Home Buying Basics: Which mortgage term should I choose?

Home buying basics

Buying a home is probably the biggest investment you’ll ever make in your lifetime. Here are some basic tips to get you started as you plan for your purchase. Once you've decided to take the plunge and switch from renter to homeowner, your first step should be to research your financing options so that you can decide which loan term best suits your need.

The Mortgage Bankers Association reported that 85 percent of purchase home loans in June 2012 were 30-year fixed-rate mortgages, popular among both first-time and repeat homebuyers. But before you jump on the 30-year bandwagon, you should understand all the loan-term options available to ensure you're getting the best home loan to suit both your lifestyle and financial needs.

Fixed-rate home loans

Fixed-rate home loans are available in a variety of terms, including 30, 20 and 15 years. Some lenders even offer less-popular 7, 10, 17 or 25-year loan terms. Thirty-year fixed-rate mortgages are really the driving force behind homeownership in the U.S. because they offer the lowest monthly payments along with the security of stable payments.

While the monthly payments on 30-year mortgages are lower, 20 or 15-year mortgages allows you to pay off the loan faster because of the shorter term and lower mortgage rates. Experts say the interest-rate spread between a 30-year and 15-year mortgage could be as much as 0.75 percent to 1.00 percent, while the spread between a 20-year and 30-year are usually a little closer. Your monthly payments will be about 28 to 30 percent higher on a 15-year mortgage compared to a 30-year mortgage. If you can afford the higher payments, a shorter loan allows you to build equity much faster.

Monthly payments

Let's consider what the monthly payments would be on a $300,000 mortgage at various fixed-rate terms:
  • 30-year mortgage at 3.86 percent: $1,408 
  • 20-year mortgage at 3.65 percent: $1,763 
  • 15-year mortgage at 3.16 percent: $2,095 
Just five years into the loan, the difference in the loan balance between the 30-year and the 15-year loan is nearly $60,000. Most first-time homebuyers choose 30-year terms because they tend to focus more on keeping monthly payments low rather than paying off the loan balance. However, building equity more quickly benefits homeowners who wish to refinance or intend to sell in the near future.

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