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Why Are Payments Higher When You Shorten the Term?

Written By: David Reed
Monday, June 7, 2021

Many financial advisors recommend taking out a shorter term loan. Why? Because over the life of the loan, less interest is paid to the mortgage company. That makes sense. Less interest is always good, right? But with a shorter term loan, theres a tradeoff. The shorter the term, the higher the monthly payments. Why is that, exactly?

Monthly mortgage payments have three basic components. The first is the actual loan amount. The second is the interest rate on the loan. The third is how long the loan is actually amortized over. Amortization simply means how the loan is paid down and when. Most mortgage loan terms in todays mortgage marketplace are the traditional 30-year fixed. When you see interest rate advertisements, its usually the 30 year term thats being promoted. The second most popular is the 15 year term. Other terms fall into the 20 and 25 year category. A 10 year note is also available. There are also programs that can customize a loan term based upon how many years remain when analyzing a refinance.

Lets now compare monthly payments for a loan amount of 300,000 and an interest rate of 3.00. The traditional 30 year yields a monthly payment of 1,264. The shorter 15 year term comes out to 2,071 per month. 20 and 25 year terms provide a monthly payment of 1,663 and 1,422 respectively. Notice how even though the loan amount and interest rate are the same under each scenario, the monthly payments are different. This is due to the term of the loan. If someone is paying off a loan with a shorter term, the result is a higher monthly payment.nbsp;

Think for example taking out a mortgage with a two year term. The monthly payments would have to be high enough to pay off that mortgage in 24 months. The shorter the term, the higher the monthly payments must be. At the same time, you can also see that a shorter term loan would also result in less interest paid over the life of the loan.

Which brings up another pointwhich term is best? There really is no definite answer but instead depends upon what the borrower wants. Yes, paying less interest over the life of the loan is a good thing but youll notice the difference between a 30 year and 15 year term using the same example is 807. Thats a lot but for some the monthly payment for the 15 year term is too much. So much so that the borrowers can no longer qualify due to the higher payment. Thats where a 20 or 25 year term can be a good choice. The best loan term is the shortest loan term the borrowers can comfortably afford each month.nbsp;

Thats why when speaking with your loan officer about your financing options, ask about other loan terms besides the more popular 30 and 15 year terms. In this way, your choices are customized to your requirements.

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