The purchase of a home is the biggest purchase most people make in their lives. This purchase also represents the largest monthly expense so it is no surprise that most strive to pay off the mortgage in the quickest way possible.
But is the 10 Year or 15 Year mortgage the best way to achieve that end? Yes, the mortgage is paid out quickly and less interest is paid to the banks but at what cost? Then maybe the 30 year option is best?
I believe that the longer term mortgage is best for first time home buyers while a reduced term is more appropriate for buyers purchasing a second or third home. Let’s see why!
First Time Buyers
A longer term mortgage means that first time buyers can buy “more” house or they can have lower payments. The lower payments means that household income can be directed at other important accounts.
Many first time buyers are just starting careers, and they can look forward to increased income in future years. So even though a 30 Year mortgage is obtained at the beginning, there are ways to speed up the payout of the mortgage. And ideally, this is exactly what you are going to do – and you might want to check our some tips on how to pay mortgage faster than the rest.
Live Within Your Means
The first principle of personal finances is “Live Within Your Means”. This means balancing your expenses in line with your income; this includes limiting your mortgage payment to a comfortable level so that all other aspects of living are addressed. Banks use a simple calculation to determine how large a monthly mortgage payment you can afford. It is the debt service ratio (DSR). Many banks use 32% as DSR. Gross household monthly income X DSR = maximum allowable payment.
As an example, household monthly income is $5,000. Maximum monthly payment would be $5,000 X 32% = $1600. $1600 per month would service a 30 Year mortgage of $350,000, a 15 Year mortgage of $240,000 and a 10 Year mortgage of $170,000. This illustrates the impact of shortening the length of the amortization.
Your personal circumstances may limit the actual maximum allowable payment further. You may have outstanding student loans, or a special needs child who has extra expenses not covered by health plans. Every individual needs to develop a budget outlining income and expenses to determine how large a mortgage payment can be afforded. But always have in mind to buy just as much house as you need, too!
Most mortgage come with pre-payment options. Typically, you are allowed one lump sum payment annually that goes directly against the principal. The lump sum is limited to 10% – 15% of amount owing. This means that you can accelerate the payout period. Lower monthly payments allow greater opportunity to save for these lump sum payments. Lump sum payments are well suited for those who have jobs with incentive bonuses. The bonus can be applied to the pre-payments.
A second pre-payment opportunity occurs when the mortgage comes up for renewal. With many mortgages, you sign up for a certain term, five years is a popular choice. At the end of the period, there is still an amount of principal left owing. This is referred to as the balloon payment. This is an opportunity for the home owner to put a lump sum down against the principal including the full amount. If the homeowner does not pay the balloon out in full, the remaining amount is normally rolled over into a new mortgage.
This mortgage renewal allows for the homeowners to restructure the mortgage and select a new amortization period. For example, the homeowner starts with a 30 Year mortgage. At the end of five years, he has twenty-five years left. At the time of renewal, the homeowner can put a lump sum down against the balloon payment and he can also reduce the amortization to a lesser term, twenty years for example. Then in another five years, the mortgage comes due, and homeowner may then opt to restructure the mortgage with ten year amortization. In this way, he can drastically speed up the process of paying off the mortgage.
For a first time buyer, I think it makes more sense to look into a 30 Year mortgage. As their income increases, the mortgage payment becomes more affordable; and at renewal dates, the payment can increased to reduce the length of time left to pay out the mortgage.
For those who have been paying a mortgage for several years, it makes sense to reduce the amortization terms with the goal of eliminating the mortgage payment as quickly as possible. When a new home is purchased, the equity from the first home can be applied to the second home purchase minimizing the principal amount to owed on the new property.
Everyone dreams of holding that time-honored tradition of “burning the mortgage” when it finally paid off in full. Even though you may sign up for a 30 Year mortgage, that does not mean it will take you that long!
Photo credits: Dan4th