Selecting the Term on a Mortgage
August 15, 1998, Revised September 7, 2005
The term of a mortgage is the period used to calculate the mortgage payment. It should be distinguished from the maturity, which is the period until the final payment is due. On most mortgages they are the same, but on some the maturity is shorter. This is true of balloon mortgages, for example, where the term is usually 30 years but the borrower must make a final "balloon" payment in 5 or 7 years.
Term selection is an issue primarily on FRMs, which are available at terms ranging from 10 years to 40 years. While 15-year ARMs appear now and then, virtually all ARMs today are for 30 years.
A mortgage that is interest-only for its entire life has the longest term possible – it never pays off. In the 1920s, many mortgages were of this type, but IO mortgages today are IO for only the first 5 or 10 years. See Interest-Only Mortgages.
The longer the term, the lower the mortgage payment but the slower the borrower builds equity. The reduction in payment from lengthening the term becomes less and less effective as the term gets longer. This is illustrated in the table below, which shows the mortgage payment on a $100,000 loan at various interest rates and terms.
For example, at 6% extending the term from 10 years to 20 years reduces the payment by $394 but extending it to 30 years and 40 years reduces the payment by only $116 and $50, respectively. The furthest you can possibly go in extending the term is to infinity, which is an interest-only loan -- you never repay any part of the loan. On a 6% loan, the monthly interest is $500, just $50 less than the payment at 40 years.
Extending the term to reduce the payment also becomes less effective at higher interest rates. For example, at 6% extending the term from 20 to 30 years reduces the payment by $116 but at 12% the reduction is only $72. Where the interest payment at 6% is $50 less than the payment at 40 years, at 12% the interest payment is only $8 less than the payment at 40 years.
The shorter the term, the more rapid the reduction of the balance, as illustrated in the table below. For example, after 10 years the borrower with a 15-year term at 7% has repaid 54.6% of the original balance whereas the borrower with a 30-year term at the same rate has repaid only 14.2% of the balance. Since 15-year loans usually carry a lower rate than 30-year loans, this understates the difference in the rate of equity buildup.
Selecting a term on an FRM should take account of the term structure of mortgage rates. Here is a typical structure in September, 2005. It assumes that everything else – the borrower’s credit, documentation, down payment, etc – are the same.
The 30 and 15 are the most popular by far, and the rate on the 15 is always well below that on the 30. The rate on the 25 is usually the same as that on the 30, while the 20 will be a little lower, but closer to the 30 than to the 15. The 40 is always priced higher than the 30 while a 10 is usually priced the same as the 15, sometimes a little lower.
The selection process should start with the 15 because it is the best deal around for borrowers who can afford the payment. Most of those who can’t afford it opt for the 30 because the payment is substantially lower. If you have trouble even with the payment on the 30, an IO option on the 30 for the first 5 or 10 years would be less costly than the 40, and more effective in reducing the payment.
Typically there is no rate advantage in shortening the term from 30 to 25 years, or from 15 to 10. If you want to pay off sooner, you can opt for the shorter term, or you can take the longer term and make the payment of the shorter term.
For example, if you would like to pay off in 10 years and have the income to do it, one way is to take a 15 and make the payment of the 10. This gives you the flexibility of being able to revert back to the smaller payment on the 15 if necessary. Alternatively, you take the 10 which requires you to make the larger payment on the 10.
Which you select depends on whether you prefer the flexibility offered by the 15, or the discipline imposed by the 10. The same principle applies in choosing between a 25 and a 30.
The 20-year term is for borrowers who want to pay off as soon as possible but can’t quite make the payment on the 15. IO’s are not available on 15s, so that is not an option.
Some borrowers who can make the payment on a 15 are persuaded to take a 30, or even a 40, in order to invest the difference in cash flow. I recommend this only for the few borrowers who have the iron discipline to allocate their income this way every month, and have access to exceptional investment opportunities.
For example, if you take a 30 at 6% rather than a 15 at 5.625%, each month you must allocate to investments $224.18 of your income for every $100,000 of loan amount. Further, these investments must yield a return in excess of 6.375%, covering not only your 6% cost of funds but loss of the opportunity to borrow at .375% less. Few borrowers can do this without taking significant risks. See Can You End Up Richer Taking a Longer Term?
What Is the Mortgage Term?
The term of a mortgage is the period used to calculate the mortgage payment. It should be distinguished from the maturity, which is the period until the final payment is due. On most mortgages they are the same, but on some the maturity is shorter. This is true of balloon mortgages, for example, where the term is usually 30 years but the borrower must make a final "balloon" payment in 5 or 7 years.
Term selection is an issue primarily on FRMs, which are available at terms ranging from 10 years to 40 years. While 15-year ARMs appear now and then, virtually all ARMs today are for 30 years.
A mortgage that is interest-only for its entire life has the longest term possible – it never pays off. In the 1920s, many mortgages were of this type, but IO mortgages today are IO for only the first 5 or 10 years. See Interest-Only Mortgages.
Effect of Term Differences on Mortgage Payments
The longer the term, the lower the mortgage payment but the slower the borrower builds equity. The reduction in payment from lengthening the term becomes less and less effective as the term gets longer. This is illustrated in the table below, which shows the mortgage payment on a $100,000 loan at various interest rates and terms.
