Tutorial on Selecting Among Different FRMs

...................

18 April 2006

FRMs vary by term, which is the period used to calculate the mortgage payment. It ranges from 10 years to 40 years. The longer the term, the lower the mortgage payment but the slower you pay down the balance.

Selecting a term on an FRM should take account of the term structure of mortgage rates. Here is a typical structure in April, 2006. It assumes that everything else – the borrower’s credit, documentation, down payment, etc – are the same.

Term	Interest Rate	Fully Amortizing Monthly Payment Per $100,000	Interest Only
Term	Interest Rate	Fully Amortizing Monthly Payment Per $100,000	Payment First 5 Years	Payment After 5 Yrs
40 Years	6.500%	$585.46	$541.67	$604.16
30	6.250	615.72	520.84	659.67
25	6.250	659.67	520.84	730.93
20	6.125	723.67	510.42	850.63
15	5.875	837.12	489.59	1103.94
10	5.750	1097.70	479.17	1921.68

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 the 10 is usually priced a little lower than the 15.

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. 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. It all depends on whether you prefer flexibility or discipline.

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 against this because few borrowers have the iron discipline to allocate their income this way every month, and those that do must earn a very high return on their investments to make it pay. See Can You End Up Richer Taking a Longer Term?