Mortgages are long loans by nature. But they don't have to be 30 years. You have some options on just how long you choose to finance your home. Stay tuned and I’m to walk you through what to consider when selecting a loan term.
Obviously the first thing to consider is your budget. The two most popular loan terms are 15 and 30 years. But you might be surprised to learn that many lenders offer mortgage terms from ten to 30 years at five-year intervals. But let’s take a deeper dive into the 15 year and 30 year term for now.
A common misconception is that a 15 year mortgage payment must be double that of a 30 year payment since it is paid back in half the time. Fortunately that is not the case. 15 year payments aren’t close to being double the 30 year. For example a 30 year payment on a $250,000 mortgage at 4% is $1,193. Whereas the 15 year payment at the same rate would be $1,849. Is it significantly more? Absolutely it is, but if that higher payment is affordable you may want to seriously consider taking it.
There’s a couple of huge benefits to shorter mortgage terms. The most apparent benefit is that you can pay your home off in half the time. However, the average person stays in their home for about eight years throughout metropolitan areas across the country. So that means most people aren’t ever going to pay off their homes. But shorter terms help you build equity significantly faster.
The amount of your mortgage payment that goes towards interest is a factor of what the balance of the loan is. Meaning the faster you pay down the balance, the less of your payment will go towards interest.
Let’s stay with the example of a $250,000 loan. On a 30 year term after eight years you will owe approximately $209,326. However, on a 15 year term that balance would be down to $135,287. That’s nearly a $75,000 difference in what lands in your pocket if you were to sell the home after living in it for eight years.
The other major benefit of shorter terms is you typically get a break on the interest rate. Remember that interest rates are risk driven. The more perceived risk a loan has, the higher the interest rate will be. When you are agreeing to pay a loan back faster that diminishes the risk, therefore you’ll get more favorable rates.
It’s not uncommon for the 15 year interest rate to be ½% (or more) lower than the 30 year interest rate. So in keeping with our example above where the 15 year payment on $250,000 at 4% was $1,849; if the 30 year rate is 4% it’s more likely that the 15 year rate will be closer to 3.5%. Which in that case the 15 year payment would be $1,787. Granted that’s $594 more than the 30 year payment of $1,193; but it’s not anywhere close to being double, and the benefits are considerable.
So when do you opt for the 15 year term? Well as a loan officer, and someone whose personally went with 15 year terms on multiple occasions I’ll tell you what my litmus test is.
What’s the difference in the interest rate? I wouldn’t consider a 15 year term unless there was a considerable difference in the interest rate I could get with a 30 year term. Remember once you sign up for a 15 year you are obligated to make the payment.
If you’re going to obligate yourself to making a higher payment, you better be getting something of equal value from the mortgage company. The only thing they can give you is a significantly lower interest rate.
Mortgage pricing fluctuates daily. At the time you’re looking to get a mortgage if the difference in pricing is only ¼% for example, there no way I would do that. Most mortgages no longer have pre-payment penalties. This means you can always make a 15 year payment on a 30 year loan without fear of triggering exorbitant fees. I would rather pay the higher interest rate and pay extra principal when I wanted to, while maintaining payment flexibility.
Being a homeowner means I’m likely to incur some expenses equal to or in excess of the difference between the 15 and 30 year payments (in this example $594). It’ll be nice to only be obligated to make the smaller payment when those unexpected repair expenses pop-up. So my advice is make sure the break you get in pricing is as meaningful to you as the payment commitment you’re making.
But what about if you’re refinancing? How do you evaluate terms in that instance? Well, I’m going to look at them the same way. However, there’s another important item to take into consideration. What is your plan for the property?
For example I refinanced a home I was living in, knowing that I was likely to buy a new home and move in the next couple of years. I also knew I intended to keep the home, and transition it to a rental property. So despite the fact that I had it financed on a 15 year loan (and had payed off nearly eight years of that loan), I felt the best thing for me to do was go with a 30 year term for the refinance.
This might seem crazy to most people. Why would you start over on a 30 year loan when you were already half way done with your 15 year loan? Because at this point I care less about paying off the property and more about receiving monthly cashflow from it. The rents received are enough to pay the mortgage and put money in my pocket that I can use to help pay the mortgage on my new home. I’m still paying off the home (albeit at a slower rate), but most importantly the rental property is profitable.
What are your plans for your home? Are you planning to transition it to rental property in the near future?
If you’re only refinancing to lower your rate, what’s more important to you? Having a lower payment or paying the house off and building equity faster? You may be in a position where you originally had a 15 year term, but now just need the lowest payment possible. There is not a right or wrong answer here. This is completely situational.
It should be noted though that when refinancing a VA loan you cannot extend the loan term beyond ten years of it’s initial term. So if you started with a 15 year, you won’t be able to take on a term of longer than 25 years with your new loan.
I’m personally a huge fan of the 15 year term. In fact I think most people should set their home budget based on what they can afford on a 15 year term. That being said, I’m not naïve.
I know that for some families they won’t be able to afford the amount of home they need if they limit themselves to a 15 year term. So you may need to go with a longer term. I suggest comparing payments for a home with different loan terms to help you determine which is best for you.
In order to do that you’ll need to know how to calculate a mortgage payment. So be sure to watch my video on “how to calculate my VA payment” where I’ll be breaking down exactly how to figure out what your mortgage payment will look like.
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