Short-term vs. long-term loans

Part 2: Mortgage selection in post-crisis market

Editor’s note: This is Part 2 of a two-part series. Read Part 1 here.

Last week I noted the large price differences between fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs), and between ARMs with different initial-rate periods. These differences largely reflect market expectations that future rates will be higher. When lenders expect higher future rates, they encourage ARMs by pricing the initial ARM rate low.

Selecting among different FRMs: The price differences between FRMs of different term are also unusually large. On Jan. 8, the rates for prime borrowers on 40-,30-, 25-, 20-, 15- and 10-year terms were, respectively, about 5.625 percent, 5.125 percent, 5.125 percent, 4.625 percent, 4.5 percent and 4.25 percent.

These differences largely reflect the increased importance lenders now attach to borrower equity as their protection against default.

With home prices no longer rising, the faster paydown of loan balances on shorter-term mortgages has enhanced value. Lenders will cut the price if you commit to paying down the balance faster.

Selecting the term is, in a sense, a judgment by the borrower of the relative importance of the present and the future. A longer term has a lower payment, which favors the present, but has a slower paydown of the loan balance, which is burdensome in the future.

By pricing short-term loans lower, the market encourages borrowers to favor the future, but this runs against the very powerful tendency of most borrowers to focus on the present. While clearly the payment must be affordable, many borrowers could afford more but give the future a low priority.

The price of being fixated on the present can be high. Let’s take the extreme case of a 10-year vs. a 40-year term. On a $100,000 loan, the payments are $524 (40-year) and $1,024 (10-year), almost 2-to-1.

The borrower taking the 40-year saves $500 a month in payment, or about $30,000, over the first five years. But at the end of the five years, that borrower will owe $96,161 compared to only $55,282 owed by the borrower who took the 10-year. The difference in balances is $40,878 compared to the $30,000 difference in payments. The larger difference in balance is due entirely to the lower rate on the 10-year.

The borrower with the 40-year paid $10,878 more in interest.

Some borrowers who can afford the higher payment on a shorter term select a longer term with the intention of investing the difference in cash flow. This is a really dumb idea, even for a borrower who has the iron discipline required to execute it. The pitfall is that, because of the higher interest rate on the longer-term loan, the return the borrower needs to earn on the cash flow to come out ahead is just too high.

For example, if the borrower selects the 30-year loan at 5.125 percent rather than the 15-year at 4.5 percent, he has to earn 6.73 percent over the 15 years just to break even. If the loan is paid off in 10 years, the breakeven rate is 8.12 percent. And over five years, it is 12.35 percent. I don’t recommend this strategy. …CONTINUED


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