The "All Cash" Equivalent
The New Year is off to a great start for MinnGo, and I hope it is for you too. After writing the last few articles about the offer process, I received a lot of questions about financing. As a result, I am going to break down the “complicated” process of mortgages over the next few weeks.
In my earlier newsletters, I discussed how the Residential Purchase Agreement (RPA) has a lot of terms that can be adapted to a specific transaction. Likewise, there are an abundance of loan products and options for homebuyers that can be customized to a buyer’s financing needs.
For now, let’s focus our attention on the length of a mortgage (and assume fixed-rates). Specifically, let’s focus on two different lengths:
- 30-year mortgage
- 15-year mortgage
The 30-year mortgage is the most common type of loan on the market for retail buyers (the most common of which is the 30-year fixed-rate mortgage). Each month the payment has a portion that is allocated to principal and a portion that is allocated to interest. Over the course of the mortgage, the amount allocated to principal is equal to the initial funding amount. For example, let’s look at a $500,000 30-year fixed rate mortgage with a 4.25% interest rate.
There will be a total of 360 equal payments over the term of the loan. The first payment of $2,459.70 will be split between principal ($688.87) and interest ($1,770.83). In contrast, the 360th payment will be for the same amount ($2,459.70), but the allocation to principal will be $2,451.02 and the allocation to interest will be $8.68.
The 15-year fixed-rate mortgage has the exact same structure as the 30-year, but in comparison to the 30-year fixed-rate, a higher monthly payment is needed to pay off the entire principal balance over the shorter time period (180 months). For example, the same $500,000 mortgage at 4.25% with a 15-year fixed-rate would have payments of $3,761.39 a month ($1,301.69 per month higher than that of the 30-year fixed-rate payment). For the first payment, $1,990.56 is allocated to principal and $1,770.83 is allocated to interest. On the 180th payment, the allocation is $3,748.12 to principal and $13.27 to interest.
In comparison to the 30-year mortgage, the 15-year mortgage will reduce your overall interest burden across the term. However, I always advise anyone thinking about a 15-year fixed-rate mortgage to remember that you can always take the difference between the 30-year fixed and 15-year fixed and apply the amount to principal each month. The payoff period is fairly similar if you follow this practice, but the strategy provides for flexibility if circumstances change. It is also worth noting that, almost always, 15-year fixed-rate mortgages have lower interest rates than their 30-year counterparts.
There are many proponents of long-term fixed-rate mortgages given the current interest rates. However, each loan product has pros and cons, and there is no “right” strategy.
So, the next time you are driving down the street and see a “For Sale” sign, remember there is an alternative to cash – and just about every single person uses it. For the next newsletter I will dive deeper into interest rates, and how one can customize the interest rate structure to best suit his or her needs.
If you ever have any questions at all, please do not hesitate to reach out. At MinnGo, we realize that real estate is not something our clients think about everyday. Lucky for you, that is what we live and breath.
Until next time.