If you're considering buying a home, you'll also need to take into consideration the type of mortgage loan that will work best for you and your finances. Here are three common loan types including the pros and cons for each:
Long-term mortgages
The most common mortgage is the 30-year fixed-rate loan.
Pros. Predictability is the big plus. You know exactly how much interest you will pay over the term of the loan. Total monthly payment of principal and interest is fixed, and in early years it consists primarily of tax-deductible interest. Your payments will be lower than if you had a shorter mortgage term.
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Mortgages without prepayment penalties permit you to shorten the term of the loan at will — and lower ultimate interest cost — by making periodic payments against principal.
Cons. The primary disadvantage of the 30-year fixed rate mortgage is that you'll probably end up with a higher interest rate (compared to a loan with a shorter term, or an adjustable mortgage). That's the price you pay for the long-term stability. You will spend more in interest over the life of the loan and your monthly payments will be stretched out over a longer period of time. Home equity will accumulate at a slower pace.
15-Year, fixed-rate, fixed-payment mortgage
Pros. Principal balance is reduced relatively rapidly compared to longer-term loans. The 15-year fixed-rate loan permits you to own your home debt-free in half the time, and for less than half the total interest cost, of a 30-year fixed-rate loan. It offers some individuals a useful financial planning tool. Interest rates may be lower than those offered on 30-year fixed-rate loans.
Cons. Higher monthly payments make these loans more difficult to qualify for than longer-term mortgages. A 15-year mortgage reduces the number of homes you can afford to buy and locks you into making monthly payments roughly 15% to 30% higher than you'd make with a comparable 30-year loan. There will also be less cash left over for investing, emergency funds, and other expenses.
Biweekly fixed-rate mortgage
Pros. The biweekly payment schedule of this kind of loan speeds up amortization, reduces total interest costs and shortens the loan term — usually from 30 years to about 24 years. You make 26 biweekly payments — which amounts to 13 annual payments — instead of 12 monthly payments. Conversion to a 30-year fixed-rate loan is usually permitted. Payments are deducted automatically from your savings or checking accounts.
Cons. Private companies and lenders usually charge for this service. Registration fees and biweekly debit charges can make this a costly way to shorten the life of a loan and lower interest expense.
The same objectives can be accomplished more flexibly with a 30-year mortgage by making an extra payment or two each year or by applying an additional sum to principal repayment when you make a monthly payment. As with other kinds of rapid-payoff mortgages, you trade total interest-cost reductions for reduced tax-shelter benefits.
Bottom line
The term of your mortgage should be influenced by your ability to pay and what other financial obligations you need to meet. Fortunately, you can always refinance if you want to change the term. A shorter term comes with higher payments, but you will pay significantly less interest over the life of the loan. If interest rates are low, it may make sense to sign on to a longer term. You may be able to invest and get a higher return that will offset the additional tax-deductible interest you'll pay over the term.
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