Mortgage Payment Per $100,000 of Loan Amount
| Term | 6.00% | 6.25% | 6.50% | 6.75% | 7.00% | 7.25% | 7.50% |
| 5 Years | $1933 | $1945 | $1957 | $1968 | $1980 | $1992 | $2004 |
| 10 Years | 1110 | 1121 | 1135 | 1148 | 1161 | 1174 | 1187 |
| 15 Years | 844 | 857 | 871 | 885 | 899 | 913 | 927 |
| 20 Years | 716 | 731 | 746 | 760 | 775 | 790 | 806 |
| 25 Years | 644 | 660 | 675 | 691 | 707 | 723 | 739 |
| 30 Years | 600 | 616 | 632 | 649 | 665 | 682 | 699 |
| 40 Years | 550 | 568 | 585 | 603 | 621 | 640 | 658 |
| Int Only | 500 | 521 | 542 | 563 | 583 | 604 | 625 |
For example, at 6% extending the term from 10 years to 20 years reduces the payment by $394 but extending it to 30 years and 40 years reduces the payment by only $116 and $50, respectively. The furthest you can possibly go in extending the term is to infinity, which is an interest-only loan -- you never repay any part of the loan. On a 6% loan, the monthly interest is $500, just $50 less than the payment at 40 years.
Extending the term to reduce the payment also becomes less effective at higher interest rates. For example, at 6% extending the term from 20 to 30 years reduces the payment by $116 but at 12% the reduction is only $72. Where the interest payment at 6% is $50 less than the payment at 40 years, at 12% the interest payment is only $8 less than the payment at 40 years.
Effect of Term Differences on Balance Reduction
The shorter the term, the more rapid the reduction of the balance, as illustrated in the table below. For example, after 10 years the borrower with a 15-year term at 7% has repaid 54.6% of the original balance whereas the borrower with a 30-year term at the same rate has repaid only 14.2% of the balance. Since 15-year loans usually carry a lower rate than 30-year loans, this understates the difference in the rate of equity buildup.
Percent of Loan Balance Repaid After Specified Periods at 7%
| Term | After 5 Years | After 10 Years | After 15 Years | After 20 Years | After 25 Years | After 30 Years | After 40 Years |
| 5 Years | 100.0% | 100% | 100% | 100% | 100% | 100% | 100% |
| 10 Years | 41.4% | 100% | 100% | 100% | 100% | 100% | 100% |
| 15 Years | 22.6% | 54.6% | 100% | 100% | 100% | 100% | 100% |
| 20 Years | 13.7% | 33.2% | 60.8% | 100% | 100% | 100% | 100% |
| 25 Years | 8.8% | 21.4% | 39.1% | 64.3% | 100% | 100% | 100% |
| 30 Years | 5.9% | 14.2% | 26.0% | 42.7% | 66.4% | 100% | 100% |
| 40 Years | 2.7% | 6.6% | 12.1% | 19.8% | 19.8% | 46.5% | 100% |
Selecting the Best Term For You
Selecting a term on an FRM should take account of the term structure of mortgage rates. Here is a typical structure in September, 2005. It assumes that everything else – the borrower’s credit, documentation, down payment, etc – are the same.
| Term in Years | Interest Rate | Monthly Payment Per $100,000 | Interest Only | |
| Payment First 5 Years | Payment After 5 Yrs | |||
| 40 | 6.250% | $567.74 | $520.83 | $587.08 |
| 30 | 6.000 | 599.56 | 500 | 644.31 |
| 25 | 6.000 | 644.30 | 500 | 716.44 |
| 20 | 5.875 | 709.24 | 489.58 | 837.12 |
| 15 | 5.625 | 823.74 | 468.75 | 1091.47 |
The 30 and 15 are the most popular by far, and the rate on the 15 is always well below that on the 30. The rate on the 25 is usually the same as that on the 30, while the 20 will be a little lower, but closer to the 30 than to the 15. The 40 is always priced higher than the 30 while a 10 is usually priced the same as the 15, sometimes a little lower.
The selection process should start with the 15 because it is the best deal around for borrowers who can afford the payment. Most of those who can’t afford it opt for the 30 because the payment is substantially lower. If you have trouble even with the payment on the 30, an IO option on the 30 for the first 5 or 10 years would be less costly than the 40, and more effective in reducing the payment.
Typically there is no rate advantage in shortening the term from 30 to 25 years, or from 15 to 10. If you want to pay off sooner, you can opt for the shorter term, or you can take the longer term and make the payment of the shorter term.
For example, if you would like to pay off in 10 years and have the income to do it, one way is to take a 15 and make the payment of the 10. This gives you the flexibility of being able to revert back to the smaller payment on the 15 if necessary. Alternatively, you take the 10 which requires you to make the larger payment on the 10.
Which you select depends on whether you prefer the flexibility offered by the 15, or the discipline imposed by the 10. The same principle applies in choosing between a 25 and a 30.
The 20-year term is for borrowers who want to pay off as soon as possible but can’t quite make the payment on the 15. IO’s are not available on 15s, so that is not an option.
Some borrowers who can make the payment on a 15 are persuaded to take a 30, or even a 40, in order to invest the difference in cash flow. I recommend this only for the few borrowers who have the iron discipline to allocate their income this way every month, and have access to exceptional investment opportunities.
For example, if you take a 30 at 6% rather than a 15 at 5.625%, each month you must allocate to investments $224.18 of your income for every $100,000 of loan amount. Further, these investments must yield a return in excess of 6.375%, covering not only your 6% cost of funds but loss of the opportunity to borrow at .375% less. Few borrowers can do this without taking significant risks. See Can You End Up Richer Taking a Longer Term?