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Understanding How Mortgage Amortization Works in Canada

Understanding How Mortgage Amortization Works in Canada

When shopping for a mortgage, you can expect to be introduced to some new terminology. For many, one of the more confusing is mortgage amortization, which isn’t surprising, as amortization is not a word most people find themselves tossing around on a daily basis. It is, however, an important concept to understand, as it can have a significant impact on your budget, as well as the amount of interest you’ll pay on your mortgage over the long term.

What is an Amortization Period?

Simply put, the amortization period refers to the length of time it will take you to pay off your entire mortgage. While the amortization period is something that’s agreed upon when you sign up for your mortgage, there are ways in which you can reduce your mortgage amortization and save money. I’ll get into this in more detail a bit later.

In Canada, the standard amortization length is 25 years, which is also the maximum amortization available on CMHC insured mortgages. Insurance from the Canada Mortgage and Housing Corporation (CMHC) is required for any mortgage with less than 20% down payment. Amortization on a conventional mortgage (20% or more down), does not have the same restrictions and can be as high as 30, even 40 years, although most Canadian banks limit amortizations to 30 years.

Mortgage Amortization vs. Mortgage Term

Many people confuse the amortization of a mortgage with the mortgage term. While the former represents the length of time it takes to pay off the entire mortgage, mortgage term represents the time period for which you’ve committed to a specific interest rate, lender, and any associated terms and conditions of the mortgage.

Mortgage terms can range anywhere from 6 months to 10 years, although the most common term is 5 years. While there are both open and closed terms, the conditions of which I won’t delve into in this article, the important thing to note is that when your term expires, you are free to renegotiate with the same financial institution or take your mortgage to a different bank, without any penalties.

Three Ways to Reduce Your Mortgage Amortization

There are typically three ways for borrowers to save interest by reducing the time it takes to pay off their mortgage. The first is by periodically applying extra payments against the principal amount owing, otherwise referred to as lump-sum payments. The second is to increase their payment frequency from monthly to rapid biweekly or rapid weekly. The third way is to increase your regular mortgage payment amount, within the allowable limit set out by your financial institution. Let’s take a closer look at all three options.

Applying Lump Sum Payments to Your Mortgage

When you make an extra (lump sum) payment against the principal balance of your mortgage, you’re reducing the amortization period, as well as the interest you’ll pay over the life of your mortgage. Most financial institutions have allowances for these extra payments, also known as prepayments, even if you are in a fixed-term mortgage. While policies vary between banks, prepayment amounts are typically between 10-20% of the original principal balance each calendar year. This is important if you plan on paying down your mortgage ahead of schedule, so it’s a good idea to make sure you know the different bank policies when shopping for a mortgage. The following example shows how you would calculate the available lump sum payment on a mortgage.

Lump-Sum Payment Example:

Original mortgage amount: $300,000

Current principal balance $226,000

Allowable lump sum/calendar year: 15% of the original mortgage principal.

$300,000 X 15% = $45,000

In this case, providing you hadn’t made any previous lump-sum payments within the current year, you would be eligible to pay up to $45,000 against your mortgage principal, without incurring a penalty. Keep in mind, there may be a minimum amount required per payment, such as $100, and some banks impose limits on the window of time during which you can make a lump-sum payment.

Increasing the Mortgage Payment Frequency

Applying a periodic lump sum payment is just one way to reduce your mortgage amortization. Perhaps the most common prepayment method is to choose to make rapid biweekly payments instead of monthly payments on your mortgage. You’ll be able to make this decision when you sign up for your mortgage. If the mortgage is already in place, most financial institutions will still allow you to change payment frequencies in the middle of the term

Choosing a rapid payment option will result in a shorter amortization, and less interest being paid over the life of the mortgage. For example, just by choosing rapid biweekly vs. monthly payments on a mortgage with a 25-year amortization will result in you paying it off as much as three years faster (approx. 22 years).

The Difference Between Rapid and Regular Biweekly Payments

There’s a common misunderstanding that to pay your mortgage off early, all you need to do is choose a more frequent payment than monthly ie. biweekly, semi-monthly (2X/month), or even weekly. Not quite. To actually save interest, and lower your amortization, you need to make a “rapid” biweekly (or weekly) payment.

