For many people, buying a home is the largest single financial investment they will ever make. Because of the hefty price tag, most people usually need a mortgage. A mortgage is a type of amortized loan in which the debt is repaid in regular installments over a period of time. The amortization period refers to the length of time, in years, that a borrower chooses to pay off a mortgage.
While the most popular type is the 30-year, fixed-rate mortgage, buyers have other options, including 25-year and 15-year mortgages. The amortization period affects not only how long it will take to repay the loan, but how much interest will be paid over the life of the mortgage. Longer amortization periods typically involve smaller monthly payments and higher total interest costs over the life of the loan. Shorter amortization periods, on the other hand, generally entail larger monthly payments and lower total interest costs. It's a good idea for anyone in the market for a mortgage to consider the various amortization options to find one that provides the best fit in terms of manageability and potential savings. Here, we take a look at different mortgages amortization strategies for today's homebuyers.
The exact amount of principal and interest that make up each payment is shown in the mortgage amortization schedule (or amortization table). Early on, more of each monthly payment goes towards interest. Interest on a mortgage is tax deductible – If you are in a high tax bracket, this deduction will be of more value than to those with lower tax rates. With each subsequent payment, more and more of the payment goes to the principal, and less to the interest, until the mortgage is paid in full and the lender files a Satisfaction of Mortgage with the county office or land registry office.
Longer Amortization Periods Reduce Monthly Payment
Loans with longer amortization periods have smaller monthly payments because you have more time to pay back the loan. This is a good strategy if you want payments that are more manageable. The following figure shows an abridged example of an amortization schedule for a $200,000 30-year, fixed-rate loan at 4.5%:
Figure 1 The mortgage payment for this 30-year, fixed-rate 4.5% mortgage is always the same each month ($1,013.37). The amounts that go towards principal and interest, however, change every month. Shown here are the first three months of amortization schedule, and then payments at 180, 240, 300 and 360 months.
Summary for the 30-year, fixed-rate 4.5% loan:
– Mortgage amount = $200,000
– Monthly payment = $1,013.37
– Interest amount = $164,813.42
– Total cost = $364,813.20
Shorter Amortization Periods Save You Money
If you choose a shorter amortization period – for example, 15 years – you will have higher monthly payments, but you will also save considerably on interest over the life of the loan, and you will own your home sooner. In addition, interest rates on shorter loans are typically lower than those for longer terms. This is a good strategy if you can comfortably meet the higher monthly payments without undue hardship. Remember, even though the amortization period is shorter, it still involves making 180 sequential payments. It's important to consider whether or not you can maintain that level of payment.
Figure 2 shows what the amortization schedule looks like for the same $200,000 4.5% loan, but with a 15-year amortization (again, an abridged version for simplicity's sake):
Figure 2 The same $200,000 4.5% loan, but with a 15-year amortization. The first three months of the amortization schedule are shown, along with payments at 60, 120 and 180 months.
Summary for the 15-year, fixed-rate 4.5% loan:
– Mortgage amount = $200,000
– Monthly payment = $1,529.99
– Interest amount = $75,397.58
– Total cost = $275,398.20
As we can see from the two examples, the longer, 30-year amortization results in a more affordable payment of $1,013.37, compared to $1,529.99 for the 15-year loan, a difference of $516.62 each month. That can make a big difference for families on a tight budget or who simply want to cap monthly expenses. The two scenarios also illustrate that the 15-year amortization saves $89,416 in interest costs. If a borrower can comfortably afford the higher monthly payments, considerable savings can be made with a shorter amortization period.
Accelerated Payment Options
Even with a longer-amortization mortgage, it is possible to save money on interest and pay off the loan faster through accelerated amortization. This strategy involves adding extra payments to your monthly mortgage bill, potentially saving you tens of thousands of dollars and allowing you to be debt-free (at least in terms of the mortgage) years sooner. Take the $200,000, 30-year mortgage from the above example. If an extra $100 payment were applied to the principal each month, the loan would be repaid in full in 25 years instead of 30, and the borrower would realize a $31,745 savings in interest payments. Bring that up to an extra $150 each month, and the loan would be satisfied in 23 years with a $43,204.16 savings. Even a single extra payment made each year can reduce the amount of interest and shorten the amortization, as long as the payment goes towards the principal, and not the interest (make sure your lender processes the payment this way). Naturally, you shouldn't forgo necessities or take money out of profitable investments to make extra payments. But cutting back on unnecessary expenses and putting that money towards extra payments can make good financial sense. And unlike the 15-year mortgage, it gives you the flexibility to pay less some months.
Tip: Online mortgage-amortization calculators can help you decide which mortgage is right for you and calculate the impact of making extra mortgage payments.
Adjustable-rate mortgages may allow you to pay even less per month than a 30-year, fixed-rate mortgage and you may be able to adjust payments in other ways that could match an expected rise in personal income. However, monthly payments on these can rise – how often depends on economic indicators and on how the contract is written – and with mortgage interest still at almost-historic lows, they are probably an unwise bet for most homeowners. Similarly, interest-only and other types of balloon mortgages often have low payments, but will leave you owing a huge balance at the end of the loan term, also a risky bet.
The Bottom Line
Deciding which mortgage you can afford should not be left solely to the lender: Even in the current lending climate with its tougher standards, you might be approved for a bigger loan than you truly need. If you like the idea of a shorter amortization period so you can pay less interest and own your house sooner – but can't afford the higher payments – consider looking for a home in a lower price range. With a smaller mortgage you might be able to swing the higher payments that come with a shorter amortization period.
Because so many factors can affect which mortgage is best for you, it's important to evaluate your situation. If you are considering a huge mortgage and you are in a high tax bracket, for example, your mortgage deduction will likely be more favorable than if you have a small mortgage and are in a lower tax bracket. Or, if you are getting good returns from your investments, it might not make financial sense to cut back on building your portfolio to make higher mortgage payments. What always makes good financial sense is to evaluate your needs and circumstances, and take the time to determine the best mortgage amortization strategy for you.