The length of your home loan is important because the longer the loan repayment term, the more interest you pay over time.
How long your home loan is has a direct impact on the interest you pay, and the size of your repayments.
The longer the term is, the lower your repayments will be over time, but the more interest you'll pay. This is because your loan spans over more years.
The shorter it is, the higher your repayments will be. This means you'll pay less interest over time, because there will be less time for interest to be charged.
New flexibility in length of home loans
Refinancing is an area where your loan term needs to be properly considered.
We have come a long way since the days of the inflexible 30 year mortgage. Today, if you want to refinance to home loan with a length of 12 years and 3 months, most lenders should have the flexibility to accommodate this. This change requires customers to change their mindset of what is possible and start demanding a tailored loan term to their specific needs.
Now what happens is that that all sounds really good about refinancing and getting a cheaper interest rate. But what we say at State Custodians is be smart about it. Don't just fall into the default position that a lender might offer you. For example, if you're applying for a home loan, or, first of all, if you actually have a loan and you've had it for 5 years, say you've had a $300,000 home loan and you've had that for 5 years, your balance might be, after 5 years of making the minimum repayment, say it's at 5.5%, your loan balance turns to $277,000. So, you say, "Okay. Well, I'm going to refinance that $277,000, and I'm going to get a cheaper interest rate."
And that all sounds really good, but what they often do that is not the smartest thing, is they just tick the box on the application that says 30 year loan term. So what happens is they've gone from having that original $300,000 home loan over 30 years, they're now going to be paying off their loan or their house over 35 years. And what happens if they're just making the minimum payment, is that they're going to have to pay more in interest than even regardless of the fact that they have a cheaper interest rate.
Length of mortgage comparison
To show simply the sharp difference a loan term makes to the total interest you'll pay over the life of a mortgage, let's compare a 25 and 30 year mortgage.
|Loan details||25 Years||30 Years|
|interest rate||6.70% p.a.||6.70% p.a.|
|total interest payable||$318,982||$396,900|
* based on monthly, principal and interest repayments
In this example, the choice of a 25 year home loan length does cost the borrower an extra $127 per month (which may push a 25 year length beyond the reaches of some people) compared with a 30 year loan, but it also saves the borrower a staggering $78,000 over the life of the loan.
Clearly the shorter the loan length, the less borrowers will pay in interest.
As you can see, this is because a 25 year loan term works in the same way as making additional repayments. Because your loan term is shorter, your repayments are calculated to be higher than with a 30 year loan term. As we know, higher repayments pay off more of your principal sooner and a lower principal means less interest is payable.
On the other hand, a 30 year loan term has lower repayments, as you now have five additional years to pay off what is the same loan amount. This of course means you also get charged interest for five extra years.
Generally speaking, home loan terms can include 10, 15, 25, 30 or even 40 year loan terms. 25 and 30 year loan terms are the most common, with 10 and 15 year loan terms generally being confined to interest-only repayments and 40 year loan terms only being offered by a small number of lenders.
Choosing to take out a home loan with a 40 year term will have even lower repayments than a 30 year loan term—$1,805.20 on $350,000 loan with a rate of 5.50% compared to $1,987.26 with a 30 year loan term, or $2,149.31 on a 25 year loan term. It’ll also come with a much larger interest bill—$516,496 vs $365,413.60 on a 30 year loan.
Remember too that just because your loan term is longer doesn’t necessarily mean you can’t make additional repayments or make use of repayment strategies which decrease your loan term. Making additional repayments or lump sum payments, or splitting your monthly loan repayment into fortnightly payments can see you pay your loan off in a shorter time period than what you’ve agreed to anyway.
Refinancing mistake: refinancing to a lower interest rate and not adjusting your loan length
One mistake to avoid is refinancing to a cheaper interest rate and just accepting the default loan term, say 30 years. Tim already had a 30 year loan for five years, Tim should consider adjusting his new loan term to 25 years — to account for the five years the loan has already been paid for.
|Tim refinances to a new home loan||Original loan||Refinance after 5 years|
|loan term||30 years||30 years (which means a real overall loan term of 35 years)|
|interest rate||6.70% p.a.||5.70% p.a.|
|total interest payable||$396,900||$404,266 ($306,645 in interest from the point of refinancing)|
* based on monthly, principal and interest repayments
Tim has made a smart move for his financial situation, switching to a home loan with an interest rate that is a full one percent cheaper than his original home loan — but he has made an error. He refinanced and started a new 30 year loan term even though he had already paid a full five years off his original mortgage. Refinancing will cost home $7,365 more in interest and will take him 5 years longer to be debt free.
A tip is to use your original loan term and years you've been paying off your home loan when deciding on a new loan term when refinancing.
If Tim had chosen a 25 year loan term when he refinanced, he would have saved himself $52,074 in interest over the life of the loan.