Want the best mortgage term? Think beyond the 30-year fixed
What were you doing 30 years ago?
Me, I was about to start my sophomore year in high school. I was thinking a lot about getting my driver’s license and staring at a lot of boobies. I had begun what would become a lifelong obsession with destroying my hearing, blasting Duran Duran, Men At Work and Loverboy through my orange-padded Walkman headset. All-in-all great times!
In other words, it was a lifetime ago. A lifetime.
Now think back to what you were doing 10 years ago. For me, I was working. My boss who thought highly of me got fired in a tussle with a hated adversary. That adversary became my new boss and he transferred all his hate to me. I was thus left fighting to save my job, even though from any objective measurement, I was doing great in my role. (No wonder I hate corporate America so much!) It was also the year I bought two fourplexes and I spent nearly every weekend for a year working on them.
The thing is, though, that doesn’t seem that long ago. Yeah, a lot has changed since then, but I still remember those days clearly.
Not long ago, when I wrote about how to get rid of your mortgage, I mentioned offhand that part of the strategy was a 10-year mortgage. I also mentioned in How much should you spend on your house that the payment on a 10-year loan should be the measure for how much house you should buy.
I realized I never completely explained my thinking around 10-year mortgages so I wanted to spend some time fleshing out my thoughts on that.
The 30-year term was created after the Great Depression in the 1930s to stabilize the real estate market. Now homes were accessible to a much larger market than ever before. As easy credit has a way of doing (we’re now seeing it with tuition costs), the rapid increase in the number of buyers created an increase in housing prices.
Thus, as time went on, the 30-year mortgage became less of an option and more of a necessity — particularly during periods of high interest rates. Now the 30-year mortgage is the standard loan in America. Nearly everyone with a house has one. Rather than simply believing it is the best mortgage term, many people assume there is no other option.
For people seeking pretirement, however, there is another option and it’s the best mortgage term: the 10-year loan.
Here’s why I say it’s the way to go right now while interest rates are still low:
It’ll help keep you honest about what you can afford
When I give the advice to not buy a house if you can’t afford the 10-year payment, I’m not necessarily recommending that you take out a 10-year loan — it’s just a way of determining the right loan amount for your budget. However in most cases I DO recommend it, because it prevents that money from cleverly turning into electronics and furniture. These many, many things that you’re going to want but don’t really need will be out of reach — and that’s a good thing. You may really want that nice, new couch for your living room, but you’re effectively buying that couch on credit if you’re only able to “afford” it because your house payment is artificially low.
The payment might not be as high as you think
Check out the difference in the payment amounts for two sample loans, one at $250,000 and the other at $450,000:
Rate for 30 year fixed
Payment on 30 year fixed
Rate for 10 year fixed
Payment on 10 year fixed
Difference in monthly payment
Now, I’m not pretending that the extra money you’ll be paying each month is not an insignificant amount of money. On the smaller loan example, you’d be out an additional $1,100 per month. That will sting. It’ll sting badly. On the higher-priced loan, you’ll be well over $2,000 more each month.
Here’s why I say that’s OK. While it certainly is a chunk of change, let’s remember that in most cases, we’re spreading this across two people. So on the smaller loan, we’re talking about $500 each. That should be doable. If it’s not doable, we have to say you’re buying too much house and send you back to my first point.
You’ll actually see results
Sure you’ll gain equity with a 30-year loan as well. Eventually. Nearly every first time home buyer is stunned that just a few pennies from their giant mortgage payment actually go toward principal. For YEARS you’ll watch your principal sit there, barely changing at all. If you sell in too short a time period and you haven’t seen any market appreciation, the theoretical equity that you’ve been earning by reliably making your mortgage payment each month will have been more than wiped out by realtor commissions, property taxes and home maintenance.
