When it comes time to buy a home, one of the first things you’ll have to do is shop around for a mortgage. When doing so, you’ll quickly realize that there are plenty of different types of mortgages to choose from. It’s obviously important to determine how each type of mortgage differs in order to make the right choice, but it’s also helpful to understand how a mortgage ‘term’ and ‘amortization’ differ from each other.
In fact, terms and amortizations are often the sources of great confusion among buyers, many of whom aren’t fully aware of their distinctions. So, what exactly is the difference between a mortgage term versus amortization?
The mortgage term refers to the length of time that you are under contract with a mortgage lender. During this time, you’ll also be committed to the interest rate that you locked into when you first entered the contract, as well as any conditions and terms that come with the mortgage.
The majority of mortgage terms can be as short as six months, though the most common term length is typically five years. When your term has elapsed, the mortgage can be renewed for the loan amount left to be repaid with your current lender, usually with the same terms and conditions. However, a new interest rate will be applied based on the current market.
Essentially, the term just represents the time frame within which you are committed to your lender. Once the term is up, you can either renew with your current lender or switch to another if you are able to find a lower rate and better conditions. At the end of the day, the mortgage term is what your interest rate is based on.
The mortgage amortization refers to the length of time that you’ll have to repay the loan amount in full. It begins when you first make your home purchase and take out your mortgage. The more common amortization period among American homebuyers is 25 years, which means the home loan would be fully repaid after 25 years based on the monthly payment amount and interest rate.
Obviously, the longer the amortization period, the lower your monthly mortgage payments will be simply because you have more time to pay back your loan. However, the mortgage will cost you more over the long run because you’ll be paying more in interest until the loan amount is fully paid off.
For instance, let’s say you have a mortgage amount of $200,000 with a 4% interest rate and 5-year term. With a 25-year amortization period, you’ll end up paying $116,656 in interest over the life of the mortgage, compared to $66,256 over a 15-year amortization period. However, the former would offer you a smaller monthly mortgage payment of $1,055.67, compared to $1,479.38 for the latter.
Borrowers who have the funds available to comfortably cover larger monthly payments may opt for shorter amortization periods in order to pay off their mortgages faster and save tens of thousands of dollars in interest. However, those on a tighter budget may want a longer amortization period in order to effectively reduce their monthly debt payment obligations.
While the term of your mortgage is the time frame that your interest rate is based on, the mortgage amortization impacts your monthly mortgage payments.
The Bottom Line
While the mortgage term and amortization are closely related, they are certainly different. Understanding the difference between the two can help you identify what type of interest rate you’d get and how much your mortgage will cost you overall. Based on these figures, you’ll be better able to pick a mortgage with a term and amortization period that makes financial sense for you.