A mortgage term refers to the period of time between the first disbursement of funds until the time the loan reaches maturity.
This is why the word is often used interchangeably with maturity. But they are not not always the same.
Lenders are specifically particular with the term as they use it to calculate monthly mortgage payments and amortization tables. And the longer a term becomes, the most interest they would make out of the deal.
Even though the term of a home loan can look like an easy decision, a lot of factors can go into the science of choosing the right mortgage term.
The most immediate impact variations of the tenure has is on the monthly payment.
It goes without saying that the more years a home loan has in it, the lower and more affordable the monthly installment will be.
In fact, this is the biggest reason why people go for the longest terms they can qualify for.
To most home buyers, it’s more about cash flow than interest expense.
But when going with the idea of “longer term equals smaller payments”, what most borrowers don’t realize is that the amount being cut from the monthly payment reduces with each additional year that is put on the term.
For example, if the monthly debt commitment reduces by $300 when changed from a 10 year term to a 20 year term, a borrower might find that it only changes by $140 when extending the term from 20 years to 30 years.
This financial phenomena also occurs as interest rates get higher.
Meaning that extending a term from 20 to 30 years on a 5% mortgage might reduce monthly payments by $$300, but for an 8% mortgage the monthly payment might only decrease by $120.
When we add this factor to a term’s impact on interest, which will be discussed below, you would realize how important choosing a term actually is.
As a the term of a home loan increases, the average amount of cumulative interest a lender makes on the loan also increases with each additional year.
For example, if a lender will make an average of $1,000 in interest per year on a 25 year loan, the average interest per year might increase to $1,300 annually when the term is stretched to 30 years.
When we add this factor to the impact on monthly payment amount, borrowers need to realize the detrimental double-attack they would suffer from for choosing long tenures.
Not only will the reduction in monthly installments become smaller, but they would be paying more interest while increasing the average annual cumulative interest.
Theoretically speaking, interest-only mortgages allow borrower to extend a term to infinity.
In this case, the loan will never be paid off.
Home equity is often not a major concern of a new home buyer who is just trying to obtain financing for the property purchase.
Nevertheless, it doesn’t hurt to be informed.
For home buyers with a focus on building equity, the preference would be to select the shortest term they can reasonably afford.
This would result in them clearing the principal amount as quickly as possible. Thus, building equity as quickly as possible too.
The shorter the term is on a housing loan, the faster a significant portion on monthly payments go towards reducing the loan principal.
In the lending market, the 15 year term is generally accepted as the sweet spot for borrowers who are concerned with equity.
This is because loans with longer terms will have significantly higher interest rates, while any decrease in interest rate below 15 year will be insignificant.
For example, by switching from a 15 year loan to 25 year might mean a rate increase of 0.50%. While a move from 15 year to 10 year might only mean a rate reduction of 0.10%.
This means that a 15 year mortgage term would enable a borrower to both obtain a low interest rate while building up equity quickly.
However, this also depends on what is available in the market.
Do check the current market before making a decision on this.
Shorter term or prepayment?
Some people hate getting into debt. And it is a main driving force for them conceptualizing a plan to fully pay off the mortgage as soon as possible.
Because of this objective, they can sometimes take up loan with the shortest term they can qualify for… which can potentially cause cash flow problems in future.
In such circumstances, borrower should consider using prepayments instead of shorter terms.
With prepayments, borrowers will have the flexibility of retaining lower and more manageable monthly payments, while keeping the option of paying down the principal when there are extra funds.
Prepayments are deeply discussed here.
Changing mortgage term when a loan is in effect
Sometimes personal circumstances change after taking up a home loan and borrowers have a desire to either extend or shorten the term.
Lenders understandably will want to avoid making any adjustments to the original contract as much as possible.
This is because it takes resources to make these changes.
In any case, lenders owe it to their customers to review such requests and will often run standard underwriting procedure on the borrowers to determine whether they can afford the new term that they are requesting.
For a borrower who wants a shorter tenure, he must have a strong income to support the higher monthly payment. For borrowers who wants to extend it, lenders might feel that he is having financial problems and refuse it.
But sometimes, this could just be simple tasks that they are doing just for the sake of doing.
Because if a lender has no interest in changing a term on a mortgage, no matter how strong a customer’s profile is, they will still come back with a negative answer.
Changing mortgage terms is really not as simple as most people think.
If your current lender has continually turned down your request, the alternative is to refinance the loan with a new lender.
A new lender, motivated by the prospect of acquiring new customers, should be able to offer you what you want.
And if you are lucky, you might even snag a lower interest rate than you current loan.
The drawback is that a new loan will inevitably come with new settlement costs.