The 30-Year Fixed Rate Mortgage Loan
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The 30-year fixed-rate mortgage loan is the most popular mortgage available today. The U.S. Bureau of Labor Statistics found that nearly two-thirds of homeowners surveyed between 2004 and 2014 held 30-year FRMs.
There are many factors to consider when contemplating a mortgage, but primarily, you are looking at how the monthly payment size and overall interest fees fit into your particular financial situation. In this post, we will guide you through the ins and outs of the 30-year fixed rate mortgage, and explain why it is the most common loan option for American homeowners.
The 30-year fixed-rate mortgage: What is it?
As the name indicates, the rate of the 30-year fixed-rate mortgage doesn’t change over the loan’s term. For 30 years, you make a payment each month that covers the interest for the previous month, and the rest of it reduces the outstanding mortgage balance. As you pay down the loan, you pay less toward interest each month and more on the balance. So long as you make your minimum required payment, you should pay off your mortgage in 30 years.
Compared with other common fixed-term mortgages, like the 15-year FRM and the 10-year FRM, a 30-year FRM requires a relatively low monthly payment because the repayment is stretched out over 30 years. But there’s a trade-off in the form of higher interest rates, which make a 30-year loan more expensive in the long run than a shorter term loan. The average rate for 30-year FRM was 4.62% as of June 14, 2018, while the figure for a 15-year FRM was 4.07%, according to Freddie Mac. On a $300,000 mortgage, that’s the difference between paying $254,950 versus $101,330 in total interest.
Still, many homebuyers don’t have the luxury of affording large enough payments to take advantage of a lower cost, short-term mortgage.
“A shorter loan is a cheaper loan but a longer loan might be a more affordable loan,” said Tendayi Kapfidze, chief economist at LendingTree.
Why is the 30-year FRM the standard?
While the 30-year fixed-rate mortgage is the most popular loan for homeowners in the U.S. Mark Perry, professor of finance and business economics at the University of Michigan-Flint, said the U.S. is actually an outlier in this regard.
“You won’t find it in most other countries, including Canada or Europe,” Perry said.
The reason the 30-year mortgage became the norm dates back to the Great Depression, when many of the mortgages lasted no more than five years and many homeowners defaulted on their loans. The national homeownership rate was well under 50%. In an attempt to make housing more affordable, the federal government stepped in and facilitated the creation of long-term fixed-rate mortgages, which eventually become the standard 30-year fixed rate.
“[The 30-year fixed rate mortgage] is only popular here because of the government intervention in the mortgage markets via Ginnie Mae and Fannie Mae, which are government enterprises to promote affordable housing,” Perry said.
One of the criteria that lenders look at when they determine whether borrowers qualify for a loan is their debt-to-income ratio (DTI). Your debt-to-income ratio is the percentage of your monthly income is going to be needed to cover your monthly debt obligations, including your potential mortgage payment. Some mortgages have DTI limits. The maximum DTI ratio for Fannie Mae-backed loans, for instance, is 45%. Your DTI has to be below the limit for you to qualify for the loan.
With a 30-year fixed, because your monthly mortgage payment is smaller than that with a 15-year fixed, your DTI will then be lower. In other words, it will be easier for you to qualify for a 30-year loan than a loan with a shorter term.
“If you get a lower payment, you can have more buying power,” Kapfidze said.
Benefits of the 30-year FRM
The biggest advantage of the 30-year FRM is that the borrower makes smaller monthly payments over the course of the loan than they would do with shorter term mortgages. This makes budgeting more manageable and frees up cash for the borrower’s other financial goals or investment opportunities.
If you lock in a 30-year fixed mortgage when the interest is low, you don’t have to worry about your rate increasing. It can be a great option for financing a home where you intend to stay for many years.
In the back of your mind, it also gives you a reassurance that the rate won’t go up even when inflation is through the roof.
“You know how much you will be paying for 30 years because you don’t have uncertainty on the interest payment,” Kapfidze said.
Drawbacks of a 30-year FRM
Although your monthly payment is relatively small and manageable, a 30-year fixed also comes with a big financial disadvantage — you will pay more money back to the bank over the life of your loan than other shorter term loans because your interest rate is higher.
Let’s say you need to borrow $200,000 for your dream house.
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A 30-year FRM with a 4.4% interest rate translates to a total monthly payment of $1,001.52. Over the life of the loan, you’ll end up paying the lender $360,547.86 — that’s over $160,000 in interest charges in addition to the $200,000 you needed to purchase the home in the first place.
In comparison, for a 15-year FRM with a 3.9% interest rate, you will need to pay $1,469.37 each month, almost 50% higher than the 30-year FRM monthly payment. However, over 15 years, your total repayment will be $264,487.21, a difference of almost $96,060.
A 30-year FRM also means the homeowner builds equity at a slower pace than a 15-year FRM.
And if mortgage rates drop significantly after you bought the house, the only way to lower your payment is to refinance your loan.
Alternatives to a 30-year FRM
Consider a 15-year FRM instead if you are someone who can afford a bigger monthly payment and hope to be debt-free in a much shorter period of time.
The 15-year FRM is the second most popular mortgage option among American homeowners, according to the Bureau of Labor Statistics.
With a 15-year FRM, you can pay off your debt in 15 years. The monthly payments are higher with a 15-year mortgage than a 30-year loan, but because its interest rate is lower, you save interest payments over the loan’s term.
Consider an ARM. Adjustable-rate mortgages (ARMs) have become much less common after the financial crisis. They are riskier mortgage products than FRMs because rates of ARMs can fluctuate greatly according to the interest rate and economy, Kapfidze said. But for some borrowers, especially those who expect to sell their home and move in a few years, an ARM can create substantial savings on interest payments.
ARMs are 30-year loans with an initial fixed period of time — it could range from one to 10 years. The 5-year fixed rate period is the most popular option, Kapfidze said. The initial start rate, known as a “teaser rate,” is typically lower than 30-year FRM rates. However, the risk is that your interest rate could jump dramatically after the fixed-rate period, and so your monthly payments could swing up.
How to start applying for a 30-year FRM
A wide variety of lenders offer 30-year FRMs and terms may vary by providers. Your options range from government-backed loans and conventional loans to products for borrowers in special categories.
Before applying for a 30-year FRM, you want to come to the table prepared to make the application process as smooth as possible: Save up enough for a down payment, pull your credit and have all your financial statements ready. Remember, lenders ultimately want to make sure that you are financially stable and responsible to repay the loan over the course of 30 years.
Once you have all your paperwork in hand, you should shop around for rates. In general, mortgage experts recommend borrowers reach out to two or three lenders and compare offers. You can also work with a mortgage broker who could save you from doing the legwork yourself.
Alternatively, you can just sit at home and use this online tool by LendingTree to compare offers from multiple lenders before applying for a 30-year FRM.