5.2.5 Amortization and term
- 5.2.1 What is a mortgage?
- 5.2.2 Down payment
- 5.2.3 Pre-approval
- 5.2.4 Home Buyers Plan
- 5.2.5 Amortization and term
- 5.2.6 Types of mortgages
- 5.2.7 Interest rates
- 5.2.8 Payment types
- 5.2.9 Fixed or variable interest rates
- 5.2.10 Video: Mortgage basics
- 5.2.11 Quiz: Mortgage terminology
- 5.2.12 Case study: Mortgage costs
- 5.2.13 Your mortgage payment
- 5.2.14 Payment options
- 5.2.15 Case study: Financing a mortgage
- 5.2.16 Summary of key messages
Two different words refer to key time periods in a mortgage:
- The mortgage term is the length of time that the mortgage agreement at your agreed interest rate is in effect.
- The amortization period is the length of time it will take to fully pay off the amount of the mortgage loan.
The mortgage term is the length of time your mortgage agreement and interest rate will be in effect (for example, a 25-year mortgage may have a term of five years). However, you don't necessarily pay off the mortgage fully at the end of the term. You may need to renew or renegotiate your mortgage to extend it to a new term and continue making payments.
Andrew and Marc want to get a mortgage for $300,000. Their banker suggests a five-year term with a 4 percent interest rate. This means that they will make regular payments of principal plus interest for five years. But the $300,000 will not be fully repaid at the end of the term. When the five years are up, they will have to renew the mortgage for a new term at a rate that will then be available. They will be free to look for a better deal from other lenders, but if they choose a different lender, they'll have to pay off the mortgage with the current lender through the arrangement with the new one.
Mortgage amount: $300,000
Term: 5 years
Interest rate: 4%
Amortization period: 25 years
Amount remaining to be paid at end of five-year term: $261,162
The term of the contract fixes your agreement for a period of time. Mortgage terms from six months to five years are common, although seven- or ten-year terms are often available. The term simply means that at the end of the period, you will have to negotiate a new mortgage term based on your personal and financial conditions at the time. Usually, your mortgage holder will offer to renew the mortgage at then-current market terms or better. However, it's an opportunity to negotiate with your financial institution or see if you can get a better deal in the market.
When Andrew's and Marc's five-year term ends, their lender offers to renew the mortgage at an interest rate one-quarter point lower than they were paying. They check with other institutions, and find one that offers to renew the mortgage on similar terms for one-half point lower. When they tell their lender that they have a better offer, the lender agrees to match the lower offer in order to keep their business. Andrew and Marc also choose to increase their monthly payments since they have both received a wage increase, and they feel they can afford to pay more on their mortgage every month.
A mortgage with a longer term may give you more financial stability because your payments stay the same for the term of the mortgage. It may be especially attractive when interest rates are lower than they normally are. However, a longer term limits your ability to look for better rates if interest rates go down. In addition, there may be a substantial pre-payment charge if you move and pay off your mortgage before the end of the term, so it's important to carefully consider the term of your mortgage. A shorter term could help avoid pre-payment charges if you think you may have to end the term early. (See the section on Negotiating a mortgage.)
The amortization period is the length of time it would take to pay off a mortgage in full, based on regular payments at a certain interest rate.
A longer amortization period means you will pay more interest than if you got the same loan with a shorter amortization period. However, the mortgage payments will be lower, so some buyers prefer a longer amortization to make the payments more affordable. Usually, the amortization period is 15, 20 or 25 years. The longest term permitted if you require mortgage insurance is now 25 years.
The monthly payments on Andrew's and Marc's $300,000 mortgage would be $1,578 with a 25-year amortization. The total interest paid over the life of the mortgage would be $173,418. With a 20-year period, their payments would be increased to $1,813, but because they will pay interest for five fewer years, they would pay a total of $135,057 in interest—almost $40,000 less interest in total.
|Total interest paid
It's often to your advantage to choose the shortest amortization—that is, the largest mortgage payments—that you can afford. You will pay off your mortgage faster and will save thousands or even tens of thousands of dollars in interest.
An alternative approach is to choose a mortgage that allows you to change your payment each year, double up payments, or make a payment directly on the principal each year. This way, even if you started with a longer amortization period, you can review your financial situation each year and speed up the amortization with extra payments.
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