If you’re in the market for a new home, you probably understand the different mortgage options. But what about amortization? Should you go short or long, and what impact does it have on your finances?
The most common amortization is 25 years. If you have at least a 20% down payment, however, you can go higher—up to 30 years, and sometimes longer.
Shorter amortizations are also available. Their benefit is helping you accumulate home equity faster. If you can afford the higher monthly payments of a shorter amortization, you can save thousands in interest.
Why go for a long mortgage amortization?
After the 2008 recession, the Canada Mortgage and Housing Corporation (CMHC) progressively lowered the maximum amortization on default-insured mortgages. Formerly, homebuyers could amortize their mortgage over 40 years. Now, homebuyers who don’t have at least 20% equity are limited to a maximum amortization of 25 years.
If you do have 20% equity or more and don’t need default-insurance, you can choose a 30-year amortization. A few lenders, such as credit unions, allow up to 35-year amortizations, but the rates are typically higher.
With today’s low interest rates and a longer amortization, you can expect your monthly mortgage payments to be a lot smaller. But the overall interest paid and length of time it takes to pay off will be longer.
Here’s an example to make the point. If you have a $500,000 mortgage, a rate of 2.39%, and a 25-year amortization, your monthly payment would be $2,213. The interest you would pay over the amortization period is $163,760. If you chose a shorter amortization of 20 years, you would see those monthly payments rise $407 to $2,620. But you would pay $34,973.83 less interest on the same mortgage amount, or a total interest of $128,786.29.
Minimize your risk
If you are stretching your budget to cover the higher monthly mortgage payments of a short amortization, you may be in over your head. If you unexpectedly lose your job or get sick, you could find it difficult to make those payments.
A longer amortization can be seen as a form of risk management. Your monthly payments wouldn’t be as high with a 30-year amortization, making unexpected financial woes more manageable.
This doesn’t mean you can’t pay off your mortgage quicker and save on interest payments. Most lenders allow generous prepayment privileges, which means you can usually make extra lump-sum payments once or multiple times a year. You can also accelerate your payment frequency to bi-weekly or even weekly and pay more than the minimum monthly payment.
Amortizing over 30 years lowers your payment to something more manageable. Then you can pay the principal faster (within the limits of your mortgage contract) when you know you have the extra funds. You can always stop the prepayments in the event of a financial emergency.
With discipline and by making regular prepayments each year, you could end up saving the same amount of interest—or more—as you would on a 25-year amortization, with less risk.
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Prioritize your debt
Even if you’re not able to accelerate your mortgage payments, you can still benefit from a long amortization. The lower monthly payments may give you the wiggle room to focus on other debts. Since your mortgage is one of the cheaper forms of debt, it makes sense to focus on paying off your high-interest debt, like credit cards, first.
Alternatively, you may have other financial priorities that give you a greater return on investment than your mortgage. For example, you may want to consider putting more money into your Registered Retirement Savings Plan (RRSP), or other investments, if the return is higher than the interest on your mortgage. If your mortgage payments are taking up too much of the budget, you may not be able to manage this. A longer amortization may offer the financial flexibility you need.
Choosing a shorter amortization
If you are afraid to check your bank account at the end of the month, or perhaps live beyond your means, you may not be disciplined enough to benefit from a long amortization. By contrast, a shorter amortization may serve as forced savings and reduce the amount of disposable income spent frivolously.
On the other hand, if you consistently use the spare money to contribute to your RRSP and investments, you may be able to take advantage of the interest rate differential between those savings vehicles and your mortgage.
Mortgage rates are currently at an all-time low, but we know all good things come to an end, eventually. If you lock-in with a low five-year fixed-rate mortgage now, you may find yourself renewing at a higher rate, resulting in higher mortgage payments. A shorter amortization would allow you to pay down more of your mortgage sooner and pay less interest. Plus, you can always extend your amortization later if need be to help lessen the impact of higher rates.
To see how much interest you can save with a shorter amortization, plug your numbers into the Mortgage Payment Calculator and adjust the amortization period.
Choosing the right path for you
Tools like the RATESDOTCA Mortgage Affordability Calculator can help you find a starting budget by factoring in your gross household income and expenses. From here, consider your financial habits, level of discipline and priorities.
The lower monthly payments that come with a longer amortization can be useful for those who work on commission or have inconsistent income, first-time homebuyers on a budget and those wishing to invest their disposable income.