If you’re like many people, a mortgage is the biggest financial commitment you will make in your life. Because it is such a big obligation, it is important to understand how mortgages work. Let’s start by looking at the concept of amortization.
Mortgage amortization refers the length of time it takes you to pay off your entire mortgage. Most mortgages in Canada have a maximum amortization period of 25 years (there are some exceptions). In addition to defining the length of mortgage, the amortization schedule also specifies how much of your payment goes toward interest and how much goes to principal (the actual balance).
Concept #1 – It’s a Slow Start
At the start of your amortization most of your payments will go toward interest and very little to paying your principal down. Let’s take a closer look.
If Jane takes out a $300,000 mortgage at 5% interest over a 25 year amortization period, her payments will be $1,745 per month. In the first month $1,261 from her payment will go directly toward interest and only $484 will go toward getting the balance down or principal. At the end of the first year, Jane will have paid $20,940 ($1,745 X 12 months). However the balance remaining on her mortgage will still be $293,766.
Even though she paid $20,940 only $6,234 went toward getting the balance down. The other $14,706 went to into the bank’s pocket through interest.
The reverse will happen when you are getting closer to the end of your amortization period. Most of your payment will go toward your principal as the bank has already received the majority of their interest. We have a free budgeting workbooks that you can use to help plan your payments.
Concept #2 – Length Matters
A longer amortization will lower how much you have to pay each month, but this will come at a cost. The longer your amortization period, the more interest you will pay.
If you can shorten the length of time it takes you to pay off your mortgage (amortization), you will pay less interest. Let’s look at Jane again.
Jane’s initial plan was to pay off her mortgage in 25 years. If she does this she will pay about $223,450 in interest on top of the initial $300,000 she borrowed over the life of her mortgage. However, if Jane pays her mortgage off in 20 years she will pay $173,130 worth of interest. This is a savings of over $50,000. Big dough. Keep this in mind when you look at your spending habits. Sometimes a few tweaks can help you to add extra onto your mortgage and save on interest. Paying more frequently such as weekly will also help you to reduce your amortization and interest paid.
A mortgage is a major financial commitment. It is important to understand the terms and concepts before signing on the dotted line. You should also consider functionality and ensure you are factoring in all cost considerations into your purchase price. A little bit of research can go a long way in helping to save you tens of thousands of dollars.