What is Amortization?

AMORTIZATION is the act of amortizing.  According to the Merriam-Webster dictionary, this is the definition of the verb amortize:

am·or·tize

verb \ˈa-mər-ˌtīz also ə-ˈmȯr-\

am·or·tizedam·or·tiz·ing

Definition of AMORTIZE

transitive verb

1

: to pay off (as a mortgage) gradually usually by periodic payments of principal and interest or by payments to a sinking fund

In other words, the term AMORTIZATION is used to describe the act of paying back your borrowed money.  The length of years that you often hear associated with amortization (for example, “35 year amortization” or “20 yr amort”) tells you the amount of time it will take you to completely pay off your loan.

The general idea is this: the shorter your amortization, the higher your payments will be.  As an investment, the goal is that you want to pay off your balance as quickly as possible so that you can build more HOME EQUITY in your house and eventually own your house CLEAR TITLE.  Clear title means that you do not owe any money for the house (ie. It is completely paid off) and, for many, this is the ultimate objective of home-ownership.  By shortening your amortization, you pay less interest and build up your equity more rapidly.

Here’s an example of the difference between a 35 year amortization and a 25 year amortization, based on a 5% interest rate for a $100,000 mortgage.  Of course, this example is completely hypothetical because it assumes that your interest rate will remain at 5% for the entire amortization period.  As you may know (I’ll write more about this later), mortgage rates will change every time you renew your mortgage; therefore, this example is not 100% accurate in the amount of total payments and interest paid. However, it will provide you with a general understanding of the differences between the two different amortizations.

35 year amortization                                                  25 year amortization

$501.42/month                                                          $581.60/month

Amount of interest paid: $110,597.32                       Amount of interest paid: $74,482.96

Total Payments: $210,597.32                                    Total Payments: $174,482.96

I often recommend longer amortizations for young, first-time home buyers who are just establishing themselves in their careers and who are earning minimal income.  It is reasonable to expect that as we get older and gain more experience and/or seniority, our income will continue to grow with us.  If income is tight, it is best to only commit yourself to a reasonable payment amount each month.  As you get older, you can shorten your amortization and increase your payments to an amount that you are comfortable with.

In Canada, the maximum amortization period is 35 years for a HIGH-RATIO MORTGAGE.  40 year amortizations are still available from some lenders for CONVENTIONAL MORTGAGES.

What is a Down Payment?

A Down Payment is a lump sum of cash that is given to a bank to show that you are seriously committed to your home purchase.  A down payment demonstrates to the bank that you have been responsible enough to save up this amount of money and that you are confident enough in the property (the house) to invest your money into it. 

The amount of your down payment is subtracted from your purchase price to determine the full amount of money needed for your mortgage.  In other words, if you buy a house for $100,000 and put $20,000 down (as your down payment) you will need an $80,000 mortgage ($100,000-$20,000=$80,000).

In Canada, you may put as little as 5% of your purchase price down as your down payment.   ie. If the house you want to buy is $100,000, make sure that you have at least $5,000 in savings to use as your down payment.  (If you wish to buy a house but you have no money at all to use as a down payment, there are other options as well, which I will write about at a later date.  For the time being, so that we do not complicate matters, I will say that the best option for all home buyers is to have at least 5% to put down.) 

There are two classifications of mortgages: High-Ratio Mortgages and Conventional Mortgages.

If you put less than 20% down, your mortgage is considered a HIGH-RATIO MORTGAGE.

If you put 20% or more down, your mortgage is considered a CONVENTIONAL MORTGAGE.

Stay tuned for more information on these two classifications.