When it comes to taking up a loan, sometimes people do not understand the obligation that comes with the loan. Meaning that they are in the euphoria of being able to purchase something (home appliance, car or buy a house) and do not pay attention to crucial loan related issues. Thus, one scenario that happens is that couple of months after they have taken the loan, they realize that they could not afford the monthly payment. For that reason they are practically forced to change their life style. Another scenario is to recognize that they have made a commitment for much longer period, then preferred. In addition, some people recognize that they could have repaid the loan in much shorter time, thus saving on interest rate charges and some other fees. For this reason, it is of utmost importance for you to know how much should your monthly installment be.
Let’s take a mortgage loan for example, since it is a loan requiring a long-term commitment. Searching the net you can find a valuable information for almost all aspects related to a mortgage loan. Among other things, you will also find information about how much house or monthly payment can you afford. In reality you should know how much your monthly payment should be taking into consideration your life style, income expectation, maturity period, etc. Thus, the question about how much house you can afford, is not the only important question. Again, don’t understand this the wrong way, you do need to know how much house you could afford. But it might be more important for you to know how much should you afford on a monthly basis (installment). Before going into details about the aforementioned issues. Consider the following choices, and think for a moment:
- Should you go for shorter repayment period and higher monthly payment, or
- The other way around, longer repayment period and lower monthly payment.
The choices listed above should be considered before applying for loan. For the reason that, the decision for choosing one over the other, could largely impact your life (financial and non-financial part of it) in the future. So what choice did you make? Again, keep in mind that whatever you have decide, it will be part of your financial life until the full repayment of the outstanding balance. Now, let’s go through both of the choices in detail.
Shorter repayment period – higher monthly payment
The first choice is going for faster repayment of the loan with a higher monthly payment. This choice is advantageous in a sense that you could be debt free much faster, at least mortgage free. Another benefit is the interest saving you would have. It is common knowledge that the longer the life of the loan the more interest you pay. Thus, going for a shorter mortgage terms would mean a lower mortgage cost, and higher interest savings accordingly. On the other hand, shorter loan life has its drawbacks as well. Namely, shorter life means less period for the principal amount to be repaid. This can only be compensated by increasing the monthly payment. Higher monthly payment is the reason why you are able to repay your mortgage in a shorter term. This can be considered a negative aspect in terms of the degree of uncertainty in your future income. It is difficult for someone to know what would be his/her income in the future, thus a downward change in the income level could mean missing on you monthly payments or changes in the life style due to worsen standard. If you income level has an upward movement then you are on the safe side, regardless of the choice you have made.
Longer repayment period – lower monthly payment
The second choice is at the other end of the specter, meaning that it is the opposite of the first choice available. With this choice you opt to repay your loan over a longer period with a lower monthly payment. One advantage of this choice is primarily the possibility to reduce the income uncertainty risk. Having lower monthly payment protects you against possible fluctuations in your income level in the future. Even if there is some short-term decrease in your income, most probably you could still make the monthly payment. Hence, a major drop in you income should happen before you start missing your payments. Another advantage, is the possibility to save portion of your income. Because a smaller portion of your income goes toward the mortgage obligations, you could be able to put aside funds in your saving accounts, without negative impact on your life style. On the other hand, longer repayment period means that you will have higher cost for your mortgage loan. Also, you will be debt free after longer time, so you would have to live with a debt for longer period, it could be a psychological burden.
Let’s see an illustrative example for the purpose of understanding the choices better. Assuming the mortgage amount is $160,000 with a mortgage life of 15 years (180 months) and 30 years (360 months) respectively, the interest rate is 3.40%, then:
Example A: Shorter period – higher installment
- Loan amount: $160,000
- Loan period: 15 years (180 months)
- Annual interest rate: 3.3%
- Monthly installment: $1,128.16
- Total amount repaid: $203,068
Example B: Longer period – lower installment
- Loan amount: $160,000
- Loan period: 30 years (360 months)
- Annual interest rate: 3.3%
- Monthly installment: $700.73
- Total amount repaid: $252,262
The examples are showing the calculation for a mortgage with a 15 years term and 30 years term. It is evident that the lower term mortgage has a higher monthly payment, whereas the longer term mortgage has significantly lower monthly payment. In addition, by know you should have noticed the difference in the total amount you will pay for the loan over the course of its life time. Summing up the examples, the difference in the monthly payment between 15 years mortgage and a 30 years mortgage is $427.42. In addition, choosing the 30 year mortgage would cost you $49,194 more during loan life.
Before or during the process of shopping around for a mortgage, you could test yourself and your finances. This is in a way that you could try to save portion of your income (approximately the amount of the monthly payment you would have). This way you will grasp the feeling of having a monthly obligation to pay. Later on, see if you could be living with the remaining portion of your income. This is how you could gain a practical experience in relation to the effect the mortgage loan would have on your finances and life style. Meaning that you could make an informed decision about the term of the loan and the installment size. Keep in mind that you should never overestimate or underestimate your financial situation. Make a realistic overview and analysis of your financial situation as well as your life style. Make sure that you have taken into account your current and expected future financial situation. Before shopping for a loan make an approximation of the maximum amount that you can direct toward a monthly payment. Consequently, you could select the best mortgage terms which are in accordance to you situation.
If you choose to take a mortgage with longer term, a smart thing might be, to try to make additional principle payments if you can afford. Note, though, that you must pay attention to possible charges for additional payments, since they could be considered as partial early repayment of outstanding balance.