When shopping for a home, many people focus on mortgage interest rates. It makes sense since the lower the rate you can get, the more home you can technically afford.
While low rates are important, it’s not the only thing you should consider when getting a mortgage. The term, amortization, and features are just as relevant. What you get in the end can greatly affect your payments which is why you need to know the difference between mortgage amortization and term.
The mortgage amortization is the length it will take you to pay back your loan. Many people these days choose a 25-year amortization since it offers lower monthly payments, but that also means you end up paying more in interest. If you choose to amortize your mortgage for fewer years, you end up paying more every month, but your debt will be cleared much faster.
To qualify for a mortgage you need to have at least 5% saved of the purchase price as your down payment. Some lenders have been willing to loan that 5% to potential homeowners, but if you can’t even save that small amount, do you honestly think you’re ready for homeownership?
If you have a 20% down payment, then you qualify an amortization as long as 30 years, but again that longer amortization means more interest payments so it doesn’t exactly benefit you. What’s the point of saving 20% and then paying a ton of interest charges over 30 years?
Mortgage term refers to the length of time you agree to pay back your amortized loan. It’s sort of like a short term contract you set with your lender, so your amortization might be 25 years, but your term can be anywhere from 1-7 years.
With interest rates being near all time lows, many people are choosing to go with 5 year fixed terms. Shorter terms are available at an even lower rate but you’re only guaranteed that rate for that set period of time. Taking a longer term will guarantee your rates don’t go up assuming you took a fixed rate mortgage.
What many people fail to understand is that once your term is up, you need to negotiate a new loan from your lender. Those low interest rates you’ve been enjoying might be higher in 5 years, so I hope you’ve budgeted accordingly. Some people are so desperate to become homeowners that they forget about the long term costs.
The case for a longer amortization
With interest payments being so low, many people are in no rush to pay down their mortgages choosing to invest instead. For example, if you’re mortgage rate is 2%, but you estimate you can get an average rate of return of 5% while investing (not factoring in taxes), you’d come out ahead.
This is certainly a good strategy if you’re a disciplined investor, but many people have maxed themselves out so they don’t exactly have any extra income to invest. There’s also the peace of mind you would get from paying down your mortgage.
Taking a longer amortization even if you can afford a shorter one can also be beneficial for cash flow purposes. Let’s say you have $500,000 mortgage at 2%, with an amortization period of 25 years. Your monthly payment would be $2,117.26. But if you had it set for 20 years, it would be $2,527.46. A difference of $410.20 a month.
What you could do is take the 25 year mortgage, but set your payments for the 20 year term (assuming your mortgage allows you to make prepayments). If you ever run into financial difficulty, you could just change your monthly payments back to 25 years without a penalty.
Where to get the lowest mortgage rates
If you’re new to mortgages, it’s worth mentioning that the rates posted with the big banks are rarely the lowest rates you can get. In most cases, you want to work with a mortgage broker who is not associated with one bank.
Generally speaking, mortgage brokers get the lowest rates since they typically work with 30+ lenders. They can go your needs, get your information, and provide you with a quote in less than 5 minutes.
This would just be a pre-approval, so you don’t need to commit right away. You can still shop around as you please. One mortgage broker worth checking out is Breezeful since everything is done online. There’s no need to meet anyone face to face (you can still call them). Breezeful can negotiate the best rates on your behalf.
Homeownership is not something you should get into just because rates are low. It may seem affordable on a monthly basis, but have you considered all the extra costs of life such as having kids and saving for retirement?
Lenders don’t care about how you’ll be afford anything else, they just care about you making monthly payments and they’re more than happy to lend you more than you can realistically afford. Take the time to learn about all the costs associated with owning a home so you’re well informed when you’re ready to buy.