How to choose your mortgage amortization

The amortization period refers to the number of years it will take to pay off your entire mortgage. What term should I choose? Here are some things to think about.

When it comes to borrowing money to finance the purchase of a house or any other investment project, amortization constitutes an essential element in making the right decision. When purchasing real estate, this is referred to as mortgage amortization.

So, what do we mean by mortgage amortization? What is the maximum term you can get? How is it calculated? This is what we will discuss in this article.

What is mortgage amortization?

Mortgage amortization refers to the distribution of your mortgage interest and principal payments over several years. Its payment is made in equal amounts to your creditor at the end of a pre-determined period of time, which is usually one month. A monthly payment, including interest on the loan and a portion of the principal, is therefore reimbursed to the bank that financed the purchase of the property over the entire duration of the amortization of the mortgage.

The length of the term depends mainly on the initial amount of money put down for the purchase of the property. This amount must cover, at a minimum, a portion of 5% of the value at which the property is contracted. In addition, any down payment that covers less than 20% of the total price of a property cannot qualify for a loan of more than 25 years.

Mortgages with a down payment of less than 20% are considered by financing agencies to be of high risk. This risk must be covered by mortgage insurance, also known as CMHC mortgage loan insurance. The insurance premium you pay is designed to protect your creditor in the event of payment difficulties. Because of the relatively high risk of default in the case of an initial contribution of less than 20%, the creditor requires insurance to ensure repayment within a limited period of time not exceeding 25 years.

What is the maximum amortization period for a mortgage?

On 9 July 2012, the Department of Finance limited the maximum mortgage amortization period that CMHC can provide to 25 years. That, and with insurance compulsory for any mortgage with a down payment of less than 20%, means the maximum amortization period for an insured mortgage is 25 years.

If, however, the initial contribution — or down payment — covers 20% or more of the property price, CMHC insurance is no longer required and, as a result, you will benefit from a longer maximum mortgage amortization period. This can be set at up to 30 years with most financial institutions.

If your mortgage amortization period is set at more than 25 years, you have the option to shorten it. This is possible essentially through the renegotiation of the terms of your contract, a privilege that most creditors offer to their customers. This option will therefore allow you to negotiate, in agreement with your bank, a shorter mortgage amortization period against both the payment of a higher monthly payment and the payment of a lump sum to pay off your loan.

A long or short amortization period: which is best?

It can sometimes be difficult to make a decision between a long-term mortgage amortization and a short-term one. However, it's mostly a matter of how much you're willing to pay at the end of each month, and how many months and years you want to spread your mortgage amortization over.

To help you understand this, let's look at the mortgage amortization table below:

So which mortgage amortization period should you choose?

The advantages of a short amortization period

It's simple math: the shorter the amortization period of your mortgage, the higher the monthly payment and the less interest you pay. In the chart above, you can see that amortizing the $350,000 mortgage over 20 years would cost $78,630 less in interest charges compared to amortizing it over 30 years.

Short-term amortization is preferred primarily due to:

• Lower interest;
• Faster mortgage repayment;
• The possibility of contributing as little as 5% of the value of the property as an initial contribution.

The benefits of long-term amortization

The main advantage of spreading a mortgage over a longer period is that it allows for lower monthly repayments, which may be suitable for households with a limited monthly budget or those that are involved in other real estate projects.

Alternatively, experienced investors may decide to spread the loan over a longer period of time and invest the difference in monthly payments - $458 in this case - in more profitable activities when the interest rate differential allows.

Example of how to calculate the amortization of a mortgage

To calculate the mortgage amortization, three essential elements are taken into consideration: the amount of the loan, the term of the loan and the annual interest rate.

You can draw up your own mortgage amortization table for any loan in just a few minutes using an Excel table or one of the calculators available online.

To better understand how to calculate this, let's take a look at the following example with the same data from Scenario A in the previous table:

• Amount borrowed: $350,000
• Annual interest rate: 3.5%
• Mortgage amortization period: 20 years
• Monthly repayment: $2,029

The monthly repayment is calculated according to the following formula:

1. First, the annual interest rate must be converted into a periodic rate. Since there are 12 monthly repayments in a year, let's divide it as follows: 3.5% ÷ 12 = 0.29%.
2. Then, you have to multiply the balance due by this rate: $350,000 x 0.29% = $1,015 in interest.
3. Of your monthly repayment, that's $1,014 in principal you're paying back: $2,029 - $1,015 = $1,014.

These last two steps must then be repeated for each monthly instalment, each time subtracting the principal repaid from the remaining loan balance. For example, your second monthly payment would be calculated as follows:

1. $350,000 - $1,014 = a remaining balance of $348,986
2. $348,986 x 0.29% = $1,012.06 in interest
3. $2,029 - $1,012.06 = $1016.94 in principal repaid

And for your third monthly payment:

1. $348,986 - $1,016.94 = a remaining balance of $347,969.06
2. $347,969.06 x 0.29% = $1,009.11 in interest
3. $2,029 - $1,009.11 = $1,019.89 in principal repaid

And so on…

Note: for the purposes of this example, we have rounded up the value of the periodic rate and monthly repayments. It is important, however, to do this calculation using the whole value of each component to achieve a fair and realistic result. 

Cover image: Freepik.com

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