Housing...Inside and Out

December 29, 2000
The Effect of Mortgage Terms on Housing Affordability

Most potential homebuyers are aware that their monthly mortgage payments are affected by the interest rate on their mortgage and certainly by the amount that they borrow. Higher interest rates and a larger principal mean higher monthly payments. They may be less aware of how the term of their mortgage-that is the length of time that they will be paying back the mortgage-affects the size of their monthly mortgage payments.

A fully amortized mortgage is one in which the borrower makes equal payments every month over the whole term of the mortgage. If the mortgage is for 20 years and the payments are made monthly, the borrower makes 240 payments, each for the same amount. At the end of the 20 years, the principal and interest are paid off.

A mortgage with a longer term-for example, 30 years-means that interest is being paid for the use of the money for a longer period of time. So the total amount paid for interest will be greater with a longer-term loan. However, the payments are spread out over a longer period of time, so the monthly payments will be smaller than with a 20-year loan.

As an example, consider a mortgage for the amount of $47,500 at an interest rate of 8 percent. If the loan is amortized over 20 years, the monthly payment is $397.31. Over the course of 20 years, the borrower will pay $95,354-of that, $47,500 is applied to the principal and $47,854 is interest. If the term of the mortgage is 30 years, the monthly payment is $348.54. Over the 30-year term, the total amount paid is $125,474. Again, $47,500 is for the principal but $77,974 is for interest.

In summary, with the same principal and interest rate, a mortgage with a longer term means that the monthly payments will be smaller than a mortgage with a shorter term. However, more interest will be paid over the term of the loan. First-time homebuyers with low incomes may have as their primary objective, obtaining a mortgage with the smallest monthly payments possible and opt for the longer-term mortgage. However, they need to be aware that they will accumulate equity in their homes at a slower rate than with a shorter-term loan.


Written by Dr. Francis Graham (Retired)

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