We begin with loan term because it is the simplest of the three factors. The “term” of the loan is the time between when the loan is made and when the loan would be paid off if you made the monthly payments in the appropriate amount and at the appropriate time. The most common terms for mortgage loans in the U.S. are 30 and 15 years, but any term is possible in principle.
What Loan Term is Right for Me?
From the Buyers point of view, choosing a loan term revolves around three factors:
Most first time home buyers opt for 30 year loans. When a bank qualifies you for a loan, you are qualified not for a specific loan amount but for a specific monthly payment. At a 6% interest rate and a 30 year term, a $1200 payment will qualify you for a loan of about $200,000. On a fifteen year term at 6% interest, the same payment will allow you to borrow only about $142,000. In an expensive market buyers opt for longer term loans because it allows them to buy a better property and to keep their monthly payment at a comfortable level.
Gaining Equity in the Property
The longer the term of the loan, the more slowly you gain equity in the property. In the first month of the 30 year loan outlined in the previous paragraph, only about $200 of your $1200 payment will go toward paying off the principle of your $200,000 loan. The rest, $1,000, pays the monthly interest charged on the principle borrowed. So, in the first year, you will have paid $14,400 in monthly payments, but you will have paid off only $2450 of your $200,000 loan. With the 15 year loan, your monthly payment is about $1700, but the full $500 extra per month goes toward the payment of principle. With the 15 year loan, then, you would have paid out about $20,400 and paid off about $8450. With the 30 year loan, only about 17% of your payment is going toward principle; with the 15 year loan, about 41% does. Moreover, because you’re paying down the loan principle more rapidly, the portion of the payment going to interest drops off more rapidly as well. For example, by the time you reach the fifth year of your loan, you’d be paying about $875 a month to principle with the 15 year loan (about 52%) but only about $250, or 21%, with the 30 year loan.
These advantages of the shorter term loan are magnified by the fact that the interests rates for shorter term loans will typically be less than those for longer term loans. Generally, the shorter the term of the loan, the lower the perceived risk to the lender. So interests rates for a 10 or 15 year loans will generally be lower than 30 or 40 year loans. The difference varies, but is commonly between .5% and 1% lower.
Why choose a 30 year Loan?
So why would any sane buyer opt for the 30 year loan? There are several very good reasons:
First, it’s Your Home. You’re getting the mortgage loan to buy a home, not a stock portfolio. While the investment aspect is important, if you can’t buy the home you need and where you need it with a 15 year loan, it makes perfect sense to use the longer term loan to make your life work. Paying out $14,400 to gain $2450 in equity (and some tax advantages) may not look good when compared to buying with a 15 year loan, but it sure looks good when compared to shelling out a similar amount for rent. Plus you get to live in the home and the community you want to live in.
Second, flexibility. With very few exceptions, you can make additional payments to principle on any loan. So many buyers opt for a 30 year loan, but make payments on the loan as if it had a 15 year term. The advantage is that you can gain equity at the 15 year rate, but have the flexibility of lower payments if you lose a job or need the extra cash to pay your kids’ college tuition.
Third, the Investor’s Perspective. Many real estate investors try to minimize the cash they put into a property, both at the outset as down payment and as a portion of monthly payment. Indeed, some investors will opt for “interest only” loans, where there is no payment of principle in the monthly payment. In part, their logic is as follows: Let’s say I buy a property for $200,000 and I sell it in 10 years for $325,000 (5% appreciation per year), so I’ve “cleared” $125,000. If my down payment was $10,000 and I got $1200 a month rent for the property, enough to cover my payment on the 30 year loan, I’ve made $125,000 on a $10,000 cash investment, multiplying my investment by a factor of 12.5. If I’d opted for the 15 year loan on the same purchase, I’d have invested $48,000 more in the property over the 10 year period, so I would have made $125,000 on $58,000 invested, multiplying my gain on the cash invested by a factor of only 1.16.