Shorten that amortization period.
And save a bundle on mortgage interest.
One of the tough choices you’re faced with when setting up your mortgage is deciding on the amortization period, or how long it will take you to pay off your mortgage. This is different from the mortgage term, which is the length of time your mortgage agreement is valid. The amortization period is usually much longer than the term – amortization periods range from 10 to 25 years (and sometimes even longer), whereas terms are typically 6 months to 10 years. If your down payment was less than 20% of the purchase price of your home, then the amortization period is a maximum of 25 years.
The temptation may be to opt for as long a period as possible, since this means lower monthly payments. Committing to low payments seems a lot less scary than signing off a huge proportion of your paycheque, even if you may be paying off your mortgage right up until retirement. Plus, you tell yourself, you always have the option of using your prepayment privileges to pay off your mortgage faster, so it may not really take 25 years…
The trade-off is that with a longer amortization period, you end up paying more interest – not just a little bit more, but a lot more. The interest component of your mortgage payments can be huge, depending on the interest rate and the amortization period. For example, with an interest rate of 6.5% and an amortization period of 25 years, you’ll end up paying back just over double of what you originally borrowed to buy your home. By reducing that period to 10 years, you’ll only pay 36% of the principal amount in interest. That’s a saving of almost $100,000 if you originally borrowed $150,000 for your home – something definitely worth doing if you can afford it.
To understand better how the amortization period affects monthly payments and interest costs, let’s work though another example. Suppose you buy a house for $250,000, with a down payment of $50,000. You borrow the remaining $200,000 from the bank at a fixed interest rate of 4%. The table below shows the monthly payment, total interest costs, and total payments for amortization periods ranging from 10 years to 25 years.
|Amortization Period||Monthly Payment||Total Interest Cost||Total Payments|
So even though choosing to pay off your mortgage over 25 years means that you’d only commit to just over $1000 a month, rather than around $2000 a month for a 10-year period, your total interest costs would be almost three times as high ($115,612.12 vs. $42,612.88). Granted, the danger in opting for higher monthly payments is that once they go up, most lenders won’t let you decrease them before the mortgage term is up. But remember, the term is usually much shorter than the amortization period, and you only commit to the payments for the term.
Why do total interest payments go up so steeply with the amortization period? Basically, it’s because interest is calculated on the amount you have left to pay off, and when you choose a long amortization period, most of your monthly mortgage payment goes towards interest rather than bringing down your balance. In the example above, by opting for a 25-year amortization period you would only have paid off $25,892.17 of the principal to the lender by the end of 5 years (or 13% of what you borrowed) compared to $90,130.92 (45%) for a 10-year amortization period. And that’s what you’re paying interest on – the 87% left 5 years into your 25-year mortgage.
So consider shortening your amortization period, because although higher monthly payments may sting a little, you’ll end reducing your interest payments by a lot more. And maybe there’s a chance you’ll be able to retire without your mortgage!