The typical mortgage that home buyers take out is the 30 year fixed rate mortgage. This means that they will make fixed payments on their home for thirty years. Is this a good thing?
The only real advantage to a thirty year mortgage is that payments are lower, and the borrower knows what they will be each month. Experts say that the home owner can then use the money they've saved on payments for investments that make a nice return. The problem with this theory is when the market crashes, as it is prone to do, the person who put their money into the markets loses out. Instead of having less debt on their home, they have a portfolio which is losing value.
The main disadvantage to the thirty year loan is the thirty years of payments it will take to pay off, and the amount of interest that is paid to the banks over those thirty years.
If a buyer gets a $200,000 loan for thirty years fixed at 5.5%, the monthly payment will be $1,136. This will amount to a total payment of $408,808 over the thirty years, of which $208,808 was interest. So over the course of thirty years the borrower will pay back twice what they borrowed, negating a large portion of any equity built up over those years. Compare the same $200,000 loan for fifteen years at 4.5% (interest rates are typically lower on fifteen year loans), and the payment is now $1530. That's an increase of $394 per month, but with 15 years less of payments. The total that will be paid by the borrower will be $275, 398, which is $133,410 less than what was paid by the thirty year loan. Not only are the savings substantial but the home is paid off in half the time, freeing up the borrowers to spend that money on other things.
Another issue with the thirty year mortgage is the fact that very little to no equity is built up in the property over the first ten years or so. Taking the above example of $200,000 at 5.5%, in 10 years the borrower will have made $136,320 in payments, but will still owe $164,703, and will have paid $102,108 of interest. Even after twenty years, the borrower will still owe $103,980, or just over half of the principal balance!
There is one way to lessen the sting of the thirty year loan's interest payments, and that is to make additional principal payments every month. Just adding $100 to the above example's payment, making the payment $1,236 per month, will take approximately six and a half years off of the payments, and save over $40,000 in total interest paid. Extra principal payments are far more effective when made in the earlier stages of a loan as that is when principal reduction is at its least. But it still takes longer to pay off the home and almost twice the interest is still paid when compared to the fifteen year loan term.
The obvious reason why banks want to push the thirty year loan is the huge increase of interest they will receive for the loan. But another, less obvious reason, is home value inflation. By lowering payments, banks can convince borrowers that they can buy more house, or that they can bid a higher price for a home they are interested in. This causes prices to go up, which in turn make larger loans for banks, which in turn make more interest. If everybody stuck with a fifteen year loan, then payments would be higher, which means that borrowers would not offer as high of a price. This would be better for consumers but bad for the banks.
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