When Does It Pay to Settle for a Mortgage at a Larger Price?
When you take out a loan to buy a home, you want to shop around and compare interest rates to keep your borrowing costs as low as possible. After all, a mortgage is a large debt that has to be paid off over a long period of time, and if you are billed high interest rates, it can become very costly to pay back your loan.
But while shopping at low interest rates is a crucial part of finding the right home loan, sometimes it can make sense to accept a higher interest rate.
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Don’t just pay attention to the lending rates
Choosing a loan with a higher interest rate versus a loan with a lower interest rate can make sense in circumstances where the loans have different repayment periods.
Mortgages come with a variety of terms, including 15-year, 20-year, and 30-year fixed-rate mortgages. Loans with shorter payout periods tend to have lower interest rates than those with longer periods – even for the same buyer and the same lender. This happens for several reasons, including the fact that the risk to the lender is lower when a loan has a shorter repayment period.
So if you choose between different loan options, the chances are that the interest rate is cheaper for 15 years than for 20 years or 30 years and that the interest rate is lower for 20 years than for 30 years.
You will also find that the loans with the shorter repayment times have a much lower total interest cost over time. This happens because of the reduced interest rate, but also because you won’t be paying interest for so long. If you pay interest for another 15 years or another 10 years, you will end up with ever higher total borrowing costs – especially if your loan comes at a higher interest rate as well.
For example, let’s say you borrow $ 200,000 and have to choose between these two loans:
- A 15 year mortgage at 2.323%
- A 30 year mortgage at 3.072%
The 15 year loan has a much lower interest rate and your total interest cost over time would be much lower. They would pay a total of $ 37,056 in interest. The 30 year loan, on the other hand, has a higher interest rate and you pay interest longer, so your total cost would be $ 106,358.
While the 15 year loan seems like the better deal, your monthly principal and interest payments on this loan are $ 1,317 compared to $ 851 for the 30 year loan. Such high payments could make your loan unaffordable.
Which loan term is the right one?
While these low-interest loans with short payback times seem good when you look at the interest rates and total cost, you also need to factor in the monthly payments. And usually because you are making so much fewer payments, each one has to be much higher.
And these high monthly payments are an important reason why it can be worthwhile to take the higher-interest loan with the longer repayment time. If you don’t, you will be spending a lot of money on your monthly mortgage payment – perhaps more than you would like.
Since mortgage rates are currently very low, even on 30 year loans, it may not make sense to choose a loan with short repayment times, even if it comes with rock bottom interest rates. You could probably get a much better return by investing extra money in the stock market instead of using extra money on a mortgage payment that is hundreds of dollars more per month.
When comparing loans, pay attention not only to which loan offers the lowest interest rate, but also to the overall picture of the entire loan. Chances are, even if your interest rate isn’t as low as it could be, a longer term loan will suit you better.