The Difference Between Mortgage Amortization and Term

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Do you want to know the difference between mortgage amortization and term? When shopping for a home, many people focus on mortgage interest rates. It makes sense since the lower the rate you can get, the more home you can technically afford.

While low rates are important, it’s not the only thing you should consider when getting a mortgage. The term, amortization, and features are just as relevant. What you get in the end can greatly affect your payments which is why you need to know the difference between mortgage amortization and term.

What is mortgage amortization?

The mortgage amortization is the length it will take you to pay back your loan. Think of it as the life of your mortgage. Many people these days choose a 25-year amortization period to start since it offers lower monthly payments. Loans with a longer amortization period cost you more in interest. If you choose to amortize your mortgage for fewer years, you end up paying more every month, but your debt will be cleared much faster and you will end up paying less interest.

To qualify for a mortgage you need to have at least 5% saved of the purchase price as your down payment. Some lenders have been willing to loan that 5% to potential homeowners, but you need to ask yourself seriously: if you can’t even save that small amount, do you honestly think you’re ready for homeownership?

If you have a 20% down payment, then you qualify a 30-year mortgage, but again that longer amortization means more interest payments so it doesn’t exactly benefit you. What’s the point of saving 20% and then paying a ton of interest charges over 30 years? If your down payment is less than 20%, the maximum amortization you can get is 25 years.

If you can afford it, a shorter amortization period will help you save more money in the long run. I suggest playing around with any of the free amortization calculators you can find online to see the total amount of how much interest you can save by having a shorter amortization period.

What is mortgage term?

Mortgage term refers to the length of time you agree to pay back your amortized loan. It’s sort of like a short-term contract you set with your lender, so your amortization might be 25 years, but the period of the term could be anywhere between 1-7 years. Then, at the end of the loan term, you need to renegotiate to get a loan for the remaining balance on your home. 

When interest rates are low, many people choose to go with 5-year fixed terms. Shorter terms are available at an even lower rate but you’re only guaranteed that rate for that set period of time. Taking a longer-term will guarantee your rates don’t go up assuming you took a fixed rate mortgage. Variable rate mortgages are appealing to people who think interest rates won’t go up much over the current term of their mortgage. 

What many people fail to understand is that once the end of the term is up, you need to negotiate a new loan from your lender. Those low interest rates you’ve been enjoying might be higher in 5 years, so I hope you’ve budgeted accordingly. Some people are so desperate to become homeowners that they forget about the long-term costs and don’t realize that depending on interest rates, in a few years they may actually have higher monthly payments. That said, if you get in early, there’s always the possibility that your home’s equity would have gone up. That alone can be worth it for some people.

Understanding your mortgage amortization schedule

As said above, the longer the amortization period, the higher amount of interest you will pay over time. It’s also worth noting that in the beginning, the largest portion of your loan payments will go towards paying the interest on your home loan. Over time, that flips to the majority of your loan payments will be going towards the principal. Your lender can provide you with a mortgage amortization schedule, also known as an amortization table, to break this down so you can see exactly how your monthly mortgage payments are broken down. This is handy for people that want to see their principal balance and loan balance at any given time. 

The case for a longer amortization

When interest payments are low, many people are in no rush to pay down their mortgages choosing to invest instead. For example, if you’re mortgage rate is 2%, but you estimate you can get an average rate of return of 5% while investing (not factoring in taxes), you’d come out ahead.

This is certainly a good strategy if you’re a disciplined investor, but many people have maxed themselves out so they don’t exactly have any extra income to invest. There’s also the peace of mind you would get from paying down your mortgage.

Taking a longer amortization even if you can afford a shorter one can also be beneficial for cash flow purposes. Let’s say you have a $500,000 mortgage at 2%, with an amortization period of 25 years. Your monthly mortgage payment would be $2,117.26. But if you had it set for 20 years, it would be $2,527.46. A difference of $410.20 a month.

What you could do is take the 25-year mortgage, but set your payments for the 20-year term (assuming your mortgage allows you to make extra payments or lump sum payments). If you ever run into financial difficulty, you could just change your payment schedule. In this case, you can change your monthly payments back to 25 years without a penalty. A longer amortization period would also help you with the mortgage stress test since your regular payments would be lower.

