Choosing the term of a home loan is one of the big decisions a borrower has to make when taking up a mortgage.
There is conventional wisdom with both choices.
Taking on a shorter term will enable the homeowner to pay off the loan faster and save more money on interest charges during the process.
Taking on a longer term will help make monthly payments more affordable, leaving the household with more money to spend on other stuff.
A lot of times, the choice of selecting a long or short term mortgage is not available to a borrower simply because his income is not able to afford a high monthly payment that comes with a 10 or 15 year loan.
Leaving with a 25 or 30 year loan to choose from.
But let’s say after loan approval that it was determined that you can afford as short or as long a term as you want.
Should you take the short option as that goes along with conventional wisdom that we should pay off our homes as soon as possible?
The answer is… it depends. There are too many variables at stake here.
I know that it was mentioned previously that the assumption is that you can afford high monthly debt commitments.
But this is the most obvious factor and it deserves to be mentioned again.
When lenders determine the approved loan amount during underwriting, the final figure is based on the monthly installment payments that a borrower can afford with his income after taking into account several indicators like the housing expense and debt ratio.
The longer the term requested by the applicant, the smaller the monthly liability, and thus a higher loan quantum approved.
Conversely, the shorter the requested term, the higher the monthly debt, resulting in a lower loan amount.
This is why often times, the option of a shorter term is simply not a decision a borrower is able to make because his income is simply not sufficient to qualify for his desired loan amount.
For borrowers who have the option of choosing between a 10-year term versus a 30-year term, then the borrower has to weigh up whether it is more important to have a more comfortable cash flow or to build wealth.
This is why one must know his situation and goals before choosing a mortgage.
Measuring the difference
If we take for example, a $100,000 mortgage at 7% for 30 years, versus one at 6.5% for 15 years, the monthly payment would be $665 and $871 respectively.
This leaves the borrower with a $206 difference. A difference that can alleviate his personal cash flow should he sign up for the 30 year loan.
When we look at the principal repaid after 5 years, the amount would be $5,869 and $23,283 respectively.
As one can observe a difference of twice the term doesn’t mean half the repayment towards principal.
But what’s more important in this analysis is that the difference of $17,414 (after 5 years) is a significant amount that can play a role in wealth building.
If there is any confusion, note that lower invested capital results in higher returns.
Prepayment changes the game
Because of the above numbers regarding amount repaid, many borrowers who discover the math choose to take up longer term mortgages instead of shorter terms due to the flexibility that come with them.
A lengthier mortgage terms minimizes a borrower’s debt obligations, at the same time, it allows the borrower to make prepayments when there are excess cash with nowhere to go.
Should a borrower feel that too much money is sitting in his bank account doing nothing, he can still put it towards prepayment.
And if he is financially squeezed, he can thank his lucky stars that the monthly payment is still affordable.
However the argument against this is that when a 15 year loan is compared to a 30 year loan, when a borrower on a 30 year loan makes payments that equate to a 15 year loan, he does not pay down the principal as quickly as a regular 15 year loan.
This is partly also due to the higher interest rate that come with longer terms.
But isn’t the point being to pay as little principal as possible?
Another counter argument against long term mortgages is that with a shorter term, the homeowner would build up more home equity more rapidly.
That is true.
But that can be offset by the tax deductions interest rates are eligible for.
In this case, the more interest, the more deductibles there are, subject to a cap.
Calculated alternatives to making bigger monthly payments
If the borrower has wealth building in mind, he should make serious considerations for buying a larger house.
For example, if the borrower can afford to make a $1,000 payment monthly on a $150,000 house (80% LTV) for 15 years, maybe he should consider buying a $187,000 house instead with a 30 year mortgage with the same $1,000 monthly payment.
This is because the appreciation would be bigger for a more valuable property.
Another alternative is to take on a 30 year loan, and use the extra funds to make improvements on the house that will increase it’s market value.
As mentioned from the start of this discussion, whether to take up a short or long term on the home loan really depends on the needs of the borrower.
We often think of inflation as an animal that is never favorable to consumers.
But in terms of a housing loan, inflation amusingly works in favor of a borrower the longer the mortgage stretches.
This is because with inflation, the value of money falls.
The implication is that a dollar you pay towards the mortgage in 10 years will be worth much less than what it is worth today.
With this concept in mind, it means that your mortgage gets cheaper and cheaper with each passing year.
So what now?
It’s worth repeating that in order for a borrower to make the correct decision for the length of the home loan, he has to have a clear idea of his plans in the future.
Too many people feel that this matter is redundant. But it really isn’t.
A mortgage should be seen as a tool for financial planning. Not just a loan to buy a house.
The general advice is to take a longer term even if you can qualify for a shorter one.
Borrower can make prepayments or bigger payments when they have extra funds. They can also continue paying the lower payments if they are low on cash.
An adjustable rate mortgage is also preferred as it has a lower interest than fixed rate loans.
Yes, there is a possibility that volatile indices might lift interest rates on an ARM above that of a FRM. But even so, there’s always the option of refinancing the loan should interest rates get out of hand.
On the other hand, if a borrower is on a 15 year fixed rate mortgage, the payments are pretty much set in stone with little flexibility.
Saying that, stability and predictability are what borrowers go for when choosing such loans.
Ultimately the decision is up to you.
Hopefully the topics discussed can help you make a decision with a little more certainty.