Mortgage Amortization Strategies

For many people, buying a home is the largest single financial investment they will ever make. Because of the hefty price tag, most people need a mortgage. A mortgage is a type of amortized loan, which means the debt is repaid in regular installments over a specified period of time. The amortization period refers to the length of time, in years, that a borrower chooses to spend paying off a mortgage. Here, we take a look at different mortgage amortization strategies for today's homebuyers.

Amortization Schedules

Though the most popular type is the 30-year fixed-rate mortgage, buyers have other options, including 15-year mortgages. The amortization period affects not only how long it will take to repay the loan, but how much interest is paid over the life of the mortgage. 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 concerning manageability and potential savings:

• 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.
  

The exact amount of principal and interest that make up each payment is shown in the mortgage amortization schedule (or amortization table). More of each monthly payment goes toward interest during the early years of the loan.

With each subsequent payment, more and more of the payment goes to the principal, and less goes 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.

Deciding which mortgage you can afford should not be left solely to the lender. Even when there are lending restrictions, you might be approved for more than you truly need. If you prefer 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.

Longer Amortization Periods Reduce Monthly Payments

Loans with longer amortization periods require 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 table shows an abridged example of an amortization schedule for a $200,000 30-year, fixed-rate loan at a 4.5% interest rate. Shown here are the first three months of the schedule, and then a jump to 180, 240, 300, and 360 months.

As you can see, the payment for this 30-year, fixed-rate 4.5% mortgage is always the same each month ($1,013.37). The amounts applied to principal and interest, however, change every month, with more money gradually shifting toward the principal and less to the interest.

Summary for the 30-year, fixed-rate 4.5% mortgage of $200,000:

• Principal Amount: $200,000
• Monthly Payment: $1,013.37
• Total Interest Amount: $164,813.42
• Total Loan Cost: $364,813.20
  

Shorter Amortization Periods Save You Money

If you choose a shorter amortization period, such as a 15-year mortgage, 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. Also, 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.

Table 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). 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:

• Principal Amount: $200,000
• Monthly Payment; $1,529.99
• Total Interest Amount: $75,397.58
• Total Loan Cost: $275,398.20

As we can see from the two scenarios, 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 disparity 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 examples also illustrate that the 15-year amortization shaves off $89,416 in interest, lowering the overall cost of the loan. If a borrower can comfortably afford the higher monthly payments, a shorter amortization period offers considerable savings.

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) much sooner.

Take the $200,000, 30-year mortgage from the example above:

• 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 savings of $43,204.16.

Even a single extra payment made each year can reduce the amount of interest and shorten the amortization, as long as the payment goes toward the principal and not the interest. Just 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 toward extra payments can make good financial sense. And unlike the 15-year mortgage, it gives you the flexibility to pay less for some months.

Other Payment Options

Adjustable-rate mortgages (ARMs) 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 increase 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

Because there are so many factors that 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 on 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.