Can you manipulate a loan’s term?

A term of a loan is the time you have to pay off your debt. Common mortgage loan terms are 30, 20, and 15 years, and some lenders offer any number of years between 8 and 30.

In three easy steps, understand your options, the advantages and challenges of each,  the difference between the term on paper and the actual term, and what it means for you.

  1. Understanding the loan’s term

The more years you have on your mortgage, the lower your monthly payment will be because you stretch out the time to pay off the mortgage. Along with this benefit, you need to understand that you will have a higher interest cost, as you are paying the interest for a longer time. In mortgage loans, the shorter the term, the better interest rate you get. This is an excellent incentive to have a shorter term, with the downside of the higher monthly payments. The market rates will determine the actual interest rate for the specific loan you get.

Calculating the remaining term of a loan can be helpful in many aspects. Sometimes, setting a date when life changes are expected to occur, such as retirement or college tuition payments, when you can benefit from having your mortgage paid off, and other times when homeowners refinance their mortgage. Often homeowners prefer not to go back in the number of years of the loan. For example, if you did a thirty years mortgage seven years ago, many will prefer the new mortgage term not longer than twenty-three years, the remaining time on the original loan.

  1. Term on paper vs. the actual term

When you are set with a monthly payment, you can never pay less, as you will be in default. You can pay more every month, which means you send your lender more money than you are required to send, and the additional payment will be applied directly to the principal; the amount you borrowed and have to pay back. By making an extra payment, you will achieve three things:

  • You will reduce your debt balance
  • You will reduce the remaining length of the loan
  • You will reduce the total interest paid to the lender

Let’s use an example.

For a $200,000 loan, in a 30-year term at a 6% interest rate, you will pay for Principal and interest only (it does not include property taxes, home insurance, or other expenses), $1,199 per month.  If you do not make any extra payments, the mortgage will be paid off in thirty years, and during the life of the loan, you will pay the lender $231,676 in interest.

If you stay in the same 30-year plan, send the lender an additional $100 per month, your home will be paid off after twenty-five years and four months, and during the life of the loan, you will pay the lender $182,538 in interest.

If you want to pay more, why not choose a different term? Instead of 30 years, do a 20-year loan or another term, and benefit from a lower interest rate. If you feel comfortable with the monthly commitment, go for it. Consider the advantages and challenges, and if you decide on a particular term and plan to send more money monthly, you can calculate in advance the impact of the additional amount in time and money. Let’s continue understanding what it means for you.

  1. What it means for you

Flexibility is the most significant advantage in choosing a longer term and sending more money monthly. You can have a 30-year mortgage loan and send additional monthly payments. The loan will be paid in a shorter term, and you can set up a direct electronic payment so you do not forget. You know that if there are unforeseen situations and for a few months you prefer to lower your mortgage payment back to the original amount of the 30 years, without the additional payment, you can. This gives peace of mind, as you do not want to default on mortgage payments. You can look online for mortgage calculators with amortization schedules (Loan amortization schedules show you the breakdown of how your monthly payment is distributed between the principal and the interest) as bankrate.com or others. In those calculators, you can estimate your additional payment and, as a result, when the home will be paid off and how much you will save in interest.

What is the downside of the above? Discipline. Are you goal-oriented and disciplined enough to follow through even though no one obligates you? Know your numbers, know your options, and make the decision that suits you best.