The term of
a mortgage is the period used to calculate the mortgage payment. It should
be distinguished from the maturity, which is the period until the final
payment is due. On most mortgages they are the same, but on some the
maturity is shorter. This is true of balloon mortgages, for example, where
the term is usually 30 years but the borrower must make a final
"balloon" payment in 5 or 7 years.
Term selection is an
issue primarily on FRMs, which are available at terms ranging from 10
years to 40 years. While 15-year ARMs appear now and then, virtually all
ARMs today are for 30 years.
A mortgage that is
interest-only 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 5 or 10 years. See
Interest-Only Mortgages.
Effect of Term Differences on Mortgage Payments
The longer the term, the lower the
mortgage payment but the slower the borrower builds equity. The reduction in payment from lengthening the term becomes less and less effective as the term gets longer. This is
illustrated in the table below, which shows the mortgage payment on a
$100,000 loan at various interest rates and terms.
Mortgage
Payment Per $100,000 of Loan Amount
Term
6.00%
6.25%
6.50%
6.75%
7.00%
7.25%
7.50%
5 Years
$1933
$1945
$1957
$1968
$1980
$1992
$2004
10 Years
1110
1121
1135
1148
1161
1174
1187
15 Years
844
857
871
885
899
913
927
20 Years
716
731
746
760
775
790
806
25 Years
644
660
675
691
707
723
739
30 Years
600
616
632
649
665
682
699
40 Years
550
568
585
603
621
640
658
Int
Only
500
521
542
563
583
604
625
For example, at 6% extending the
term from 10 years to 20 years reduces the payment by $394 but extending
it to 30 years and 40 years reduces the payment by only $116 and $50,
respectively. The furthest you can possibly go in extending the term is to
infinity, which is an interest-only loan -- you never repay any part of
the loan. On a 6% loan, the monthly interest is $500, just $50 less than
the payment at 40 years.
Extending the term to reduce the
payment also becomes less effective at higher interest rates. For example,
at 6% extending the term from 20 to 30 years reduces the payment by $116
but at 12% the reduction is only $72. Where the interest payment at 6% is
$50 less than the payment at 40 years, at 12% the interest payment is only
$8 less than the payment at 40 years.
Effect
of Term Differences on Balance Reduction
The shorter the term, the more
rapid the reduction of the balance, as illustrated in the table below. For example, after 10 years the borrower
with a 15-year term at 7% has repaid 54.6% of the original balance whereas
the borrower with a 30-year term at the same rate has repaid only 14.2% of
the balance. Since 15-year loans usually carry a lower rate than 30-year
loans, this understates the difference in the rate of equity buildup.
Percent
of Loan Balance Repaid After Specified Periods at 7%
Term
After 5 Years
After 10 Years
After 15 Years
After 20 Years
After 25 Years
After 30 Years
After 40 Years
5 Years
100.0%
100%
100%
100%
100%
100%
100%
10 Years
41.4%
100%
100%
100%
100%
100%
100%
15 Years
22.6%
54.6%
100%
100%
100%
100%
100%
20 Years
13.7%
33.2%
60.8%
100%
100%
100%
100%
25 Years
8.8%
21.4%
39.1%
64.3%
100%
100%
100%
30 Years
5.9%
14.2%
26.0%
42.7%
66.4%
100%
100%
40 Years
2.7%
6.6%
12.1%
19.8%
30.9%
46.5%
100.0
Selecting the Best Term For You
Selecting a term on an FRM should
take account of the term structure of mortgage rates. Here is a typical
structure in September, 2005. It assumes that everything else � the
borrower�s credit, documentation, down payment, etc � are the same.
Term
Interest Rate
Monthly Payment
Per $100,000
Interest Only
Payment First 5
Years
Payment After 5
Yrs
40 Years
6.250%
$567.74
$520.83
$587.08
30
6.000
599.56
500
644.31
25
6.000
644.30
500
716.44
20
5.875
709.24
489.58
837.12
15
5.625
823.74
468.75
1091.47
10
5.625
1091.47
468.75
1915.90
The 30 and 15 are
the most popular by far, and the rate on the second is always well below
that on the first. The rate on the 25 is usually the same as that on the
30, while the 20 will be a little lower, but closer to the 30 than to
the 15. The 40 is always priced higher than the 30 while the 10 is
usually priced the same as the 15.
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 5 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, or 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.
Which you select
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. IO�s 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% rather than a 15 at 5.625%, 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%, covering
not only your 6% cost of funds but loss of the opportunity to borrow at
.375% less. Few borrowers can do this without taking significant risks.
Copyright Jack Guttentag
2005
Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.
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