Are you researching the perfect home for your family? Maybe you’ve already looked at dozens of homes for sale online and have a good understanding of what type of properties interest you. Good! Now it’s time to think about how to finance it!
Smart first time home buyers (and second-time buyers for that matter) can get started with a mortgage pre-approval. Pre-approvals are important for several reasons:
- You’ll save time by visiting/viewing homes that you can afford.
- Real estate agents and sellers typically only want to work with pre-approved buyers.
- Sellers will take your offer more seriously – any offer coming from you is viewed as legitimate.
One of the key questions that you will need to answer is: How long do you want to take to pay back the home loan? Do you want to pay if off fast and live debt-free or spread payments out? It all comes down to the amortization period.
The amortization period is simply the amount of time that it takes to pay off a mortgage. Currently, in the United States, the maximum amortization period that banks offer is 40 years (for government-backed mortgages like FHA loans and VA loans).
How does my mortgage term affect my monthly payments?
Lenders offer more than one option. You have a wide array of choices. In fact, mortgage terms can be set as 5, 10, 15, 20, 30 all the way up to 40 years.
- Longer amortization periods decrease the amount you’ll need to pay each month. That’s the good news. The bad news is that a longer loan amortization periods increase how much you’ll pay the bank in mortgage interest.
- Shorter amortization periods cost the homeowners less. For two reasons. First, Banks offer lower interest rates for mortgages with shorter terms because the money they lend to you is tied up for a shorter period of time. Compressing a mortgage term into a shorter duration also means you’ll pay less interest.
What amortization period should I use?
Glad you asked. There are two ways to evaluate this decision.
First, as mentioned above, longer terms mean you’ll have a lower mortgage payment. As payments are spread out, less is needed each month to meet your monthly mortgage obligation. And home affordability is based, in part, upon your monthly income (lenders make a calculation called a debt-to-income ratio) compared to your expected mortgage payment. Therefore, lower payments translate into a bigger home. That’s a very appealing option for young families.
Shorter amortization periods decrease how much you’ll pay in interest. You’ll pay off the home faster and save money (less interest). While a buyer would qualify for a smaller home should he or she chose a shorter term, saving money can be quite appealing. You’ll certainly have more cash to diversify and invest elsewhere.
Make a decision based on your personal financial plan.
30-year mortgage terms are the most popular option. That’s because people love bigger homes; folks tend to choose more square footage above all else. Longer terms tend to be more forgiving for first-time homebuyers who want a bigger home to “grow into” with their family.
Conversely, people obsessed with saving money tend to choose shorter terms and smaller homes. Here’s another reason to choose a shorter term: if you are over 40 years old and want to retire debt-free, carrying a mortgage for 30 years will not make that possible. Older homebuyers may want to plan ahead and choose a 15-year or 20-year term.
Clearly, you should choose a mortgage term based on your preferences. It’s important to know the difference between a longer and shorter amortization period. Armed with an understanding of the tradeoffs, you’re in a better position to make a choice that matches your style; carefully draft your future goals to make the best selection based on the kind of financial future you envision.