How Does Mortgage Amortization Work?
If you are contemplating buying a house, then you will most likely need a mortgage. So how does mortgage amortization work? We have taken the time to write this article and outline what you need to know as some terms can be confusing.
There are two time periods that apply to a mortgage: the term and the amortization period.
- The term is the time that you commit to a specific interest rate. For example, if you signed up for a mortgage at 4% for 5 years that is the “term” in which you are guaranteed that interest rate. After five years, and every five years after that, your mortgage interest rate will be “renewed” at the current interest rate. This will continue until the mortgage is paid off.
- The second time period of a mortgage is called the amortization period. This is the entire length of time required to pay the mortgage off in full. Commonly, this is 25 years, but some are longer.
So what is Amortization?
Besides being the length of the mortgage, it is also a method of allocating how much of each of your payments goes towards interest. Also, how much goes towards paying off the balance, or the “principal” of the mortgage. Unlike other loans, the allocation is not the same each month. Even though your payment amount remains unchanged throughout the term of the mortgage as your interest rate is locked at that rate.
When you make a payment the principal balance is reduced, and the interest due on the next payment is recalculated based on the new principal balance after your payment. This means that each month the amount allocated to interest goes down. Resulting in the amount allocated to pay off the mortgage amount going up.
Why is it set up this way?
Amortization is set up to collect the most interest at the beginning of the mortgage. In fact, your first payment on your mortgage will be almost all interest and very little principal. The primary reason for this is that it is a method of reducing risk for the lender. They have loaned you the money to buy a house, but they want their money back as soon as possible. The interest portion of your payment is their earnings and mortgage lenders loan money to make money.
If you should default on your obligation to pay your mortgage back, the lender minimizes their profit loss as they have collected the maximum amount of interest possible with each payment. If this sounds unreasonable, consider their position. Wouldn’t you want your money back as quickly as possible if you loaned someone hundreds of thousands of dollars?
If you want to know just how much principal and interest you will be paying over the years, you can obtain an amortization schedule by using our online calculator. All you need to do is input the interest rate and length of the mortgage and a program will calculate the rest. For a typical mortgage, it will take 17 years to pay off the first half of the mortgage. At this point, the tables turn and more money is going towards principal than interest and the balance comes down quickly.
Conclusion
Fortunately, there may be ways to speed up the allocation towards principal, instead of interest. Putting down lump sum payments when the mortgage comes up for renewal is a common way to do this. A lump sum payment comes straight off the principal balance. Shortening the length of the mortgage and consequently reducing the amount of interest paid.
Not all mortgages permit this, while some do so with a penalty. So it is important that you talk to your mortgage broker. They will sift through the different lenders to find the best deal for you. No one wants to pay than need be, mortgages.ca can help you find the best mortgage customized to your needs.