But God, being rich in mercy, because of the great love with which he loved us, even when we were dead in our trespasses, made us alive together with Christ; by grace you have been saved.
Ephesians 2:4-5 (ESV)
The definition of mercy is: "compassion or forgiveness shown toward someone whom it is within one's power to punish or harm." God showed His mercy toward us through His love by having compassion on us. We deserve eternal punishment because of sin. Yet God chose to pardon our sin because of His mercy.
Grace means: "the free and unmerited favor of God, as manifested in the salvation of sinners and the bestowal of blessings." When He pardoned our sins, He made the way for us to have salvation. He saved us purely because He loves us. Not only that, He gives us favor and blessing beyond measure, even though we don't deserve it!
"A state of mind that sees God in everything is evidence of growth in grace and a thankful heart."
- Charles Finney