Short Amortization Period Pays Off in the End

One of the least-known secrets among new homebuyers in particular is the huge effect the amortization period of your mortgage has on the interest you will pay during its lifetime.

Decades ago, a young Edmontonian bought his first home, and after paying $21,492 in monthly mortgage payments over three years, was shocked to find out the principal had been reduced by only $1,485.

I learned to my horror that at the start of a 25-year amortization - the period over which the mortgage was to be paid off - that 93 per cent of the mortgage payments went toward interest. When only eight years remained in the amortization period, more than half the payments would go toward the principal.

"The key is still to pay it off as soon as you can, within reason," says Adrian Mastracci, president and portfolio manager with KCM Wealth Management in Vancouver. "Get the monkey off your back in 10 or 15 years, then focus the rest of the time on getting your retirement nest egg up and running. I would do my darndest to keep it within 15 if I could. You just put so much money in your pocket."

Mastracci uses the example of a $240,000, five-year closed mortgage charging 5.75 per cent interest. Paying it off at $1,268 a month over 35 years costs $313,410 in interest, while paying it off at $2,626 a month over 10 years incurs $65,165 in interest. That's a whopping saving of $248,245.

And because more of your money goes toward interest than principal the longer the amortization period that is left, you save the most in interest with the least increase in payments when you start a mortgage.

In Mastracci's example, reducing the amortization period from 35 to 30 years saves you $52,910 in interest while increasing monthly payments only $72. But going from 15 to 10 years in amortization saves only $42,005 while monthly payments go up by $640.

The federal government offers a handful of ways to reduce your amortization period in the article The ABCs of Mortgages, on the Financial Consumer Agency of Canada's website.

These include:
• You can increase the amount of your payments, which may be done once a year with some mortgages and once a term with others. One caution is that if increased payments later become too onerous to keep up, your institution may not let them be reduced before the term of your mortgage expires, if then.
• Making payments bi-weekly over 52 weeks is essentially like making 13 instead of 12 monthly payments a year. For instance, paying $500 every two weeks instead of $1,000 a month in the example above, cuts your amortization from 25 to 22.58 years and reduces the interest you pay on a 6.45 per cent mortgage by $29,411.34. Going to weekly payments saves you even more.
• Another saving comes from keeping the same payments if you renew at a lower interest rate. The consistency is easy on your budgeting, and the amount greater than your required payments goes directly to pay down principal.
• You also directly pay down principal when you make a lump-sum payment, which can be as much as 20 per cent of the original principal and made as frequently as once a year or once a term, depending on the mortgage and institution.
• Some lenders let you make extra payments on your payment dates, sometimes called "double-up" payments, although they may reduce the amount of the lump-sum payment allowed.

A Canadian Mortgage and Housing Corporation survey showed 78 per cent of respondents want to pay off their mortgages as soon as possible, which is a much higher priority in Canada than in the United States, where mortgage interest is tax-deductible.

But more than half of new mortgages taken out during the first half of 2008 had 40-year amortization periods, which Mastracci describes as "long-term rent," since you build up little equity if the value of the house does not increase. (The government no longer allows CMHC to insure mortgages longer than 35 years, as of Oct. 15, 2008.)

"Most people may not be able to do 10 (years remaining), but they can do 15 or 20," Mastracci says. "You can save $160,000 in interest (by going from 35 to 20 years amortization) and that's a lot of loot."

By Ray Turchansky, For Canwest News ServiceApril 1, 2009