Amortization
By PAUL MURPHY. Paul Murphy is a 20-year financial veteran and Managing Partner at 4 Pillars.
What Is Amortization?
Amortization is the length of time where you’ve agreed to have the loan paid in full.
In general, the longer the amortization period, the lower your monthly payments.
While most Canadians opt for long amortization periods (especially with mortgages), they should also understand that those lower monthly payments mean more interest over the course of the loan as you’ve borrowed the money for longer.
Understanding Amortization
Amortization is often confused with “a term.” A loan term is a length of time where your loan payment amount and interest rate do not change.
With smaller loans, the term and amortization period will often be the same. A car loan might have an interest rate of 5% with $500 monthly payments for five years.
You both agree to the term (5% and $500 monthly payments) and the amortization period which says the loan will be repaid in five years.
With larger loans (like a mortgage), you’ll have one amortization period and multiple terms.
With a 25-year mortgage, for example, you’ll agree to new monthly payments and a new interest rate every five years. In this case, you have one amortization (25 years) and five terms (each with different monthly payments and interest rates).
KEY TAKE-AWAYS:
The longer the amortization, the lower your monthly payments. But also, you pay more interest over time.
“Term” refers to the monthly payments and interest rate you agree to for a set period of time. Amortization is the full length of time you’ve agreed to pay the loan back in full.
For most borrowers, paying your loan back faster with extra payments makes good financial sense.
Amortization and mortgages
With a car loan, understanding amortization is simple. Your payments are fixed for five years and it’s easy to see the amount of interest you’re paying.
Mortgages have longer amortization. And the interest rate you have today might change in a few years.
Your mortgage payment is what is known as a fully amortizing payment. This means your monthly payment is divided into two parts: the interest portion and the principal portion.
As you’ve likely noticed in your loan statements, as your total payment stays the same every month, your interest and principal portions change in size.
Every month, your interest owed decreases a small amount (as you paid down the principal last month), which means more of your monthly payment goes towards your principal. The amount paid to interest gradually declines, while the amount paid to your principle gradually climbs.
Is paying down your mortgage faster a good idea?
While everyone wants to live mortgage-free, the amortization periods for mortgages are so long, so it’s hard to see exactly how much interest you’ll pay over the entire life of your loan.
When mortgage rates are low, often investing in things like RRSPs, RESPs, or TFSAs can yield a better financial return than paying down your mortgage faster.
However, with a fully amortized payment, this means that if you do pay a small amount beyond your required monthly payment, 100% of this money goes straight to paying down your principal.
For simplicity, let’s say you have a $100,000 mortgage that has 4% interest and a term of 30 years.
Paying an extra $10 a month means you’d pay off your mortgage 13 months early.
Paying an extra $100 a month means you’d pay off your mortgage 101 months early, nearly nine years early.
Extending your mortgage to deal with other debts
If you have high-interest debts, paying down those debts obviously should take priority over any extra mortgage payments.
Even further, if cash flow is an issue and you’re having trouble paying all your bills, extending your mortgage into an even longer amortization period also makes sense as this will help to even out your cash flow, preventing you from falling into more debt or lines of credit.
Mortgage amortization during low-interest periods
With a more realistic mortgage number (say, you owe $700,000), paying an extra $700 per month would be a larger sum. And as Canadians often borrow to the very limits of their financial abilities, it’s easy to see why most choose to pay the regular monthly payment and skip the extra payments.
However, if you’re investing in other areas like stocks, it’s worth looking at whether adding some extra payments would produce a better return.
A good rule of thumb is that you can think of these extra payments as investments with a guaranteed return equal to your mortgage’s interest rate. If your mortgage interest rate is 4%, then every extra payment is earning that 4% in return.
When mortgage rates are low, a 2-5% return on your investment might not excite you. It’s here you go back to your financial goals.
If you feel stretched by your current mortgage payments and worry about the future payments when interest rates start to rise, prioritizing paying back your mortgage ahead of schedule makes good sense.
In contrast, if you have a high income and an appetite for risk, you can invest that extra money in stocks or RRSPs, with the goal of using future returns to aggressively pay down your mortgage in the future.
Whatever path you take, the longer your amortization schedule, the more interest you’ll pay over time. And while investing is exciting, nothing beats being debt-free.
Frequently Asked Questions
What is amortization?
For loans, amortization is the length of time where you’ve agreed to have the loan paid in full. Amortization is also used in financial statements, where it is similar in concept but used in a specialized context for accounting processes, allocating the cost of intangible assets such as patents, licenses, and research development.
Why is amortization important?
In the context of debt repayment, amortization helps you weigh the pros and cons of paying off your loan ahead of schedule. All things equal, it’s best to do extra payments and reduce your principle as fast as possible.
How can I figure out how much interest I’ll pay over my amortization schedule?
If you’d like to explore how much interest you’ll pay over your amortization schedule, this video tutorial is helpful. This is also a helpful tutorial. If spreadsheets are not your thing, you can call your lender and ask them. Some mortgage statements will provide different estimates automatically for you as well.
