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Which mortgage is better?

When getting a mortgage, homeowners often run into this question: “Should I choose a shorter term mortgage or a longer term mortgage?

It is an important to answer. If you make the right choice at this stage, you can possibly save significantly over the life of the loan.

And to make the right choice, it’s quite important to understand the scenarios in which one is better than the other. Once you do, you’ll make an informed decision. And that’ll set you apart.

Many homebuyers lean towards the longer-term mortgage

Most homebuyers lean towards the longer term mortgage. The reason is not always because it is better for them.

Rather, it’s more because that’s what they hear most of their friends and colleagues went with. “If so many people picked that option, it is likely the better choice” is how they go about making that decision.

That’s a very irrational way of thinking. For first-time homebuyers though, there is so much information to absorb and so much knowledge to gather. 

And when the learning curve is so steep already, it’s very natural for us to not want to make another decision. “Let’s just go with what most others are doing” can’t be too wrong.

That could be true. It may not be too bad in the end. But when making the biggest purchase of your life, one should lean heavily towards “better” or “the best”, instead of “not too bad”. 

After all, it’s a big commitment one is making. A little more due diligence can help one save a lot.

Why do so many people choose the longer term mortgage?

Mortgages are available for a range of terms. 

Ideally, most people don’t like to have any debt. The lower it is, the larger the share of their monthly income that they can keep to themselves (to be used for other purposes) instead of having to make loan payments every month.

But when debt is necessary, such as in a big purchase like a home, people do want to get out of it as early as they can.

For that reason, one would think people should choose a shorter term mortgage over a longer term mortgage.

But counter to intuition, a fixed longer term mortgage is the most popular choice even though it keeps the debt for the longest period amongst them all. 

The main reason for that is the lower monthly payment with a longer term loan (vs the rest). Most people prioritize having free cash flow every month (over how long they have to pay the debt for).

But that does not mean your priorities are the same. It all depends on your situation.

Why is the monthly payment for a longer term mortgage lower?

Most mortgages originated in the US are amortizing. What that means is that a fraction of the monthly payment goes towards paying the interest and the remaining portion is used to pay off the principal gradually every month.

At the end of the loan term, the borrower doesn’t have to pay any big principal balance because they’ve paid that off little-by-little all along. Read more about that in this article.

What that means is that with a longer term mortgage, one gets a longer duration to pay off the principal. When that same time period is shorter, the same amount of principal needs to be paid in a shorter time.

As a result, the monthly payment comes out to be much higher with a shorter term loan.

Is the monthly payment double for a shorter term loan (vs. longer term)?

Given the same amount of principal has to be paid off in half the time with a shorter term loan, one might guess that the monthly payment would be double. 

But in reality, the payment for a shorter term loan is often significantly less than double that of a longer term loan. There are two main reasons for that:

Lower rate: Firstly, the interest rate for a shorter term mortgage is typically lower than that of a longer term loan. And when the rate is lower, the interest paid in actual dollars would be smaller as well.

Smaller principal balance: Because a shorter term loan is paid much quicker, the outstanding principal balance every month reduces faster.

That means that the principal balance at the beginning of any given month in a shorter term mortgage is lower than that in a longer term one.

And when the principal balance in any given month is lower, the interest charged for that month is also lower, thereby reducing the total interest paid further.

In reality, the payment for a shorter term loan is often significantly less than double that of a longer term loan, because of lower rate and smaller principal balance remaining. Click To Tweet

Should I choose the shorter term mortgage if I can afford the higher payment?

The one big downside of a shorter term mortgage is the higher payment. If you can afford it, you can potentially select that.

When exploring mortgage terms, do take into account your marginal tax rate and consult your licensed financial advisor and the licensed tax consultant.

As Stem Lending is not licensed to provide financial advice, you might want to consult a duly licensed financial advisor for feedback. 

I can afford the higher payment today. But what are my options if in a few years, I cannot?

