Tuesday, April 12, 2011

Principal Payback and Amortization Lengths

With the instigation of recent rule changes to CMHC-insured mortgages that reduce a qualifying loan's maximum amortization length from 35 years to 30 years, designed to ensure Canadians' debt loads do not become any worse than they already are, it's worth a closer look at why the government may have chosen this particular form of fiscal "tightening" over other methods.

Mortgage payments are calculated according to a standard formula that gradually repays principal and charges interest on the remaining principal so as to provide a series of fixed payments (usually monthly) over an amortization period. One can imagine the extreme of 0% interest would result in a straight-line linear principal repayment. As we add interest into the equation, payments are front-loaded with higher interest payments and lower principal payments. Later payments constitute more principal and lower interest. We can ask the question "how long will it take to reduce my principal by 10%?" and plot the result for various interest rates and amortization periods as shown below.

At an interest rate of 2% it takes about 3 years to pay back 10% of principal at 25 year amortization and 5 years at 35 year amortization, a 2 year difference. But look what happens as interest rates increase: at 5% it takes 4.5 years at 25 year amortization but 8 years at 35 year amortization, a 3.5 year difference; at 7% it takes 5.5 years at 25 year amortization and a whopping 10 years at 35 year amortization, a 4.5 year difference!

The problem with higher interest rates and longer amortizations is that not only do interest payments increase, it also takes a longer period to pay down principal at the beginning of an amortization schedule, a double-whammy for long amortization periods. While days of 7% interest rates may be a way's off, the non-linear nature of mortgage loan repayments gives an indication why the government (rightly in my view) chose to reduce maximum amortizations on government-backed insured mortgages over other methods.


takloo said...

thoughtful post. the chart says it all.

too bad there are limits on principal repayment unlike US.

jesse said...

@takloo, the principal repayment limitations have more to do with matching securitization structures. If you want an open mortgage you pay a premium because of the duration risk to investors.

There was a case in the news of a guy getting dinged $30K penalty trying to break his closed Scotia mortgage due to interest rate differential. The poor fellow ended in an interest rate swap contract without realizing it! Sucker!

The US has other problems.

patriotz said...

There are no limits on principal repayment at all at end of term, and hardly anyone gets a term of over 5 years.

Even during term most closed mortgages offer payment double-up or annual extra payments.

People don't pay off their mortgages early because they lack the means and will to do so. The lenders aren't stopping them.