(This is Part 4 of a seven-part series. See Part 1: Mortgage shopping: what you should know before you begin; Part 2: Pros and cons of fixed, adjustable mortgages; Part 3: Three options available on most mortgages; Part 5: Investment returns influence real estate down payment; Part 6: Understanding choices in mortgage insurance and Part 7: Navigating real estate loan locks, docs.)
This is the fourth article of a series on the decisions mortgage borrowers should make prior to entering the market. Previous articles were about selecting the best type of mortgage, and selecting among three options: payingpoints, waiving escrows, and accepting a prepayment penalty. This article is about selecting the best term.
The term of a mortgage is the period used to calculate the mortgage payment. The longer the term, the lower the mortgage payment but the slower you pay down the balance.
A mortgage that is interest-only (IO) for its entire life has the longest term possible–it never pays off. In the 1920s, many mortgages were of this type, but IO mortgages today are IO for only the first five or 10 years.
Term selection is an issue primarily for fixed-rate mortgages (FRMs), which are available at terms ranging from 10 years to 40 years. Virtually all adjustable-rate mortgages (ARMs) are for 30 years.
Selecting a term on an FRM should take into account the term structure of mortgage rates. Assuming that everything else–points, the borrower’s credit, down payment, etc.–are the same, the rate on a 15-year term is always well below that on a 30-year term. These are the two most popular terms, by far.
The rate on a 25-year term is usually the same as that on the 30, while the rate on a 20-year term will be a little lower, but closer to the 30 than to the 15. A 40-year term is always priced higher than a 30 while a 10 is usually priced just a little lower than the 15.
Here is the structure of wholesale rates and points (those quoted to mortgage brokers) covering a prime loan of $300,000 with 20 percent down and full documentation, on Oct. 31, 2005: 30 and 25 years, 5.875 percent and 0.1 rebate; 20 years, 5.75 percent and zero points; 15 years, 5.375 percent and 0.2 points; 10 years, 5.375 percent and 0.1 rebate; 40 years, 6.25 percent and zero points.
The selection process should start with the 15 because it is the best deal around for borrowers who can afford the payment. Most of those who can’t afford it opt for the 30 because the payment is substantially lower. If you have trouble even with the payment on the 30, an IO option on the 30 for the first five or 10 years would be less costly than the 40, and more effective in reducing the payment.
Typically there is no rate advantage in shortening the term from 30 to 25 years, and very little in reducing it from 15 to 10. If you want to pay off sooner, you can opt for the shorter term, or you can take the longer term and make the payment of the shorter term.
For example, if you would like to pay off in 10 years and have the income to do it, one way is to take a 15 and make the payment of the 10. This gives you the flexibility of being able to revert back to the smaller payment on the 15 if necessary. Alternatively, you take the 10, which requires you to make the larger payment on the 10.
It depends on whether you prefer the flexibility offered by the 15, or the discipline imposed by the 10. The same principle applies in choosing between a 25 and a 30.
The 20-year term is for borrowers who want to pay off as soon as possible but can’t quite make the payment on the 15. IOs are not available on 15s, so that is not an option.
Some borrowers who can make the payment on a 15 are persuaded to take a 30, or even a 40, in order to invest the difference in cash flow. I recommend this only for the few borrowers who have the iron discipline to allocate their income this way every month, and have access to exceptional investment opportunities.
For example, if you take a 30 at 6 percent rather than a 15 at 5.625 percent, each month you must allocate to investments $224.18 of your income for every $100,000 of loan amount. Further, these investments must yield a return in excess of 6.375 percent, covering not only your 6 percent cost of funds but loss of the opportunity to borrow at 0.375 percent less. Few borrowers can do this without taking significant risks.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com
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