When you go with the best mortgage term — the 10 year fixed loan — it’s the opposite. We have a 10-year loan on my current house (AND I live mortgage-free — guess I should explain that one of these days). It’s incredible watching the principal balance drop in big heavy steps. In fact, I’m finding it rather hard to put into words how breathtaking I find it to be each month. Even in the first month our principal began dropping by $1,700 per month. Every year it’s another $20,000 gone. Compare that to a 30-year loan where on a loan of our size you’d see a drop of just a few hundred a month. Take a look for yourself with an online amortization table.
Low interest rates make it possible
My favorite reason to pursue a 10-year loan is that you can. The low interest rates we see currently make a massive difference on your total payment size, all else being equal. That means you can put your house purchase on the accelerated plan, something that was largely impossible for middle class buyers until recently.
You can lower your debt load
Back when I was carrying five mortgages at once, it really sucked doing loan applications. Sure, credit was unbelievably easy to get. I once had a loan officer looking at my list of five mortgages and ask me “So do you want to run this through as a no-doc loan?” Meaning they wouldn’t need to verify my income, they’d just approve the mortgage based on my credit score. WTF?
That was still easier than in the days following the great economic collapse. When the list of loans popped up on my credit report, it would take about 45 minutes to walk them through each one, explain the rental situation for each and explain how I managed to make all my payments on time. While it’s still pretty tough for me to get a home loan, it’s getting easier. As I’ve been shedding properties (and related debt) in recent years, the ice has been melting. My overall debt looks much more reasonable and I don’t get the shocked questions about the eye popping numbers on my credit report.
It gives you options
Even if you have a few years left on your 10-year loan, your disciplined focus on getting rid of debt and building up equity creates new opportunities for you. You’ll be able to consider buying investment property or just pay off your house completely. You can take out an affordable home equity loan and start a business or pay for your kids’ education. You name it. But even more fun, if you start out on a 10-year loan path and save up a little on the side, you could pay off your mortgage in as little as seven years! Now that’s an option.
It’s less risky
The biggest push-back against a 10-year loan is usually fear of a cashflow crunch should hard times arrive. The classic scenario is one or both members of the couple lose their job. The house payment is too large to be made on one salary and the house of cards collapses and you lose the house and the kids are out on the street.
Is it really a concern? Of course it is. But you’re not going to run into this situation because you’re reading Pretired.org and are going to take some measures to keep yourself safe. If we look a little deeper we can see that it’s actually less risky to go with the 10-year over the 30 year loan. You wouldn’t be buying a house if your employment wasn’t reasonably stable anyway. But how far into the future can you see? You might feel reasonably safe for the next 7-8 years but what about the next 20-25 years? It’s a lot harder to predict a couple decades out, right?
Also, because you’ll be building up your net worth instead of buying a bunch of crap, you’ll have a larger margin of safety. If things go south on you, you’ll have equity available and controlled housing costs so you’ll have more security than your highly leveraged neighbors.
Which brings me to final reason you’re safer with a shorter-term loan: Your emergency fund. Now, in the first couple years things could be tight and you need to be careful. Bad things can happen. I’d say keeping 6-12 months of emergency cash handy is pretty important in the early years. In later years, however, you can open a line of credit to access your newly-built equity, which will serve as your emergency fund.
Your housing costs will be controlled
One of the important steps toward reaching pretirement is bringing your housing costs under control. Whether it’s as a renter or homeowner, you need to ensure housing costs don’t rise suddenly on you in later years, eating up your cashflow and sending you back to work. Getting rid of your biggest expense gives you a lot of power over your monthly finances.
You could be mortgage-free
Hey, need I say more? The American Dream used to be “owning” a house (even though the bank really owned it). These days, the American Dream is about getting rid of your mortgage as early as possible in life. That mortgage payment is what keeps us chained to our desks. You dream of doing something else, anything else, but the career brought you to this place and you’d have to make much less if you changed careers. Getting rid of your mortgage is what makes this possible. And the 10-year loan is the best path to getting there.
What do you think? Have I convinced you the 10-year fixed loan is the best mortgage term?