less than 20% for homes priced below $1.5 million, you’ll need to purchase mortgage default insurance (commonly known as CMHC insurance). This insurance protects the lender in case you default on the loan.

5. The Importance of Mortgage Pre-Approval

Before house hunting, getting pre-approved for a mortgage is a smart move. Pre-approval helps you:

• Determine your budget by showing how much you can afford.
• Lock in an interest rate for 90-120 days, protecting you from rate increases.
• Show sellers that you’re a serious buyer.

Read our step-by-step guide on how to get pre-approved for a mortgage to start your journey.

6. Factors That Affect Your Mortgage

Several factors influence the size of the mortgage you qualify for and the interest rate you’ll receive:

Credit Score

Lenders use your credit score to assess your financial reliability. A higher score (generally 660 or above) can help you secure a lower interest rate.

Debt-to-Income Ratio (DTI)

Your DTI compares your monthly debt payments to your income. A lower ratio increases your borrowing power.

Gross Debt Service (GDS) and Total Debt Service (TDS) Ratios

Canadian lenders typically use GDS and TDS ratios to evaluate affordability. These ratios measure how much of your income goes toward housing costs and overall debts.

7. The Mortgage Stress Test

In Canada, the mortgage stress test ensures that borrowers can afford their payments even if interest rates rise. When applying for a mortgage, you’ll need to qualify at either:

• The Bank of Canada’s qualifying rate (currently 5.25%), or
• Your contract rate + 2%, whichever is higher.

Learn how the stress test impacts your mortgage approval in this detailed article.

8. First-Time Home Buyer Incentives in Canada

The Canadian government offers several programs to help first-time buyers, including:

• First-Time Home Buyer Incentive: A shared-equity program that reduces monthly payments.
• RRSP Home Buyers’ Plan (HBP): Allows you to withdraw up to $35,000 from your RRSP tax-free for a down payment.
• First-Time Home Buyers’ Tax Credit: A $5,000 non-refundable tax credit to help cover closing costs.

Explore these programs in our guide to first-time home buyer incentives.

9. How to Choose the Right Mortgage

Selecting the best mortgage involves evaluating your financial goals, risk tolerance, and lifestyle. Consider:

• Fixed vs. Variable Rates: Do you prefer stability or the potential for savings?
• Open vs. Closed Mortgages: How important is flexibility to pay off your loan early?
• Term Length: Shorter terms may offer lower rates, but longer terms provide more certainty.

Use our mortgage comparison tool to explore your options and find the right fit.

10. The Bottom Line: Make an Informed Decision

A mortgage is more than just a loan—it’s a long-term commitment that shapes your financial future. By understanding the basics of mortgages, researching your options, and seeking professional advice, you can navigate the process with confidence and find the best solution for your needs.

Conclusion

Buying a home is a significant milestone, and understanding mortgages is the first step in making informed decisions. Whether you’re saving for a down payment, exploring first-time buyer programs, or comparing mortgage types, knowledge is power. Visit our articles section for more insights and tools to guide you on your homeownership journey.

By breaking down the complexities of mortgages into actionable steps, we aim to make the path to homeownership in Canada as smooth and achievable as possible. Ready to get started? Let Homewise help you every step of the way.