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When you start shopping around for a mortgage, you look at your options for mortgage terms and amortization periods. These will impact your overall costs, interest rates and how much you’re required to pay toward your loan each month.
Mortgage Amortization: A Definition
Mortgage amortization is the length of time it takes to pay off your mortgage in full and is an estimate based on the interest rate for your current mortgage term. To put it simply, it’s the total life of your mortgage.
For example, if you have a fixed-rate mortgage of 25 years, amortization means that you’ll make a set payment each month and if you make these payments for 25 years, you’ll have paid off your loan. With a fixed-rate loan, these monthly payments will remain fairly consistent but may rise or fall slightly if insurance or property costs change.
An adjustable-rate mortgage, which has your interest rate staying fixed for a period of 5 – 7 years, means that your rate could rise or fall in accordance to the market and as a result, your monthly payments will do the same. Amortization with adjustable-rate loans means the same as it does with fixed-rate loans. It’s simply the process of making regular monthly payments, even though the amount you pay each month may vary over time, to steadily pay off your mortgage.
How Mortgage Amortization Works
As a borrower, your goal is to make on-time payments every month so that your principal balance gets smaller and eventually reaches zero. With each mortgage payment, you build up your home equity and own a larger percentage of your house.
Mortgage amortization has a formula that allows lenders (and borrowers) to calculate what percentage of monthly payments will go toward interest and what will go toward the principal balance. To find out how much of your first mortgage payment will cover the interest, you’ll need to multiply your original loan balance by the periodic interest rate. The resulting number will be the amount of interest that’s due. From there, you can subtract the interest payment amount from the total payment amount to get the portion that’ll be used to cover the principal.
Amortization Period Lengths
The longer your amortization period, the lower your payments will be. This isn’t always a good thing though, as the longer it takes you to pay off your mortgage, the more money you’ll end up paying in interest. When it comes to amortization period lengths, the majority of Canadian mortgages fall into the 25 years or less categories, with far fewer choosing 26 – 30 years or 30+ years [Canadian Association of Accredited Mortgage Professionals (CAAMP) Annual State of the Residential Mortgage Market in Canada 2019].
Shorter Term Amortization
If you can afford to do so, choosing a shorter amortization period will help you pay your loan off faster, with higher monthly payment requirements. This option promotes positive saving behaviour and significantly reduces the total interest paid over time. Your lender’s prepayment terms will determine if you’re able to shorten your amortization period by increasing your monthly payments or putting down a lump sum of cash toward the principal, without penalty. Beware that you’ll likely incur penalties associated with making additional payments so it’s best to be aware of your lender’s terms before you make any decisions regarding your original amortization term.
Maximum Amortization Period
As of March 2020, the maximum amortization period on all CMHC insured homes is 25 years. Since CMHC insurance is required on all home purchases with a down payment of 20% or less, you can expect this maximum amortization period if that’s your plan for your down payment. If you intend to put down more than 20%, lenders may be willing to give you an amortization period of 30+ years.
How Lenders Determine What You Owe
When it comes to calculating your monthly mortgage payments and how much interest you’ll pay each month, your lender will divide your loan’s interest rate by 12 to calculate your monthly interest rate. They’ll then multiply your current loan balance by this number to determine how much interest you’ll pay each month. Your lender will then use this information to calculate how that amount spreads out over the course of your term, whether it’s 15 years, 25 years or more.
How Is Amortization Period Different Than A Mortgage Term?
When you’re looking for a mortgage, you’re going to hear both of these terms mentioned a lot, so it’s important to understand what each one means, how they impact your overall costs and how they differ.
Your mortgage term relates to the length of time that your mortgage contract is in effect. This term can range from a few months to 5+ years (most common) and at the end of the term, if you still owe money on the mortgage, you’ll need to renew it. This process is almost like “resetting” your current mortgage as you’ll need to renew at a new rate, and potentially with new terms.
Your mortgage amortization period is the length of time it will take you to pay off your entire mortgage. As mentioned above, amortization periods are typically 25 years in duration, so it’s likely that over the course of that time, you’ll sign many mortgage term contracts (potentially five if you choose 5-year terms each time).
Understanding An Amortization Schedule
Having a clear sense of what an amortization schedule is will help you better understand how your monthly payments will break down and what portion of them will go toward the interest vs. the principal. This will help you better understand how making extra payments can save you a significant amount of money, as the faster you chip away at your principal balance, the less interest you’ll pay.
In the beginning, the majority of your payments will go toward the interest, but once you’re a few years into your term, this will start to shift with most of your payments going toward the principal balance instead. An amortization schedule shows you how this looks over time, but keep in mind, this can change based on the type of loan you take out and what your interest rate is.
While looking for a mortgage, you’re going to encounter a lot of different terms, information and numbers. Make it a point to prioritize the information that matters most, like amortization periods, so you can make the smartest possible financial decisions at the start, and through the early years of your loan.