Your monthly payment is calculated using three different factors- the interest rate, the loan amount and the term of the loan. While we’re all familiar with the idea that the interest rate is responsible for the monthly payment, so too is the term of the loan. The most common loan term among residential mortgages is the standard 30 year fixed rate. The interest rate and loan amount are amortized over 30 years, or more precisely 360 months. As each monthly payment is made a portion is applied to the interest that is due and the other toward the outstanding loan balance. What many may not realize however is the term of the loan is also just as important when arriving at a monthly payment.
While the 30 year term is the most popular, the next most popular loan term is 15 years, or 180 months. Why choose a different loan term? The 30 year will provide the lowest monthly payment, and, in this example, the 15 year is the next most common choice. The 15 year loan term will result a higher monthly payment, but the amount of interest paid to the lender is dramatically reduced.
For example, taking a $300,000 loan amount amortized over 30 years at 3.00% yields a monthly payment of $1,264. A 15 year term using the same loan amount and rate gives a monthly payment of $2,071. Over the life of each loan, there is about $82,000 less interest paid with the 15 year term. The shorter the term, the higher the payment but lower overall interest. Same loan amount, same rate but different results by switching loan terms.
Most consumers might generally agree that the sooner a loan is paid of the better. However, due to the somewhat market increase in monthly payment with a 15 year compared to a 30 year term, sometimes borrowers who want the 15 year term can’t qualify because the monthly payments are too high. Yet there are “tweeners” that should be considered in such a situation.
Most lenders who advertise their rates will quote a 30 and 15 year term. What many may not know is there are other terms from which to select. These two are the 20 and 25 year terms. If a 15 year loan payment is too high but the amount of interest paid with a 30 year term is too much, a 20 or 25 year term might be the better option. When getting interest rate quotes from your lender and you’re exploring your options, know that beyond the traditional 15 and 30 year terms are other options that might be an optimal choice. You should also compare the 20 and 25. Further, many loan programs can be amortized over 10 years, although the monthly payments will be higher still.
When you call your loan officer and ask the ubiquitous question, “What are your rates today?” you’ll most likely hear about the 30 year loan term. Further query could result in the 15 year term but if you ask for the other available terms, you’ll get those too upon request. Your lender doesn’t really care which loan term you decide to take as long as you can still fall into the affordability category.
Because a 30 year loan is indeed amortized over 360 months, most of the initial payments will go toward interest, with very little left over to pay down the loan balance. With a 15 year loan, less goes toward interest early on compared to the 30. However, the 20 and 25 should not be overlooked. They can provide the balance between the desire to pay less interest over time along with getting a favorable and affordable monthly payment.
