Amortization periods have a profound effect on your mortgage repayment figures. Here we discuss the difference between a short and long term mortgage.
Once the down payment has been deducted from the price of your new home, the balance is amortized over a period years. Each monthly repayment includes the decreasing principal owed after the previous payment and the corresponding interest payment have been made. Amortization is the process of averaging all payments over a specific number of years, so that each monthly sum paid is the same.
Without amortization, your monthly mortgage repayments would reduce each month. This would render the first payment very high since the interest portion would be based on the full amount of the mortgage loan and you would also pay a fixed sum towards the principal. Amortization avoids this.
You make the same payment every month, commonly for 15 or 30 years. The amount you pay towards the principal increases each month as the interest reduces. As you earn more money your mortgage becomes increasingly more affordable, and the equity on your home increases as you pay back the principal.
Short Term Amortization Periods
Is it better to take a long term mortgage, over 30 years for example, or a short term mortgage over 10 or 15 years? A lot depends on the debt to income ratio and the affordability of a short term amortization period.
For many, paying off their mortgage as quickly as possible is more important than maintaining lower monthly repayments. They also prefer to pay as little interest as possible, since this is lost money that can never be regained. The longer your mortgage period, the more interest you will pay. There is a significant difference in the interest paid between a 15 year and 30 year mortgage.
The monthly repayments on a $150,000 mortgage at 4% interest over 30 years would be $716.12. This amounts to a total of $257,803.20 over the 30 years. The total interest paid is therefore $107,803.20.
The corresponding figures over 15 years are $1,108.53 monthly, $199,715.40 total and $49,715.40 interest. You therefore save a total of $58,087.80 by repaying a mortgage like this over 15 years! It is therefore of significant financial advantage if you can repay your mortgage over 15 years – or over as short a period as you can afford.
Long Term Mortgage Period
Many people are unable to make the high monthly payments involved in short amortization periods. They generally settle for a 30 year mortgage because the lower monthly repayments enable them to buy a larger home. The ‘now’ is more important to them than the longer term gains.
In some cases it is possible to reduce the amount paid in interest by arranging biweekly payments. In this case, the principal reduces twice monthly, so interest is slightly lower while payments may still be affordable. This will depend on the flexibility of your lender.
The upshot is that if you can afford the monthly repayments involved in repaying your mortgage loan over a shorter period of time then it makes sense to do so. Otherwise, take your mortgage over as long a period as is necessary to enable you to purchase the property you want at a monthly figure you can afford.