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.
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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.