Real Estate Investment: Return On Investment and Cash Flow Calculation

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Select the Best Mortgage Option

A lot of people get confused when it comes to Mortgage term. With so many different options on the market regarding terms, mortgage rate and points, it's very confusing to find out which is the best term for you, especially if you are a first time buyer.

Mortgage term typically refers to the number of years that the loan will last. Understanding the effects of the term of your mortgage can help you choose the mortgage term that is best for your situation today as well as for tomorrow.

At one time, the two traditional choices were 15-year and 30-year fixed mortgages. Today, however, you will see a variety of other mortgage terms, including 20, 25 and 35 years. There are even sometime mortgage terms that are offered for 40 years.

One critical element regarding mortgage terms that must be understood is that the longer you finance the mortgage, the lower your monthly payments will be in most cases. With that being said, however, it is also critical to understand that the longer you draw out the payments, the more money you will pay overall for the house. This is because you will be paying more money in interest.

Conversely, the shorter the mortgage term, the higher your monthly mortgage payments will be, but the less you will pay overall for the house over the life of the loan.

Mortgage rate is the interest rate you pay during the life of the mortgage. If the mortgage term keeps the same, the lower the rate, the overall money you pay toward interest is less. We always shop for the lowest interest rate possible for same mortgage term.

You must also take into consideration the fact that a longer term will also slow down the build-up of equity in the home. Likewise, a shorter mortgage term will allow you to build-up equity at a much faster pace.

So, how much of a difference can a mortgage term make? Let's take a look at some examples. Let's assume that you have received a 5% interest rate on a loan for 15 years for a $100,000 loan. With this type of mortgage, your monthly mortgage payment would be $791. When you pay off the mortgage at the end of 15 years, you will have paid over $42,000 in interest.

Let's do a comparison of two loans to get an idea. One is the above example with 5% interest rate on a 15-year loan for $100,000. Another is 4.75% interest rate on a 30 years loan for the same amount. Using our All-in-One Real Estate Investment Calculator to compare the two loans. Here's the result.

Click on image for larger graph in new window. mortgage1

As you can see, doubling the length of the mortgage can make some significant differences in terms of the amount of money that you pay on a monthly basis for your mortgage loan. With a 30-year mortgage you pay $521.64 instead of $790.79 for 15 year. But you will pay more interest($87,793.04 for 30-year mortgage than $42,342.85 for 15-year mortgage) over the life of the loan.

Now let's look at points. What is a point? Point is fees you pay up-front to lower your mortgage rate. But is it a good idea to buy point? Depends. If you plan to stay at the house for a very long time, then it pays to buy point. If you only stay for a few years, it actually cost you more.

How much is a point? The cost of each point is equal to one percent of the loan amount. For instance, for a $100,000 loan one discount point equals $1,000. Then how much does buying a point lower interest? Each discount point paid typically lowers the interest rate by 0.25 percent. That means a 6% percent rate would be lowered to 5.75% percent if you purchase one point. Paying for points lowers your interest rate, because the lender receives the income in a lump sum at closing rather than collecting the interest as you make payments on your loan.

After understanding discount point, the very important question is: how do I decide if I should buy points or not? Let's use the above example. We have a loan $100,000 for 30 years at 4.75%. Now if we buy a point to reduce the interest rate to 4.5% for the same amount loan and paid $1,000 for the point. At which point can we make even? Here's the result using our All-in-One Real Estate Investment Calculator.

Click on image for larger graph in new window. mortgage2

We can see from the result, if you buy one point, it takes 6 years 7 months to break even. If you don't plan to stay more than 7 years. you lose money by buying discount point. If you stay longer, you save money by buying a point. The longer you stay, the more you save.

When choosing a mortgage term, it is important to consider what is most important for you and your current needs. For some people, it is more important to make sure that they get a monthly mortgage payment that they can afford. For other buyers; however, it can be more important to pay off the mortgage loan sooner and save the money in interest. If you can afford the mortgage payment on a shorter mortgage term, this will often be the most financially savvy choice to make.

You must also take into consideration how long you plan to hold the mortgage. If you think that you may refinance the mortgage or even sell the home within the next few years, then the benefits of saving money on interest associated with a shorter term may not be as important as obtaining a lower monthly payment with a longer term. On the other hand, if you think you are going to be in the home for the life of the loan, or at least for longer than five years, then it may be a better choice to go with a shorter mortgage term so that you can pay off the loan sooner and save money on interest, provided that you can afford the higher monthly mortgage payment.

Ultimately, deciding which mortgage term is the best option for you is really a matter of personal preference and there is certainly no right or wrong answer. Make sure that you take all the facts into consideration and make sure that you make a decision based on your personal needs and situation. This will help to ensure that you receive the best mortgage deal possible that will benefit you not only today but also in the future as well.