Like many decisions in life, there’s no one-size-fits-all approach to choosing a mortgage term. Although a 30-year fixed-rate mortgage is the industry standard, it’s possible to get a loan of virtually any length these days, from a 5-year to a 40-year fixed-rate, or even one of customizable length. Whichever you elect, understand that each option affects your financial picture differently in regard to cash flow, investment potential, tax benefits and equity generation. In the end, what matters ultimately is that you’re neither stretching your budget too thin nor undermining your fiscal potential.
Fixed Rate Mortgages
In 2016, 90 percent of US homebuyers chose 30-year fixed-rate mortgages, according to Freddie Mac Vice President and Chief Economist Sean Becketti. A mortgage of this length allows the benefit of a lower monthly payment over a long time period. If you’re anticipating a life change in the future, just starting a career, or need cash available for things like paying down debt and building a nest egg, this mortgage is an attractive option. The overall cost of your home, however, will be higher than if you choose a shorter-term mortgage, plus, you’ll build equity more slowly.
If you can afford the monthly payment, a 15-year fixed-rate mortgage is a great option because you’ll pay less interest over the life of the loan and your home equity will build quickly. Essentially, you’re paying off your loan’s principal in half the time. This term also achieves a lower interest rate, often up to 1 percent less than a 30-year mortgage. In the long run, you’ll save yourself many thousands of dollars on your home purchase.
Adjustable-Rate Mortgages
With an adjustable-rate mortgage, your loan’s interest rate is fixed for a set time period, and once that time is up, the loan resets to the prevailing rate. The most common ARM is a 5/1, where the loan is at a fixed rate for 5 years, with an annual rate adjustment thereafter. Other common ARMs are 7/1 and 10/1. These types of mortgages are sometimes good for people who intend to sell or refinance before the fixed-rate period is over. Historically, when interest rates have been higher, borrowers with good credit have obtained ARMs with initial interest rates significantly lower than fixed-rate mortgages, allowing more cash for the short run.
How Things Stack Up
With so many loan scenarios, it’s important to consider what a monthly payment might be across various terms and rates. This is what a monthly payment on $300,000 borrowed looks like, using November 2017 rates:
- 15-year fixed-rate at 3.5 percent=$2,145
- 30-year fixed-rate at 4 percent=$1,432
- 5/1 ARM at 3.875 percent=$1,410 for the first 60 months
Here are examples of total principal and interest costs on $300,000 borrowed, using the two most popular mortgage loan terms and November 2017 rates:
- 15-year fixed-rate at 3.5 percent=$386,037 at maturity
- 30-year fixed-rate at 4 percent=$515,609 at maturity
Now that you know a little more about mortgage terms, try using one of these simple calculators to help determine the potential cost of your new home.