Should You Choose a Shorter Amortization Period?
There’s more to worry about than interest rates when you take out a mortgage. You must also consider the term or amortization period. In fact, the 2 go hand-in-hand. The shorter your loan’s term, the lower the interest rate. Of course, this depends on your credit and other qualifying factors. Generally, though, you can get a somewhat lower rate with the shorter term.
So should you choose the shorter term? We look at the pros and cons. First, though, let’s look at the definition of amortization.
What is Amortization?
Amortization refers to the length of time you borrow the money. The average borrower takes a 30-year term. However, there are 15, 20, and 25-year terms available. The shorter the term, the less you pay for the loan. Your interest rate may be lower. But, you also pay less interest over the life of the loan. This occurs no matter your interest rate.
The Benefits of a Shorter Amortization Period
Taking the shorter amortization period definitely has its benefits. We discuss them here.
- Own your home faster – The less time it takes to pay off your loan, the quicker you own it. A shorter term means you pay more principal with each payment. The longer terms mean you pay more interest. The first several years consist mostly of interest payments on these terms. Borrowing for less time means you must pay more principal in order to pay the loan off in time.
- Gain equity faster – As you pay your principal down, you earn equity. Each principal payment increases your equity proportionately. You don’t have to use the equity, but it can offer a great return on your investment. If you end up in an emergency, the equity may be there to help you.
- Pay less interest – A shorter term means you pay less interest. Let’s compare a 30-year term to a 20-year term. Borrowing money for 30 years means you pay interest on the balance for those 30 years. Borrowing for 20 years means you pay 10 less years of interest. At several hundred dollars a month in interest, that’s a significant savings.
The Disadvantages of a Shorter Amortization Period
As always, there is good with the bad. You should consider some downsides before opting for the shorter term.
- Higher payments – Paying the principal down faster may mean you have higher payments. You won’t pay as much interest, but you’ll pay more principal. This directly affects your investment. It’s not a bad thing to pay more principal. But the payments are usually higher than the shorter term’s payments. They can be harder for some people to afford.
- You may afford less home – If you purchase a home, a shorter term may lower your buying power. Your debt ratio affects the amount you may borrow. The higher the ratio, the less you can borrow. A higher mortgage payment increases this ratio. Because a shorter term means a higher payment, it can limit how much you may borrow.
- Higher risk of default – You don’t have the option of paying less than your required payment. If you don’t make the payments, you risk losing your home. There’s no way around it.
Getting Around a Longer Term
There is one way you can have it both ways. You can opt for the longer term at the onset. Take the lower minimum payments. You’ll also take the higher interest rate. But, you can make larger payments down the road. Most loans today don’t have a prepayment penalty. You can pay as much as you want on the loan. You can go about this several ways.
- Make biweekly payments – Make ½ of your monthly mortgage payment every 2 weeks. Because some months have more than 4 weeks in them, you pay 13 mortgage payments per year. This can knock off several thousand dollars off your principal. This means knocking a few years off the term of your loan.
- Make lump sum payments – If you receive large sums of money at certain times of year, apply them to your mortgage. Tax refunds or bonuses are 2 good examples. You can put the entire amount towards your principal. It doesn’t change your payments or interest rate. But, it does knock your principal down which knocks the term down.
- Pay extra when you can – You can also just pay more towards the principal when you can afford it. There’s no rule stating you have to make regular extra payments. You pay what you can and lower your term as much as is affordable for you.
What Should You Do?
Now, what should you do? It’s a personal decision. Look at your finances. What can you afford? Does the shorter term affect your buying power? Are you willing to sacrifice for a smaller or less expensive home?
You must ask yourself these questions. Then compare your options. How much more is the 15-year term versus the 30-year? Did you look at a 25 or 20-year term? They are less common, but available.
Talk to your lender. See what options they have. Sometimes they have incentives for shorter terms. They may charge fewer closing costs or points. Lenders prefer shorter terms because they get their money back faster. They may have ways they encourage borrowers to choose this option.
Weigh the pros and cons of each term. Then look at your Loan Estimate to see the true cost of each loan. Look at not only the interest rate, but also the cost over the life of the loan. Your Loan Estimate shows you the payments over the life of the loan. Use this information to make your decision. This way you base it on not only payments today, but also how much you pay for the home over its entirety.
Take your time and compare offers from different lenders. Not all lenders offer 20 or 25-year terms. Some don’t reward borrowers for a shorter amortization period either. See what options you have and choose the one that is right for you.
Source: Blown Mortgage