Pros and cons of a 30-year or 20-year mortgage for home purchases
For most home buyers the type of mortgage is one of the biggest decisions they make when planning the acquisition of their new house.
Buying a house is the biggest single investment many hard-working Americans will make in their lifetime, and given that most individuals and families don’t have enough money saved to buy a house up front the choice of which mortgage to use to finance the purchase of their property is a crucial one.
First up, it’s vital to remember that every individual’s circumstances differ, so broad brush rules can’t necessarily simply be applied to each and every situation. Taking professional advice from a mortgage broker or other financial professional may be advantageous (though remember that some may take commissions from the finance providers for setting up a mortgage).
That said it is worthwhile looking at the general pros and cons of taking out a fixed rate 20-year versus a 30-year mortgage, two of the most common mortgages. For a standard repayment mortgage what 20-year or 30-year means that at the end of the mortgage period the full amount of the capital (the amount borrowed) will have been repaid. Where that mortgage is fixed rate that means the interest rate is set for the entire duration of the mortgage.
Remember there are many other mortgage products on the market, the 20-year and 30-year fixed rate mortgages are two of the more popular ones for some of the pros we’ll look at now, but shorter and longer terms can often be arranged, as can variable interest rates and a variety of other options.
Fixed rate 20-year mortgage
With a fixed rate 20-year mortgage the mortgage provider will advance you the capital for the house acquisition. You will then pay this amount back plus interest over the course of 20 years, usually paying one instalment per month, so 240 instalments in total.
The fixed interest rate means that rate will not change over the life of the mortgage. Most finance providers calculate what the total amount of interest will be over the life of the mortgage and then work out what you need to pay every month to pay back the mortgage over the 20 years.
This means the monthly payment stays the same, although in reality at the start of the mortgage you will be mostly paying interest with just a little capital repayment and by the end of the mortgage each monthly payment will be mostly capital with a small amount of interest, given how little capital there is left to pay back.
If you’re paying back your mortgage over 20-years compared to 30-years you will usually get a slightly lower interest rate, because the finance provider is without their money for a shorter period of time, and the risk of them losing it is also very slightly lower. You will also pay less interest for the mortgage because you have only borrowed money for 20 years rather than 30.
A 20-year mortgage monthly payment will be higher though than an equivalent 30-year product, because you are repaying back the capital faster.
Fixed rate 30-year mortgage
A standard fixed rate 30-year mortgage is basically the same product as its 20-year sibling, but as its name suggests the payments are over 30 years meaning 360 monthly instalments.
This means the monthly repayments will be lower compared to the same 20-year product, but the total interest cost will be higher, as the rate will be slightly higher, and there are 10 more years of outstanding capital on which to pay the interest.
What will lenders consider when applying for a 20-year or 30-year mortgage
According to Rocket Mortgage, a finance provider, lenders will look at your three-digit FICO score (FICO stands for Fair Isaac Corporation, a company that provides consumer credit scores). The score takes into account how you’ve managed credit throughout your life and reliability at paying bills. A score of 740 or above is considered excellent, although scores in the lower 600s may be enough to qualify for a mortgage.
Lenders will also look at your Debt to Income ratio, known as DTI. This measures what percentage of your income goes on debt payments each month and will be looked at INCLUDING the mortgage you are applying for. In general lenders would want no more than 43% of your income going to pay debts each month.
Finally, mortgage providers will examine your three credit reports, produced by the major national credit bureaus: ExperianTM, Equifax and TransUnion. Credit reports set out all your outstanding debts and loans and how much you owe on each. They also cover missed or late payments and adverse financial events, such as foreclosures and bankruptcies.
Once the mortgage lender has your file complete they will be able to make a decision on whether to approve your mortgage or not.
How long do you expect to stay in the house
It’s not a hard and fast rule, but advisers often suggest looking at how long you expect to live in the property when choosing the mortgage repayment period. If you are expecting to move fairly quickly, it might make sense to take a longer mortgage repayment period, because the difference in the amount of interest is not so important over a shorter period, say five years. If however you expect to be in the property for a longer time, the benefit of lower overall interest has a bigger impact the longer you stay there.
20-year mortgage cheaper compared to 30-year mortgage
The main thing to bear in mind is that if you can afford the higher monthly payments of a 20-year mortgage compared to the equivalent 30-year mortgage it will be cheaper to take the 20-year mortgage. With a 20-year mortgage you will also repay the mortgage earlier and also build your equity in the property faster.
However it is vital to remember to only take out a mortgage where you are comfortable meeting those monthly payments. Each lenders’ precise policy will differ but if you are unable to make your mortgage payments the standard procedure is for the lender to foreclose on the loan and repossess the house to be sold to repay the capital, so ensuring you will be able to cover your mortgage payments is vital.
Other things to consider when taking out a mortgage
There are a raft of other factors to consider when choosing a mortgage, these include, but are not limited to:
- Is there a penalty clause to terminate the mortgage early? You may wish to repay the capital on the mortgage early if you come into money, or if you are going to remortgage. The penalty clauses can vary greatly, so if you are expecting to switch mortgage, or know you may receive for example an inheritance a mortgage with a low penalty rate may be preferable. You will often pay a higher interest rate though.
- What deposit is required? Lenders vary what percentage of the equity (value) in the house they expect you to be able to pay up front. Generally the larger the deposit you can put down on buying the house, the lower the interest rate you will pay.
- Ability to increase the mortgage - some lenders will allow you to draw down additional lending, depending on your circumstances. A common reason for doing so is to renovate or extend the property the mortgage covers. Clearly this will increase monthly repayments, but can be an efficient way of financing work on your home.
Please note this article gives general advice only. Diario AS recommends seeking professional financial advice for any doubts or queries you may have.