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.

Acceptable Sources of Down Payments

A Down Payment may come from a variety of sources, including:

1.      Savings

2.      Home equity

3.      A gift from an immediate family member

4.      RRSPs

The first source, savings, is pretty straight-forward.  The bank* may want to see a history of your savings to ensure that the money you are using for your down payment is coming from your own resources (earnings) and that you will not have to pay anyone back.  This can usually be proven through bank statements.

I wrote about home equity earlier, so you should be familiar with the term.  If you are transferring your mortgage or refinancing, you can use the equity in your home as a down payment.

A gifted down payment must come from an immediate family member.  The bank will want to see a signed agreement between you and the family member stating that the family member is giving you the money and he/she does not expect you to pay him/her back.  The gift letter should also include the full name, contact information and relationship of the donor. 

*A note/disclaimer: I realize that I have been using the term “the bank” quite often in my writing and this may seem misleading to some.  To clarify, when I say “the bank”, I actually mean this to represent any number of lenders.  These lenders could be banks, credit unions, mortgage investment companies, private lenders, etc.  In my day-to-day dealings, I have noticed that most people just refer to lenders as “the bank”, since this term is used so often in our daily conversations and since “the bank” was where people traditionally used to get their mortgages in the past.  I will continue to use the term “the bank” in this blog for ease of explanation.

What is Home Equity?

I’m sure you’ve heard words similar to these in advertisements: “Use your equity to pay down your debt” or “Let your home equity lend a hand”.  What is this equity that all these lenders speak of?  There are a few different definitions for equity but the one definition that is most important to you is that of HOME EQUITY. 

Simply put, home equity is the difference between your home’s market value or purchase price and your mortgage balance. 

In other words, HOME EQUITY = MARKET VALUE or PURCHASE PRICE – MORTGAGE BALANCE

Let’s go through a fairly easy example. 

1. You buy a house for $100,000.
2. You put down a down payment of $10,000.
3. Therefore, your mortgage balance is $90,000.
4. 5 years later, because you have been making regular payments, your mortgage balance will be $85,000.
5. Also 5 years later, because your neighbourhood has become a desirable place to live and property values have gone up, the value of your house has gone up to $150,000.

$150,000

-$85,000

$65,000

ie. 5 years later, your home equity amount is $65,000!

Building up equity should be the #1 goal for homeowners.  The more your property value increases and the faster you pay down your mortgage balance, the more equity you have!

Home Equity can be used as collateral to borrow money from the bank (perhaps for renovations or to consolidate debt).  This is often done through home equity loans or home equity lines of credit, which I will explain further at a later time.