downmortgagedown

While mortgage rates are at historic lows, having that large debt in the picture can still be stressful when you think about any changes in your current financial situation.  A common goal for many home owners is reduce the mortgage as quickly as possible.  There are three primary methods of doing this.

The below methods are your best options for ways to structure your mortgage so that you have more paid off, sooner.  Apart from them, the easiest way would be to win the lottery.  Please let me know if you figure out how to do that!

In brief, the methods are:

  1. Choosing a shorter amortization period.
  2. Choosing a shorter mortgage term.
  3. Choosing a lender or mortgage with high pre-payment options.

Before we discuss the specifics of these methods, it is worth doing a very quick review of the definitions of some very important terms.

  • Amortization period means the length of time your mortgage will be paid off in.  Before we add in interest costs, this is basically saying your borrowed X amount of money and you are going to pay it back in N number of years.  Amortization period is therefore just how many years it will take you to pay off – in full – the mortgage loan you are taking out.
  • Mortgage term means the length of time your lender agrees to loan you the money at and what the agreed upon interest rate for that money will be.  In essence, this means that after you agree with your lender to pay off the money over a certain number of years (your amortization period as above), you then agree to how high an interest rate you pay on that money and for how long you will be borrowing the money.
  • Interest rate refers to how much the lender is charging to loan you the money to pay for the rest of your property.  This interest rate is either tied to the mortgage term as above (fixed) so that you know your interest rate over a given period of time, or it changes with the prime rate (variable) and you don’t know how long the rate will stay at its current level.

Let’s discuss the three ways in which you can pay more of your mortgage sooner than is typically done.

1.  Choosing a shorter amortization period

As discussed, the amortization period is the length of time that your mortgage will be paid off in.

In Canada, the typical amortization period is 25 years.  Shortening the amortization period has the effect of increasing your payments, as you are paying off the same money in a shorter time.  Extending the amortization period has the opposite effect, causing you to have lower payments but it will take longer to pay off the money.  In either case, how much interest (in actual dollars) you pay is affected by how long you take to pay off the money.  A shorter amortization period means you are borrowing the money for less time, which means you pay interest for less time, which means less interest in actual dollars.  A longer amortization period  means you have that loan for longer, which means a longer time where you pay interest and of course that means more interest in actual dollars.

Example:

  • Borrow $400,000 at 3.49% with a 25 year amortization period and your payment is $1,994.97 per month. 
  • Borrow the same amount, at the same interest rate with a 30 year amortization period and your payment is $1,788.35 per month.  This is $206.62 less per month because you are taking longer to pay it off.
  • Borrow the same amount, at the same interest rate with a 20 year amortization period and your payment is $2,312.63 per month.  This is $317.66 more per month because you are paying it off quicker.

The advantages of choosing a shorter amortization period are:

  •  Your mortgage is paid down sooner.
  • The amount of interest you pay on your mortgage in actual dollars is less.
  • Your aggressive repayment plan is set and fixed and you are forced to pay it down as planned.

The disadvantages of a shorter amortization period are:

  • Your payments are higher.
  • You have no flexibility on paying down your mortgage sooner.  If you have a period where you would appreciate not having to make those higher payments, you have no choice in the matter.

I would recommend choosing a shorter amortization period if:

  • You think you would have difficulty sticking to an optional, as you can, repayment plan.
  • You receive your pay in regular (such as bi-weekly) installments with little to no bonus amounts of large lump sums.
  • You do not foresee any likelihood of a time during the tem of your mortgage (typically 5 years) where you will have difficulty making these higher mortgage payments.

2.  Choosing a shorter mortgage term

As discussed, the mortgage term is the length of time that the lender agrees to loan you the money for the property, at the rate you agree upon.

In Canada, the typical mortgage term is 5 years, with purchasers choosing either a fixed interest rate option or a variable interest rate option.   (For more on this, read my post on interest rates.)

Choosing a shorter mortgage term only impacts your payments in the sense that the interest rate charged will be affected.  While there are exceptions based on market conditions and the cost of funds, in general the longer the mortgage term, the higher an interest rate is charged.  As such, a shorter mortgage term can result in a lower interest rate, which means you pay more principal down.

The other benefit in choosing a shorter mortgage term is that this can be useful in that you reach the point at which you are allowed (or required depending on your viewpoint) to pay off your mortgage sooner.  As the majority of mortgages limit how much additional money you can pay back in any given period, a shorter term means less time before you have absolute freedom to pay back as much as you like.

Example:

  • Borrow $400,000 with a 25 year amortization period and a 5 year term.  With a 5 year term, your interest rate is 3.49% and your payment is $1,994.97 per month.
  • Borrow the same amount at the same amortization period, but with a 3 year term.  With this shorter term, the interest rate available drops down to 3.19% and your payment is $1,932.19 per month.  This is $62.78 less per month because you are “keeping” the money for less time.
  • Borrow the same amount at the same amortization period, but with a 7 year term. With this longer term, the interest rate available jumps up to 3.99% and your payment is $2,101.91 per month.  This is $106.94 more per month because you are “keeping” the money for a longer time.

