The Amortization Effect

The Amortization Effect

Each year from 2008 through 2010 the Federal Government reduced the maximum amortization as follows.

Purchases with less than 20% down –from 40–35 years, then 35- 30 and finally 30–25 years where it remains today.

Purchases with 20% or more down were cut from 40–35 years, and then from 35 - 30 (*certain lenders still offer 35 years to specific applicants)

Any risk within the real estate sector can most accurately be measured by the amount of equity in a property. Thus the focus on the purchases with less than 20% was more extreme, and logical.

The following table demonstrates the effect reducing the amortization by five years had at each point, an increasingly powerful effect. It essentially cancelled out the interest rate drops.

Today's buyers do not qualify for radically higher mortgages thanks to lower rates, anyone who suggests otherwise has perhaps forgotten about the amortization effect. The final move from 30 years to 25 years has the same effective impact as a 1% interest rate increase.

Mortgage          Rate      AM                      Payment

$100,000              4.49        40                           446.26
$100,000              4.14        35                           449.08
$100,000              3.49        30                           447.09
$100,000              2.49        25                           447.47

Today's buyers putting less than 20% down with a maximum amortization of 25 years at 2.49% basically qualify for the same amount of money as they did back in 2008 at 4.49% with a 40 year amortization.

Few clients are aware of this, and many Brokers are not either.

The next time you hear somebody saying that 'today's low rates have allowed borrowers to qualify for too much debt' you will know better. 

Interest rates are not quite the key driver behind the current boom in prices; interest rates play a role, but it is a much smaller one that people realize as the lower rates have been largely neutralized by shorter amortizations.

Perhaps the most important point of all to take away from this is that as interest rates rise the Federal Government will almost certainly extend amortizations back out, in turn negating the impact of rising rates.

Food for thought. 

 Thank You

Dustan Woodhouse