What’s the best amortization period for your loan?

What is amortization?

Amortization allows you to spread the repayment of the principal and interest on a loan over several instalments. It determines the fixed amounts you have to pay periodically, often on a monthly or weekly basis, over a set period of time.

For example, if you take out an eight-year loan, amortization refers to the time it will take you to repay the principal and interest in full by making monthly or weekly payments. No matter what type of interest-bearing loan you take out, the amortization period you choose has an effect on the total amount you’ll pay.

How do you calculate loan payments?

To calculate loan payments, there are three elements to consider: the amount you’re borrowing, the annual interest rate and the amortization period. There are a number of online loan calculators (External link) that allow you to estimate the effect of a longer or shorter amortization period – or a lower or higher payment – in just a few clicks.

How do you calculate the interest on a loan?

Let’s say you take out a personal loan for $25,000 at 10% for 4 years with monthly payments of $634.06. Here’s how to calculate the portion of interest and principal you pay for each instalment:

1. Convert the annual interest rate into a periodic rate: 10 ÷ 12 = 0.83%.
2. Multiply the loan amount by this rate: $25,000 x 0.83% = $207.50 in interest (for the first month)
3. Subtract the interest from the payment: $634.06 - $207.50 = $426.56 in principal.

Then repeat this calculation for each instalment, subtracting the principal repaid from the remaining balance each time. Interest on an amortized loan is always calculated on the balance.

What effect does amortization have on interest?

If you take out a fixed-rate loan, the longer you pay off the principal balance, the lower the interest portion will be – even when your payments are the same each time. This is the principle of diminishing interest rates. Take a look at an amortization schedule and you’ll see that the amounts corresponding to principal repayment and interest payments vary from one instalment to the next.

The amount allocated to interest is at its highest for the first payments then gradually decreases. In the case of a longer amortization period, such as with a mortgage, the first few years are devoted mainly to interest payments rather than principal repayments.

For example, if you borrow $200,000 to buy a house at 5.49% amortized over 25 years, only after 12 years will you start paying more principal than interest. But if you take out a personal loan of $20,000 at 10.15% over 5 years, you’ll start paying down the principal from the very first payment. The longer the amortization period, the longer it’ll take to pay off your loan and the more interest you’ll pay. The shorter the amortization period, the less interest you’ll pay.

How do you choose the right amortization period for your mortgage?

If you have or plan to take out a mortgage, it’s likely to be the largest sum you’ll borrow in your lifetime. At National Bank, the maximum amortization period for a mortgage is 30 years. Most people, however, choose to pay off their home in 25 years.

Even a 5-year difference adds up to a lot of money. If you have a $400,000 mortgage at 5% amortized over 25 years instead of 30, you’ll pay about $70,000 less in interest. If the amortization period is 20 years instead of 30, you’ll save around $137,000. Online mortgage calculators allow you to simulate different amortization schedules.

Is it better to choose a shorter or longer amortization period?

Paying off your mortgage quickly isn’t always the best option. The shorter the amortization period, the higher your payments. So make sure your budget can handle it.

If you’ve opted for a longer amortization period, it’s still possible to make accelerated mortgage payments. Your payments will be applied directly to the principal, thereby reducing the amortization period and interest on your loan.

Here are four ways to optimize your repayment:

1. Increase the frequency of your payments (to weekly or bi-weekly).
2. Make an additional payment (sporadically or regularly until the end of the term).
3. Make an early repayment.
4. Redeem your credit card points and use them for an additional payment.

Since certain restrictions apply depending on the type of loan you have, talk to your advisor about the best strategy for you.

How do you choose the right amortization period for your car loan?

If you’re planning to buy a car using credit, it’s likewise a good idea to take amortization into account. Use a loan calculator to work out the details before simply settling on the lowest payments possible. The lower the amount, the longer the amortization period and the more interest you’ll pay.

For example, if you opt for a car loan of $31,640 at a rate of 6.34% amortized over 7 years, the interest will be $7,620.69. If the financing is spread over 5 years, the interest will be $5,362.27. By reducing the amortization period by 2 years, you’ll save $2,258.42. However, your weekly payments will increase from $107.69 to $142.07.

Is it better to choose a shorter or longer amortization period?

When choosing the amortization period for your loan, you need to take into account the vehicle’s depreciation, i.e., the difference between its purchase price and the price you’ll get when you resell it. As soon as a car leaves the dealership, it begins to depreciate. In the case of a new model, it loses about half its value in three years. Depreciation then continues at a rate of 8% to 10% per year.

Can you afford higher payments? Consider a shorter amortization period – unless you plan to keep your vehicle for many years. If you amortize your loan over 7 years and sell your vehicle after 36 months, its resale value could be less than the amount of your debt.

Using the same example as above, if you pay $31,640 for your car, after 3 years it will have an estimated value of $15,820. Since your loan balance will be $19,770, you’ll lose $3,950. But if you amortize your loan over 5 years, you’ll only have to pay off $13,866, and your profit will be $1,954.

How do you choose the right amortization period for your personal loan?

Personal loans are used to finance short-term projects, such as renovations, travel or wedding receptions. Generally, their amortization periods are no longer than five years. Since this type of financing isn’t secured by a collateral asset, as is the case with car loans or mortgages, it often involves a higher interest rate.

Whether you’re taking out a mortgage, car loan or personal loan, amortization has a major impact on the total interest you’ll pay. Talk to your advisor to find out whether you should choose a shorter or longer amortization period. Together, you can analyze different scenarios and find the best solution for you.