Choosing your loan term is an important step in ‘designing your debt.’ You can typically take between 5 and 30 years to repay your mortgage. But how does a longer loan term affect your total cost?
If your natural inclination is to take the maximum loan term that you can get, then you are probably less likely to clear your mortgage ahead of schedule than someone who opts for a shorter term. It seems that people with the foresight and committed desire to get mortgage free faster, do, whereas people who shift debt elimination further down the list tend to lull in indebtedness.
With a longer exposure to the pressures of the Repayment Rollercoaster plus the math behind how interest works, borrowers opting for a 30 year plus loan term have it stacked against them. Quite simply, it’s going to cost you a LOT more money to repay the same debt.
Glance at any mortgage interest chart and you will notice they all have a curve in them. This curve happens because of the way your interest bill is calculated. It’s called compound interest. Although most people understand that you pay more interest the longer you owe money, compound interest is a lot nastier than that.
In the simplest of terms, compound interest means you get a little less yet pay a lot more. If you double the time it takes to repay your mortgage you will MORE THAN DOUBLE your interest bill. Triple the time it takes to repay your debt and you pay more than triple your interest costs and so on.
Take a $379,000 home loan for example. Let’s say the interest rate is 7.15%. (Far greater than today’s rates but this is just an example.)
If you repay that debt in 10 years, you pay around $152,500 in interest which if you double is $305,000. Yet if you take double that time to pay it off (i.e. 20 years), you’ll pay almost $334,500 in interest.
Take triple the time like many borrowers do, repay it over 30 years and the merchant charges you $542,500.
That’s more than three and a half times the amount of interest you would pay if you killed the debt in 10 years.
The main thing to remember is taking a longer loan term reduces the minimum repayment you are required to make, however it also has a few serious problems.
1. You stay in debt longer.
2. You stay at risk for longer.
3. Small increases in loan term create:
a. smaller reductions in minimum repayment
b. much larger increases in interest costs
As a guide, you should always choose the shortest term that works for your comfort zone.
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