Locking yourself to a shorter term loan does put you in a situation where you have to make the higher monthly payment for the life of the loan.

However, there are situations where you think you can afford the higher payment associated with the shorter term loan but are not sure if that’ll change in the future. 

What if five years down the line, you have some sudden need for the extra cash that a longer term mortgage allows you to save every month. How do you deal with that? The answer to that depends on the likelihood of that need arising:

If the scenario is totally unforeseen:

If you are quite confident you’ll be able to afford the higher payment, it’s not too unwise to go with the shorter term loan.

In case of completely unforeseen circumstances, you can potentially refinance into a longer term loan if you want to reduce your payment later. You’ll end up paying the closing costs twice and may not potentially qualify for a longer term loan in the future, depending on future income levels, so think through it carefully.

If the scenario is likely enough:

If there is a reasonable chance that your affordability (with respect to a higher payment) might go down in the future, you can go with a hybrid strategy. 

The hybrid approach captures some advantages of both. So let’s discuss that:

The hybrid approach — Pre-paying

The hybrid approach is, as the name suggests, a mix of features of both the shorter term and the longer term mortgage. This strategy picks up some good aspects of both, thereby offering some advantages associated with each one.

Here is how it would work:

  • Qualify for a longer term mortgage that doesn't have pre-payment penalty
  • Start out with extra monthly payments towards principal as if it’s a shorter term loan
  • When need for extra cash flow arises, resume paying the lower monthly payment of a longer term loan
  • You can make the higher payment again when the need for extra cash flow goes away.

While the extra pre-payments reduce the total interest paid (as lenders charge interest on unpaid principal balance) and thereby help you become debt-free sooner, home equity might be difficult to liquidate depending on your future income levels, so please consult your licensed financial advisor for proper planning.

If need for extra cash flow never arises:

You can continue to pay as if it’s a shorter term loan. Yes, the rate of interest is that of a longer term loan, i.e. a bit higher. But because you are paying the principal faster, the outstanding principal balance every month will be comparatively lower (than a longer term loan). As a result, the total interest you pay will be lower.

If need for cash flow arises at any point:

You have the flexibility to slow down your payments and pay the rest of the loan as a longer term loan. This is possible because the minimum payment signed up for was that of the longer term loan (which is lower).

What about qualifying for the loan? Is one better than the other?

For loan qualification, a borrower’s DTI (Debt-To-Income) ratio has to be below a certain threshold. Read more about DTI here.

When doing the DTI calculation, the payment for the mortgage in process is also taken into account. Given the loan payment for a longer term is lower, it results in a lower DTI. Therefore, chances of qualifying are higher.

This is only binding when your DTI is high enough to be close to the threshold. When it’s sufficiently low, you’ll qualify for either of them equally and there is no difference between the two in such a situation.

What about other terms?

The lower the mortgage term:

  • The lower the rate (typically)
  • The higher the payment will be (just as you saw above with the shorter term). 
  • The lower the total interest paid over the life of the loan.

The tradeoff here is monthly payment vs. total interest paid.

The reason for that is that most mortgages are sold to investors in the secondary market as a pool (i.e. collection of a few hundred mortgages, say). And depending on the need to complete the required pool when the lender is short a few, they can sometimes offer discounts by offering lower rates for those. These inventory imbalances can then lead to short-term anomalies like that.

When you are making that choice though, do carefully review your closing disclosures to confirm that there is no prepayment penalty.

What if I am still not sure whether to go with shorter term or longer term?

We covered the major advantages and disadvantages of both loan types. Not only that, we reviewed many different situations which people commonly think about or run into.

In spite of that, it’s possible that you are still not sure about your decision and/or are not sure which one to go with.

If that’s the case, please feel free to reach out to us. At Stem Lending, our goal is to help you make the most informed mortgage decision. If you are already sure about it though, you can start right away at: stemlending.com/apply

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