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Is prepaying a mortgage better than a shorter loan?

Posted by  on Jul 02, 2014
 

Q: I am about to buy a house. I like the idea of paying off the mortgage in less than 30 years, but I've heard some people advise just to make extra payments on a 30-year mortgage rather than to commit to always making the larger payments that would come with a shorter mortgage. What do you think of that?

A: Making larger payments at your discretion is certainly one way to pay a mortgage loan off sooner without fully committing to a shorter repayment period. However, there are some drawbacks that come with that flexibility.

The most prominent disadvantage to what you propose is that longer mortgages generally have higher interest rates than shorter mortgages. So, if you take out a 30-year loan with the intention of doubling up on many of the payments, you will be paying back the money sooner without getting the benefit of lower mortgage rates. That would be especially unfortunate right now, because the spread between 30-year and 15-year mortgage rates is especially wide. For example, back at the end of 2008, the difference in rates was only 25 basis points, but these days it is up over 85 basis points.

Another potential drawback could be prepayment penalties. Because mortgage lenders like to be able to predict their future cash flows and interest revenues, some charge a penalty if you pay a loan back early. If you are going to pursue your plan of taking out a longer mortgage but paying it back ahead of schedule, you should make sure you can get a loan that won't penalize you for doing this.

On the plus side, a 30-year mortgage might be a safer approach if you feel your budget would be stretched to the breaking point by payments on a shorter loan. First-time home buyers often over-commit to their monthly payments, only to find out that the various expenses associated with owning a house make their payments harder to meet than they expected.



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