What’s the difference? Well, a rapid bi-weekly payment is exactly ½ of a monthly payment, while a regular bi-weekly payment is less than half of the monthly. To calculate the regular bi-weekly payment, you multiply the monthly payment X 12 and then divide by 26, to represent the 26 bi-weekly periods that are in each year.

Here’s an example of how both rapid and regular bi-weekly payments are calculated, based upon on a monthly principal and interest payment of $1200.00:

Rapid Bi-Weekly payment: $1200 / 2 = $600 bi-weekly.

Regular Bi-weekly: $1200 X 12 = $14,400 / 26 = $553.84 bi-weekly

As you can see, the regular bi-weekly payment is slightly less, at $553.84 bi-weekly, which is why the rapid payment is the one that will pay your mortgage down more quickly, up to 3 years ahead of schedule on a 25-year amortization. With the rapid payment, you’re making the equivalent of a monthly payment every 28 days and taking advantage of there being 26 biweekly periods every 12 months.

You can also opt for rapid weekly payments, but know that this will not pay your mortgage off any faster than the rapid bi-weekly option, as some people believe. Borrowers may want to choose the weekly payment option out of convenience, for example, if they are paid by their employer on a weekly basis.

Increasing the Mortgage Payment Amount

The third and final way to pay your mortgage off faster, and reduce your amortization period, is to increase your regular payment amount. This is something that can be easily programmed by your bank, in fact, many banks allow you to make the change yourself, online. You just need to know how much you are permitted to increase the payment by.

Some banks will allow you to double the regular principal and interest amount, while others will impose a limit of 10 to 15%. I should note that these limits apply only to the principal and interest portion of your regular payment, and not other amounts that may be included, such as a property tax or credit protection (life insurance) component.

How to Save Money by Reducing Amortization

While a shorter mortgage amortization means increased monthly payments, it’s a great way to save thousands of dollars in interest over the long run. The following example illustrates the savings realized by paying your mortgage off early. For this purpose, we’ll use a mortgage amount of $300,000 with a 5-year interest rate of 2.99%. While interest rates vary, the rate I’m using is similar to what you can currently expect for a fixed, 5-year term.

Example A: 30 Year Amortization

Mortgage Amount: $300,000

Amortization: 30 Years

Term: 5 Years

Interest Rate: 2.99%

Monthly Principal & Interest (P&I) Payment: $1260.21

Interest paid over 30 years: $153,676.51

Example B: 25 Year Amortization

Mortgage Amount: $300,000

Amortization: 25 Years

Term: 5 Years

Interest Rate: 2.99%

Monthly Principal & Interest (P&I) Payment: $1418.20

Interest paid over 25 years: $125,459.29

Bonus Example: 25 Year Amortization with Rapid Bi-Weekly Payments

Mortgage Amount: $300,000

Amortization: 25 Years (with rapid bi-weekly payments)

Term: 5 Years

Interest Rate: 2.99%

Bi-weekly Rapid Principal & Interest (P&I) Payment: $709.10

Interest paid per Amortization Period: $110,067.28

Example Summary

From the example above, a borrower would save $28,217.22 in interest just by choosing a 25 vs. 30-year amortization. This is not a small amount of money. The savings are even greater ($43,609.23) if they were to opt for rapid biweekly payments on the 25-year mortgage. Not only that, but they would end up paying the mortgage off in full in just over 22 years. I should add that any lump sum payments applied to the mortgage periodically would further reduce both amortization and the interest paid.

The Importance of Choosing The Right Mortgage Amortization

When people are shopping for a mortgage, their primary concern is usually to get the best interest rate possible. It is, after all, the biggest loan they will ever take out. But other factors, such as selecting the right amortization period, can be just as important. More specifically, you want to choose a mortgage with flexible prepayment options, to make it easy to reduce the amortization over time, and save interest.

My advice is to shop around not only for a great rate but for the right fit when it comes to amortization and prepayment options. As for rates, if you are currently in the market for a mortgage, feel free to check out some of the current rates being offered by Canadian financial institutions, using the table below.

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