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Amortization is a word you'll hear a lot when applying for a mortgage. What is it exactly, and why is it important? Understanding the concept of amortization helps you know how much your mortgage truly costs and gives you the information needed to make decisions about paying when and how quickly to pay it off.   

Amortization Defined

Amortization is the process of spreading out the repayment of a loan with a series of fixed payments over a specified period of time. It makes mortgages - the largest personal loan you'll ever have - possible for the average person to afford. Mortgages are typically amortized over 15 to 25 years. The process of amortization is used to calculate payments which consist of interest charges plus a portion of the principal. This ensures that with every payment, a small amount of the loan amount is repaid. At the end of the amortization period, the loan, plus all accrued interest, is fully paid. 

The amortization period differs from the mortgage term, which is the period in which your specific interest rates and mortgage conditions are in effect. Mortgage terms usually span three to five years so you will have several terms over the amortization period of your mortgage.   

How Amortization Works

If you already have a mortgage, you know that you pay a fixed amount weekly, bi-weekly or monthly, depending on your payment schedule. However, while the total payment amount is the same, the ratio of interest to principal varies with each payment. At the beginning of your mortgage, interest makes up a significant portion of your payment. Only a small amount of principal is paid. As time passes, the amount of principal owing decreases and the amount of interest payable also decreases. Towards the end of your mortgage, your payments consist of mostly principal and a much smaller proportion of interest. An amortization schedule, provided when your mortgage is finalized, tells you exactly what portion of each payment goes towards principal and interest. When you renew your mortgage term, the interest rate often changes. In that case, the remaining amortization is recalculated, and a new schedule is provided to you.    

The Optimal Amortization Period

How do you know the optimal length of time to repay your mortgage? In fact, there is no 'best' amortization period. It depends on your financial situation and how much principal you can realistically afford to repay regularly. To illustrate the difference between two amortization periods, let's say you applied for a $300,000 mortgage with an interest rate of 2%. You can find mortgage calculators on the internet that do these calculations for you. 

Amortized over 15 years, that mortgage will have monthly payments of over $1900. 

The same mortgage amortized over 25 years will have payments of $1270. 

Lowering your payments is one reason to choose a longer amortization. However, longer amortization means more interest paid in the long run. 

The same mortgage scenario above would incur over $81,000 in interest charges over 25 years. 

Interest on the 15-year mortgage amounts to about $47,000. 

Making Amortization Work for You

There is a way to leverage amortization to have reasonable fixed payments while minimizing the overall cost of your mortgage. That is to make additional payments whenever you can. Most mortgages will allow you to repay at least a small percentage of the principal each year, on top of the regular payments. Any additional payments you make are applied entirely to reducing the loan principal. In turn, it reduces - ever so slightly - the overall amount of interest charged. The more principal you can pay down, the more you'll save and the sooner you'll be mortgage-free. The effect is amplified in the early years of amortization when the greatest amount of interest is accruing. 

Every Little Bit Helps

Some homeowners leverage this scenario by using annual bonuses, tax refunds, or pay raises to make additional mortgage payments. Even making tiny additional payments can add up to savings in the long run. If it is allowed by your lender, ask to add on a few dollars to each fixed payment. While you won't notice the small increase, you'll be saving hundreds of dollars and shaving months off of your amortization. 

Now that you understand what amortization is and how it works, find out how to make it work better for you. Your mortgage broker can help explain the details and advise you on the best course of action, whether you are applying for your first mortgage, renewing or refinancing an existing mortgage. Your broker will work with you to ensure that you meet your goals for repaying your mortgage at your own pace and saving as much as possible in overall interest costs.