Buying a home? Then odds are, you’re going to need a home mortgage loan. When most folks think about mortgages, their mind goes to current interest rates. Here’s one reason why your home mortgage is about more than interest rates.
From ‘interest rates’ to ‘down payment’ to ‘debt-to-income ratio’… there are so many terms involved in the mortgage process. It can be hard to learn them all and keep them straight. Of all of them, the term ‘amortization period’ might be one of the most important terms associated with your financial well-being. If you’re currently considering what length period of loan you should choose, here are some things to think about before making a decision.
Firstly, what Is Amortization?
According to Investopedia, amortization is the paying off of debt with a fixed repayment schedule in regular installments over a period of time. They further clarify amortization in terms of loan payments:
At the beginning of the loan term, most of the monthly payment goes toward interest. With each subsequent payment, a greater percentage of the payment goes toward the loan’s principal. For example, on a five-year $20,000 auto loan at 6% interest the first payment of $386.66 allocates $286.66 to principal and $100 to interest. The last monthly payment allocates $384.73 to principal and $1.92 to interest.
While the terms ‘amortization period’ and ‘mortgage term’ technically have different meanings, in the world of residential home loans, they are frequently used interchangeably due to the fact that the amortization period aligns with your mortgage term. A typical amortization period on a mortgage is 25 years. However, there are many periods over which home buyers can choose to pay off their mortgage. While all homeowners should opt for what works best for them, it is frequently the case that a shorter mortgage period will be more financially beneficial in the end. It may not only mean lower overall costs, it may also mean financial freedom from a loan much sooner than originally anticipated.
The ‘Principal’ Of The Matter
While a shorter amortization period means a higher payment amount, it also means a higher amount paid on the principal which translates to paying more on the actual loan (or principal) amount each month. A longer amortization period means lower monthly payments, but will add up to more interest payments and less paid toward principal each month. If you can swing it, a shorter amortization period could save you from paying tons of interest by the end of your loan term.
Saving yourself from paying more in interest is financially savvy, but it’s also important to have a monthly mortgage payment amount that’s sustainable. The standard rule for lenders, before doing any calculating of other homeowner expenses, is 28% of your gross income. However, what’s sustainable for you may not be what’s sustainable for others with similar incomes. This is relative to each individual’s financial snapshot. The best way to determine what you can afford is to simply ‘put pen to paper’. What is your net monthly income? What are your expenses? (ALL of them.) How much do you want to set aside for savings, retirement, or investments each month? How much spending cash do you want each month? It’s crucial, for your financial health, that you have a solid grasp on your own financial snapshot. This includes knowing exactly what your monthly budget looks like.
The Bottom Line
It is understood that a shorter amortization period will pay down the principal sooner and cost less over time, but that doesn’t mean that it’s the best choice for you. Because your monthly payment may well be your largest monthly expense, it might be difficult to swing a higher payment to pay off your loan in 10 years. If it’s doable without compromising your quality of life, it’s a fantastic option, but if there’s too much sacrifice you might consider a longer loan period.
Everyone has a choice in the amortization period that works for them, but it’s important to make your decision based on what works for you and will be beneficial for your finances. If you’re currently getting prepared to invest in a home, give our mortgage partner, Sherrie Kitto (Cornerstone Home Lending, Inc.) a call to talk about the best options for you.
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