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You're purchasing a new home and wonder how you can build equity quicker than you have in the past. The answer could be a shorter-term mortgage.
More and more buyers realize that it makes little sense, especially in the era of affordable interest rates, to take on a thirty-year mortgage. It may have hit you when refinancing and viewing the mortgage comparisons provided by the lender. With a long-term loan, you're postponing whittling down that principal balance. And in some cases, it's time, and money, lost forever.
Here's an example of the equity building power of a twenty-year loan. Let's assume we're comparing two $100,000 mortgages at 8% -- one for thirty years and the other for twenty. Although we don't know exactly how long we'll stay in this house, let's assume that we know we'll be there for two years.
In the payment department, we'd pay $733.77 principal and interest for the thirty-year loan, compared to $836.45 for the twenty-year loan. That's a monthly difference of $102.68. For many buyers, this is where the comparison ends since they may not be able to qualify for the higher payment and/or the larger monthly payment scares them. The rationalization (the one often touted by lenders) is that the buyer could always make prepayments on the lower-payment loan; while the higher payment would be tougher to make, especially if there's a job loss or other financial down turn.
But when we look at the rest of the story, we see just how much more we're paying for the longer-term loan. In two years time, the twenty-year loan is paid down to 95.6% of its original balance, or to $95,600. But the thirty-year loan is reduced to only 98.3% of its original balance, or $98,300. That's a difference of $2,700. So the $2,464.32 we thought we were spared by taking the lower monthly payments (with the longer-term loan) is more than offset with the loss in equity buildup; and the longer we make payments, the greater that savings gap becomes. Five years into both loans, the twenty-year loan balance will be at $87,500 while the thirty-year loan will still be at a whopping $95,100---roughly an 8% difference in equity build-up in just five years!
But there's even more to consider. We compared two loans with the same interest rate. In the mortgage world, there's no reason why you should pay the same rate of interest for a twenty-year loan than you would for a thirty-year loan. Even if a lender doesn't quote you much of an interest spread between the two loan terms, always bargain. After all, if you qualify for a higher monthly payment, it can indicate that you're a stronger borrower; thus, the lender's risk is potentially less.
After weighing the payment difference and the rate of equity build-up in tandem with your financial goals for owning the property, the dollars and sense of a shorter-term mortgage may be just the boost your equity needs!
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