The advantages of choosing a shorter mortgage term are:

  • The interest rate you pay may be less than for a longer term , resulting in more principal paid.  This is generally true but there are sometimes exceptions so make sure your mortgage broker explains this fully.
  • If mortgage rates have gone down since you started your mortgage term, you can refinance at a better interest rate.
  • If your situation has changed (credit score, employment type, job status, pay) for the better, it may be easier to get your mortgage refinanced and you may be able to get a better rate.
  • The point at which you are able to pay off as much of the mortgage as you want – the end of the term – comes sooner.  This gives you tremendous flexibility.
  • If your property has gone up in value considerably, you may be able to take some of that equity out in the form of a lower refinanced mortgage without incurring the extra costs that doing that with a current mortgage normally entails.

The disadvantages of a shorter mortgage term are:

  • You may see little to no benefit or even pay more for a shorter mortgage term than a longer, more typical term.  This would mean no interest savings and possibly even paying higher interest than a longer term mortgage.
  • If interest rates have gone up since you started your mortgage term, you may have to refinance at a higher rate than you otherwise would have had if you had originally chosen a longer mortgage term.
  • If your situation has changed (credit score, employment type, job status, pay) for the worse, it may be difficult to get your mortgage refinanced and it may cost more.

I would recommend choosing a shorter mortgage term if:

  • You believe you will be in a position before the end of a typical mortgage term to pay off substantial amounts of your mortgage.  Keep in mind that most mortgages allow you to make additional payments of between 10 to 20% of the total mortgage per year.  If you believe you will have more than 20% of your total mortgage available at a certain point, a shorter mortgage term could be a good move.
  • You believe your situation will have changed to such an extent before the end of a typical mortgage term that you will find it much easier to get a mortgage at a better rate at that point.  If you are a student, in the entry stages of a career or have credit problems that you are confident will be gone at a later point, then you may choose to take a shorter mortgage term at the best rate you can get now and aim to be in a much better negotiating stance when your shorter term is over.

3.  Choosing a lender and mortgage with high pre-payment options

Pre-payment options refers to the ways in which you can make additional payments on top of your monthly or bi-weekly mortgage payments.  This can mean lump sum payments of 10 to 20% of the total mortgage owing, doubling up your mortgage payment once every calendar year or other additional payment options on top of your regular payments.

Every lender sets their own rules on what sort of pre-payment options are available and also distinguishes what is allowed on different mortgage types they offer.  This detail is typically in the fine print and your mortgage broker would be able to provide you with the pre-payment options for any mortgage you are considering.

The largest difference in your pre-payment options comes from whether your mortgage is open or closed.  What most of us think of as a “typical mortgage” is a closed mortgage, in that once you sign off on the papers, you can’t just pay it all off without incurring penalties.  On the other side of the equation is an open mortgage, which provides tremendous flexibility in allowing you to pay off as much more of your mortgage as you want.  Win the lottery and want to pay it off?  No problem.  Inherit $100,000 and want to pay off 28% of your mortgage?  No problem.  The flexibility comes with a price though, as the lender may end up receiving the money back sooner than they thought, therefore earning less interest on the loan.  This results in open mortgages being offered with a higher interest rate than closed mortgages.

Example:

  • Borrow $400,000 at 3.49% with a 25 year amortization period, 5 year closed term and your payment is $1,994.97 per month.
  • Borrow the same amount, at the same amortization period and term but have the mortage open and your interest rate rises to 4.49%.  Your monthly payment is $2,211.67 per month.  This is $216.70 more per month because you have the freedom to pay off as much as you want whenever you want.

The advantages of choosing a lender and mortgage with high pre-payment options (such as an open mortgage or greater lump sum payments allowed) are:

  • If your situation changes where you have funds you can use to make additional payments on your mortgage, you can use that money to reduce your mortgage and therefore the interest that you pay.

The disadvantages of a lender and mortgage with high pre-payment options are:

  • You may need to pay a higher interest rate for the ability to make significant additional payments.  A lender or mortgage with more restrictive pre-payment options may offer lower interest rates as they can better forecast how long the money will be invested with you.

I would recommend choosing a lender and mortgage with high pre-payment options if:

  • You are paid in such a fashion that you have larger lump sums of money available at various points.  As long as these sums do not exceed the maximum pre-payment amount, you can choose to use them to pay down the mortgage with no extra fees.
  • You are interested in aggressively paying down your mortgage but are worried about committing to higher payments every month in case something goes wrong with your job or your health.

A final caveat for those looking to reduce their mortgage quicker than is typically done.  While the above methods will help you achieve that goal, it is worth speaking with a financial planner to make sure it is the wisest strategy.  With mortgage rates at 50 year historical lows, paying off debt that is costing you so little may not be advisable.

If aggressively paying down your mortgage makes sense for you, all three of the above methods are valid options.  In most cases, it boils down to analyzing what you think your short-term future will hold.  Mortgages can always be broken early if need be, but by planning ahead you can minimize the costs and fees you incur as you do what is best for your particular situation.

If you or someone you know wants to discuss a particular situation, I would be happy to do so.  Feel free to email me or call my mobile at 416-728-9924.  Until then, good luck – and let me know if you figure out that whole how to win the lottery thing!