Where to get the lowest mortgage rates

If you’re new to mortgage loans, it’s worth mentioning that the rates posted with the big banks are rarely the lowest rates you can get. In most cases, as a borrower, you want to work with a mortgage broker who is not associated with one single bank. Don’t worry about additional costs either. If you are a qualified borrower, there will be no fee charged by the mortgage broker as they get a commission from the lender.

Generally speaking, mortgage brokers get the lowest rates since they typically work with 30+ lenders. They can go your needs, get your information, and provide you with a quote in less than 5 minutes. 

This would just be a pre-approval, so you don’t need to commit right away. You can still shop around as you please. One mortgage broker worth checking out is Homewise since everything is done online and over the phone. There’s no need to meet anyone face to face.

Final thoughts

Now that you know the difference between mortgage amortization and term, you can think about the big picture. Homeownership is not something you should get into just because rates are low. It may seem affordable on a monthly basis, but have you considered all the extra costs? These include things like property taxes, home upgrades, and repairs. Not to mention other costs of life such as having kids and saving for retirement. 

Lenders don’t care about how you’ll be afford anything else, they just care about you making monthly payments and they’re more than happy to lend you a higher loan amount than you can realistically afford. As a potential home buyer, you need to take the time to learn about all the costs associated with owning a home so you’re well informed when you’re ready to make the purchase.

About Barry Choi

Barry Choi is a Toronto-based personal finance and travel expert who frequently makes media appearances. His blog Money We Have is one of Canada’s most trusted sources when it comes to money and travel. You can find him on Twitter:@barrychoi

6 Comments

  1. Susan on January 3, 2016 at 12:42 AM

    What amazes me is how little most people know about all things financial – mortgages, taxes, RRSPs, TFSAs, interest, leasing, withholding taxes vs actual taxes, etc. Etc. These are not taught in school and for many families the blind are leading the blind since the parents don’t understand these themselves. Kids should be taught how to reconcile a bank account, prepare a simple tax return (on paper so they can see how the numbers were work), reading and calculating from payroll tables, and leasing.

    • Barry Choi on January 3, 2016 at 1:00 AM

      Susan,

      Yes it’s pretty insane how such basic financial terms aren’t understood by the majority of people. I wrote this piece about mortgages since I kept getting asked about them. The thing is, if they’re buying a home, they should know this already.

  2. Ashley on January 8, 2016 at 8:24 AM

    I just clicked on the button to renew my term for 5 more years. It was painful to give up my current 1.9% rate to go to 2.7% but really, is that such a bad rate? No. Besides, with extra payments I’ve knocked almost 6 and a half years off my 25 year mortgage in 10 years, and hoping it’ll be even more by the time it’s gone.

    • Barry Choi on January 8, 2016 at 8:26 AM

      Ashley,

      That’s still a pretty good rate. In the near future you won’t see 5 year fixed rates at less than 3% (still an incredible rate). Awesome job at paying down your mortgage.

  3. Jaymee @ Smart Woman on January 18, 2016 at 2:06 AM

    I remember when I was so gung-ho about buying a house because I wanted to “own my first property before 25 years of age” – I’m glad I came to my senses before signing for that house I almost bought last year. I can vouch for the fact that I was only looking at the short-term “how can I get into a house asap” and not so much what would happen in the next 5 or 10 years.

    Now I’ve sat down with my advisor and went over my house buying plan. He agrees with my plan to buy but recommends not paying off my house as soon as possible (which was my game plan before). He recommends I put more money into my investments instead and pay off the house later. We went through the numbers and they completely make sense – understanding the risks of course!

    Long story short – I’m glad I waited on buying a house. And I’m glad I’m learning about different strategies and approaches to home buying. 🙂

    • Barry Choi on January 18, 2016 at 9:33 AM

      Jaymee,

      I don’t own yet either, but I definitely used to think the same way. Before I told myself when I got a mortgage I would pay it down as quickly as possible, but with interest rates so low it makes sense to invest some money for the long term. With creative math, any home will seem affordable on a monthly basis.

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