How to choose loan term?
Updated: Mar 11, 2021
Let us say you are looking to buy a house. You are free to select any loan term for your mortgage. If you have the money would you choose a 5-year loan over a 30-year loan?
Sometimes its more financially sound to pay more in interest if your opportunity cost is high.
If you had to guess then you might want to choose a 5-year loan because you would pay less interest during the course of the loan. But, to pay low interest you have to make higher payments. These higher payments must be thought of as higher opportunity cost.
If you think about investing the money that you would save on a 30-year loan monthly payment then you would end up with a higher net worth than paying high payments for a 5-year loan.
Let me show you with an example, here are my assumptions:
Return in investments: 7%
Tax bracket: 25%
You have $65,039 a year to invest or make yearly loan payments. The time horizon is 30 years.
The interest rate for each of the loan terms is given below. Typically for a longer-term loan, the interest rate charged is a bit higher.
Now, for a 5-year loan, your yearly payment would be $65,039 so you would be using up all your money to make the yearly mortgage payments. After 5 years, you would have paid your loan and you would be investing all of your $65,039 a year. Whereas, for a 30-year loan, you would be paying $16,311 in yearly mortgage payments and investing $48,728 ($65,039 less $16,311) for all 30 years.
Over the 30 years, while in a 5-year loan you would have invested 9% more than in 30 years loan, you would have ended up with an 11% lower net worth. Want to make a guess why?
Time is the king for financial independence.
High 5-year loan mortgage payments make you wait 5 years to start investing and this eats away the most valuable asset you have, time. I explain this in detail in this post. I highly recommend checking it out.
Here is the table for my calculations,
Word of caution
Some benefits of a 30-year loan,
A lower loan payment in 30-year loan gives you more flexibility
Higher total interest paid gives you a higher tax write of
Some drawbacks are,
Going out of budget. As the loan payments are low, it is easy to assume you can afford more. The ideal scenario here is that if you’re getting a home for yourself to live in, buy something where you could afford the 15-year mortgage, but take a 30-year for additional flexibility. DONT get a mortgage where you can ONLY afford a 30-year payment.
The constant mental stress of having debt
Higher interest rate. If the interest rates go higher or your investment returns decrease then it would not be feasible to take a 30 year.