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Why You Should Go Long on your Mortgage Amortization

Nearly every Canadian chooses to extend their amortization for as long as possible. Data from Canada Guaranty shows that 97% of mortgages insured through them in the first quarter of 2018 had amortizations between 20 and 25 years at origination.

Why are longer amortizations so overwhelmingly popular?

The most immediately obvious reason is that longer amortization periods mean lower monthly payments. With the currently high real estate prices it makes sense that people are trying to keep their monthly payments as low as possible.

Shorter amortization periods mean higher monthly payments but are cheaper in the end as you pay less in interest. But there is a danger in opting for a shorter amortization that longer ones don’t have at all.

 

Minimum Monthly Payment

When you take out a mortgage or any installment loan, you’re given a fixed minimum monthly payment which you must pay every month. Unlike a credit card, which changes its monthly minimum payment month-to-month based on your spending and repayment habits, an installment loan doesn’t change. The only exception to this is when you have a variable rate. However, in many cases the lender will simply readjust the percentage of your payment going to interest rather than increasing your payment.

Unlike a credit card, you can’t just pay off as much as you want at any time. There are rules about exactly how much extra you’re allowed to pay on your mortgage. Depending on your repayment terms, you’re allowed to overpay a certain amount each month, each year, or both.

Extra monthly payments normally range from 20% to 100% of the monthly mortgage payment, and lump-sum payments are usually from 10% to 25% of the outstanding mortgage balance.

 

Why would I pay more?

The whole idea of shopping for the best rate and extending your amortization as long as possible was to get a super low monthly payment, right? So why would you want to pay more?

Because extra payments accelerate your amortization, saving you money in interest. Faster amortizations also mean you own your home years sooner than if you hadn’t paid more.

 

Extra Payments on $500,000 Mortgage

 

Scenario 1

Scenario 2

Scenario 3

Interest Rate

3.29%

3.29%

3.29%

Monthly Mortgage Payment

$2,447

$2,513

$2,585

Extra Monthly Payment

$0

$66

$138

Total Interest Paid

$234,148

$223,762

$213,462

Time Until You Own

25 years

24 years

23 years

Savings

$0

$10,386

$20,686

 

Increasing your monthly payment in this case by just $66 shaved a whole year off your amortization and saved $10,386! An extra $138 shaved two years off and saved $20,686!

 

Extra Monthly Payments

If you’re paying $1,500 per month, for example, and your lender allows 100% extra payments, you can pay up to $3,000 each month. You can pay any amount up to that – any more and you’ll incur a pre-payment penalty, which will negate the savings you’d otherwise earn.

Lump sum payments do not affect your monthly payments but will still help accelerate your repayment. Lump sums are interesting because they depend on the remaining value of the mortgage, which decreases over time, whereas monthly payments are steady for the entire term (except with variable mortgages).

An important thing to note about extra payments, whether they’re monthly or annual, is that they are most effective at the beginning of your mortgage. $10,000 in a lump sum at the beginning of the second year of a $500,000 mortgage can save about $11,000 in interest over the rest of the mortgage, but if you waited to pay the last $10,000 off with a  lump sum instead, you’d only save $100 (yes, one hundred dollars).

 

Why you should go long

If you plan on shortening your amortization with extra mortgage payments anyway, then you might think it doesn’t matter if you opt for a longer or shorter mortgage. The problem is that it’s really easy to shorten your repayment but very difficult to extend it.

Extra payments shorten your amortization without you having to do any extra work. So long as it’s allowed in your contract, you can shorten your mortgage by a lot without having to get a new agreement.

Extending your amortization is different. In order to get a longer amortization, you have to refinance your existing mortgage. Essentially, you have to get a whole new mortgage to pay off the old mortgage, and that new mortgage will have a longer term. If you want to refinance in the middle of your term, you’ll have to break your mortgage – and that comes at a cost that could outweigh the benefit of lower monthly payments.

Even if you go into a shorter mortgage with the intention to pay more every month, you may run into financial difficulties at some point in the future. That’s why we recommend an emergency fund of at least 3 – 6 months’ expenses. If you were simply making extra payments you could just scale them back to the minimum. But if your minimum is already high, you have no more wiggle room.

Choosing a shorter mortgage offers no substantial benefit over a longer amortization except in the case where you also plan on making extra monthly payments on top of the faster period. That means you have to have a high income.

With a normal monthly pre-payment limit of 20%, on a mortgage of $500,000 you could pay up to $489 more per month. That same mortgage with a 20-year amortization would allow pre-payment of up to $3,415, or $569 more. That would greatly reduce the length of your mortgage – but you’d have to be able to pay $3,415 a month in the first place.

 

In Conclusion

You can shorten your amortization easily by paying more per month, or making a lump sum every year. This doesn’t require you to change any of the conditions of your mortgage contract. You cannot easily extend your amortization, so unless you have enough income to comfortably afford extra payments on top of a shorter period, you should still choose a longer one. 


Chris Chris 01/26/2019
Canadian personal finance buff and all-around writing enthusiast, Chris loves breaking down complicated money ideas to show that they're really not so complex. 
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