Choosing Between a Long-Term or a Short-Term Mortgage Loan
What should you aim for when you choose a mortgage term, short-term or long-term? The term is the length of a mortgage, after which a borrower renews its terms and conditions if the balance is not fully paid. It spreads from 6 months to 25 years, and the longer it is, the higher the interest rate. Let’s make sure to understand here that this period of time is not used to amortize the balance and calculate the monthly payment, but just to decide when the next renegotiation is. The borrower's profile would determine which term to go for in respect of its budget and its vision of the future. But let see the different aspects that divides them.
Long-term Before Renegotiation
A mortgage with a term of 3 years or more is considered a long-term mortgage. The mortgage rate of a long-term is generally higher than the short-term, but in return it secures the borrower by locking the payments and the interest rate for a good period of time. If the mortgage rates are presently reasonable and the borrower has a tight budget, the best option would be to go long-term in order to avoid unexpected costs. This would turn out to be the right choice if the mortgage rates increase during its term.
Short-term Before Renegotiation
The short-term mortgage is less than 3 years and offers interest rates that are generally lower. People choose this term in the hope the interest rate will drop at the renewal, so they keep their options opened on a short-term basis. Borrowers accept instability in exchange for lower interest. Therefore, they need to have a more flexible budget.
Very Long-term Amortization
Some banks push the quest for small monthly payments to the extreme by offering 40 to 50 years term amortized on the total amount. Let's put these very long-term loans into perspective. A 25 year old person signing for a mortgage loan of 40 or 50 years will do their final payment at 65 or 75 years old, an age where we should have gotten rid of the mortgage a long time ago.
The total paid interests on such a term will reach new summits. For example, let's calculate a mortgage loan of $200,000.00 at a rate of 6.75%, going from a term of 30 years to 50 years at a rate of 7%. The monthly payments then drop from $1,297.00 to $1,203.00 and the total sum of interests go from $266,992.00 to $522,028.00. For smaller monthly payments of only $94.00 per month, you pay around $255,000.00 more in total interest, which is seriously disproportionate and unfavorable.
Term Impact on the Interests
The previous example seems extreme, but it does demonstrate a few things. First, with identical interest rates, the longer a term, the more you pay interests at the end. In addition, the market offers higher interest rate on long-term mortgages, which additionally increases the total interest paid on top of choosing a longer term.
We can reduce the total interest paid by working on two fronts: choosing a shorter term and increasing the monthly payments. With a lower interest rate you increase the payments on the capital portion. If, on top of it, you boost the monthly payment, you will be able to amortize the loan in a shorter period. Therefore, you will pay your mortgage faster, and, once it is paid, you will be able to invest these monthly payments somewhere else.
Which Mortgage to Choose?
Bottom line, it is generally preferable, if your budget allows it, to choose a short-term loan over a long-term and try to increase the monthly payments as much as possible to take advantage of the lower interest. The combination of a smaller interest rate and a bigger monthly payment will allow you to have a much bigger payment on the outstanding balance. This approach will help you pay less interest on the loan and end your mortgage sooner.
If you hesitate to apply a big monthly payment on your house, don't forget that a payment in capital on a house is an investment. The propriety takes value in time and gives you a positive return on investment. Also, on rainy days, you can always convert your mortgage into a home equity line of credit and borrow the capital already paid. Reducing the monthly payments by going for a longer term, with the objective of investing these monthly savings somewhere else, is a risky option that needs to be well calculated. You will also be stuck longer with a mortgage and will pay more interests, which we all want to avoid.