30-year mortgage amortization: the great debate
So you’re in the home-buying market –congratulations! We know that shopping around for a home can be exciting, but getting into the nitty gritty of mortgages can be a little scary. The recent news that effective August 1, the federal government will allow 30-year amortizations to first-time homebuyers who have a down payment of less than 20% and are purchasing a new build has reignited the debate on whether extending mortgage terms is beneficial or detrimental for consumers. (If you have a down payment of 20% or more, you were already able to spread mortgage payments over 30 years, and buyers of resale homes who have less than 20% to put down are still limited to 25-year amortizations.)
The move aims to make housing more accessible amid skyrocketing prices, but while this decision certainly provides more financial flexibility, it also raises concerns about the long-term financial impact on homeowners. It’s not an easy choice to make, considering that we’re living far longer, making longer terms more reasonable, but then we end up paying more interest. But with many first-time buyers struggling to save up for a 20% downpayment, the reality is that saving longer to have a larger down payment means increased risk that prices will keep soaring, making it even less feasible to break into home ownership.
How do you know if a 30-year amortization is right for you?
Well, the first step is figuring out how much you can afford to pay for a home. You can start your mortgage education journey with this post that answers many of the questions you’ll have when taking out a mortgage for the first time. Then come on back for Amortization 101!
First of all, what is amortization? When you buy a home and you can't pay all the money at once, you apply for a loan called a mortgage to help you buy it. Then you need to decide how long you'll take to pay it back. This length of time to pay back the loan is called "amortization". In Canada, 25 years has traditionally been the most common amortization period, and the longest the major banks offered most first-time homebuyers until now. (It is possible to have longer amortization periods with some alternative lenders, but we’ll stick with the standard to explain the pros and cons here.)
To start, you’ll need a minimum of 5% of the purchase price of your home (for homes up to $999,999, and 20% down payment for those over $1M) to hand over to the bank as a downpayment.
A comparison of 25- and 30-year amortization
Let’s assume you’ve got a 20% down payment ready. Choosing 25-year amortization is like choosing to pay off your credit card faster than just making minimum payments—it saves you money on interest, which is the extra money you pay for borrowing the original amount. By choosing to pay the loan off 5 years sooner, you save a bunch of money in the long term. Also, banks often give you a slightly better deal (like a discount on the extra money you pay for borrowing) if you agree to pay off your house in 25 years.
Here's what the financials would look like for a 25-year versus a 30-year amortization period on an $800,000 home, with a $160,000 (20%) down payment and a fixed interest rate of 4.79%*.
*This is not the current fixed rate. It is being used for illustrative purposes only.
Home price: $800,000
Down payment: $160,000 (20% of the home price.)
Loan amount: $640,000 (the amount borrowed after the down payment.)
Here's how the mortgage payments break down:
25-year amortization:
Monthly Payment: $3,663.49
Total interest paid over 25 years: $459,047.25
30-year amortization:
Monthly payment: $3,353.99
Total interest paid over 30 years: $567,436.71
We can see that the 30-year amortization has lower monthly payments by about $309.50 compared to the 25-year term, which frees up a lot of money on a monthly basis. But spreading the payments over 30 years means you pay significantly more interest: an additional $108,389.46 compared to the 25-year term.
(Hot Tip: RateHub has an easy amortization calculator you can use to input the purchase price, your down payment, the interest rates offered to you by banks, and then you can compare 25- and 30-year amortization easily.)
Pros and cons of 25- and 30-year amortization
30-year amortization
Pros
Lower monthly payments: Lower monthly payments make homeownership more accessible, especially in high-priced markets like Toronto and the GTA. This could be a game-changer for first-time buyers who often struggle with the financial demands of a 25-year term.
Cash flow management: With lower payments, you can manage monthly budgets more effectively, allocating funds to other important areas like investments, emergency savings, or everyday expenses.
Investment potential: The money saved monthly could be invested with potentially higher returns, especially if mortgage rates remain lower than the average return on other investments.
30-year amortization
Cons
Higher interest costs: Extending the amortization period means significantly more interest paid over the life of the loan.
Delayed equity building: You accumulate equity at a slower pace, as more of your initial payments go toward interest rather than principal. This can be particularly problematic if home values stagnate or decline.
Longer debt burden: A longer loan period keeps you in debt for longer, which could complicate financial planning for other goals, such as retirement.
25-year amortization
Pros
Less interest paid overall: By shortening the amortization period, you'll pay less interest over the life of the mortgage. This results in significant cost savings in the long term.
Quicker equity build-up: You gain equity in your home faster because a larger portion of each payment goes toward the principal rather than interest.
Get debt-free faster: You'll be mortgage-free five years earlier, which can be particularly appealing as you approach retirement or want to achieve other financial goals.
25-year amortization
Cons
Higher monthly payments: The monthly payments are higher than those of a 30-year mortgage, which could strain your monthly budget, especially if your income is variable or you have other significant expenses.
Less budget flexibility: Higher payments mean less cash flow for other expenses, savings, unexpected financial stressors, or investments each month.
Qualification might be tougher: Higher monthly payments could make it harder to qualify for the mortgage initially, as lenders heavily scrutinize your debt-to-income ratio.
The final verdict
The decision between a 25-year and a 30-year mortgage amortization doesn't have a one-size-fits-all answer. It hinges on individual financial situations, future income stability, investment strategies, and personal comfort with long-term debt. It’s important to ensure that the benefits of lower monthly payments today don’t overshadow the potential financial constraints of tomorrow.
The best thing to do is seek out a knowledgeable mortgage broker who will make this exciting process as smooth and stress-free as possible.