A short mortgage term can beat a long one if you can afford it

The rise in housing prices during the last few years has created a huge market for creative and risky types of mortgages. Option ARMs, which can increase the amount you owe even as you make monthly payments, are but one example of a type of home loan that can get you in trouble quickly. With fallout ahead from Hurricanes Katrina and Rita, it appears that the rate of home foreclosure in the United States will soon increase dramatically.

While many, if not most, home buyers are struggling to make their payments, others are still acquiring more traditional home loans, such as the 30 year, fixed-rate loans and the rarer but far more useful 15 year, fixed rate loan. The 15 year mortgage, if you can afford it, is by far the best option available for buying a home. And it’s not as expensive as you might think.

The gut reaction that anyone might have when contemplating a 15 year loan is that the payments must be at least twice as much as for a 30 year loan. It runs for half the time, so the payments must be double, right? It turns out, thanks to the miracle of compounding math and a quirk of the lending industry, that it just isn’t so. Lenders like to lend money, but they don’t like to take risks. That’s why, among other things, they’re so careful to check credit scores and credit reports on their prospective customers. The longer the life of the loan, the greater the risk to the lender. After all, you’d rather lend someone money overnight than for a year, wouldn’t you?

What this means for the average buyer is that interest rates are lower for 15 year loans than they are for 30 year loans. Furthermore, because of the way interest is calculated, a greater portion of the payment goes to principal on a 15 year loan than for a 30 year loan. The result of this is that payments for a 15 year loan are only 25-30% higher than for a 30 year loan. For many buyers, particularly those who have a large down payment from selling a previous home, a 15 year mortgage represents quite a bargain.

On a $100,000 loan at 6% for 30 years, principal and interest would be about $599 per month. For 15 years at a slightly lower 5.5%, payments would be $817 per month. Granted, that’s about one third more, but the property would be paid off in half the time.

It’s worth mentioning that even if you have a 30 year loan, you can still get the benefits of a shorter term note by paying extra principal each month. If you pay 30% more you can pay it off in half the time, but any extra payment towards the principal, even $10, contributes