How to Choose the Right Mortgage Term

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For many Americans, a house will very likely be the largest purchase they ever make. With homeownership in America often viewed as a sign of socioeconomic success, it's not surprising that the latest data from the U.S. Census Bureau showed 63.5%, nearly two out of every three adults, owned a home.

However, buying a home can be a dangerous venture if you're unprepared. Not understanding your options could wind up costing you thousands, or tens of thousands, of added dollars if you aren't well informed. Arguably the most important decision you'll make during the house-hunting process, aside from picking out the house itself, is the type of mortgage you'll choose and the length of your loan.

Fixed vs. adjustable?

Mortgages essentially fall into two types of categories: fixed rate and adjustable rate. As the name implies, the interest rate on a fixed-rate loan is locked in by you, the homebuyer, during the buying process with your lender. A fixed-rate mortgage holds no surprises. The amount you'll pay in the first year of your loan will be the same as the last year of your loan, regardless of your mortgage term.

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The only variables that can alter your monthly payment with a fixed-term mortgage are whether you'll owe private mortgage insurance (PMI) for putting less than 20% down on your home and your property taxes, assuming they're rolled up into your mortgage payment with a lender. It's also possible your homeowners insurance could be rolled into your monthly payment and your rates can change annually, affecting your total payment.

An adjustable-rate mortgage, or ARM, is a complete wildcard in the mortgage industry, and it's almost always more trouble than it's worth. ARMs usually have an enticingly low interest rate that's below some of the most popular fixed-rate mortgage options. This teaser rate typically lasts for a few years (three to seven is common), then your loan "adjusts" to reflect the movement in mortgage rates during the period where your interest rate was below market. If mortgage rates have moved up substantially, you could be in for an unpleasant surprise. ARMs do have use for prospective homebuyers, but they're better off used in situations where a homebuyer expects to pay off their purchase fairly quickly.

Similar to those with a fixed-rate mortgage, homebuyers with an ARM could also see changes in their property taxes and insurance, as well as their need for PMI, affect their monthly payout.

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How to choose the right mortgage term

Now that you have a better idea of the type of loans you can choose from, let's take a closer look at the trade-off between the four most popular mortgage terms: 10-, 15-, 30-, and 40-year. The following options assume a fixed-rate mortgage.

  • 10-year mortgage: One of the more intriguing options for those of you who'll be able to put a large down payment on a home is a 10-year mortgage. Lenders are usually willing to offer significantly lower interest rates for 10-year mortgages since there's less time risk to the lender (i.e., the lender will get their capital back quicker). The downside of a 10-year mortgage is that your monthly payment will usually be much higher. Of course, the real advantage is that your total loan cost will be the lowest with a 10-year mortgage.
  • 15-year mortgage: A 15-year mortgage is the second-most popular mortgage term in America, next to the traditional 30-year loan. Like a 10-year mortgage, a 15-year offers a notably lower interest rate than a 30-year. On the other hand, you can also expect higher monthly payments as a homeowner than a conventional 30-year loan.
  • 30-year mortgage: The 30-year mortgage is the most popular loan option for purchasing a home in America. It's often viewed as one of the least risky options for lenders, but having the convenience of stretching your payment out over 30 years means you as the homeowner will pay more in interest over the life of the loan (assuming it's stretched out over all 30 years). For homebuyers who plan to stay in their home for a long time, the 30-year mortgage tends to be a good option.
  • 40-year mortgage: Though not the most popular option, a 40-year mortgage may offer benefits for certain types of homebuyers. In particular, it may be useful for consumers looking to buy a pricey home while keeping their monthly payment low. The downside of a 40-year loan is it often bears the highest interest rate of these four options, and is the costliest loan when interest is included.

How about a visualization to go along with these descriptions? Assuming you were going to take out a $200,000 loan across each mortgage length, and based on the current mortgage interest rate in each category, courtesy of Bankrate as of Dec. 21, 2016, here's how much you'd owe monthly and over the course of the entire loan:

Mortgage Term 10-Year 15-Year 30-Year 40-Year
Fixed mortgage rate 3.24% 3.56% 4.31% 4.56%
Monthly payment $1,953 $1,436 $991 $907
Total cost of loan $234,414 $258,420 $356,730 $435,290

Data source: Bankrate as of Dec. 21, 2016. Author estimated 40-year mortgage rate based on an average increase across the industry of 0.25% for a 40-year loan compared to a 30-year. Table by author.

As you can see, the monthly payment for the 10-year loan is more than double the 40-year loan and about double what you'd pay with a conventional 30-year loan. However, the 10-year mortgage term also results in just $34,414 in total interest compared to $156,370 in interest for a 30-year loan and $235,290 in interest with a 40-year loan. In fact, you'll pay more in interest than your house was initially worth with a 40-year mortgage.

One last reminder

A final factor worth keeping in mind is that the size of your loan may come into play as well when deciding on term length. While there's no concrete number here, a small home loan of under $100,000 can result in a higher interest rate since the lender will want to ensure that making such a relatively small home loan nets it a profit. Likewise, a jumbo loan (a mortgage of $417,000, or higher) often results in a slightly higher interest rate since a lender is taking on a bigger risk by lending out so much of its capital.

Now that you have a firm understanding of the variables that'll determine your mortgage, you're better prepared for the house-hunting process.

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Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.

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