Choosing the Mortgage Term

Earlier we pointed out that while mortgages are amortized over 300 months, the rate is fixed for a shorter period, usually no longer than five years. Suppose the rate of 6 percent in Example 6.13 is fixed for five years and you are wondering whether to lock in this rate or to take a lower rate of 4 percent fixed for only one year. If you chose the one-year rate, how much lower would your payments be for the first year?

Question

Choosing the Mortgage Term

Earlier we pointed out that while mortgages are amortized over 300 months, the rate is fixed for a shorter period, usually no longer than five years. Suppose the rate of 6 percent in Example 6.13 is fixed for five years and you are wondering whether to lock in this rate or to take a lower rate of 4 percent fixed for only one year. If you chose the one-year rate, how much lower would your payments be for the first year?

Accepted Answer

The payments at 4 percent are $525.63, a reduction of $111.40 per month. If you choose to take the shorter-term mortgage with lower payments, you are betting that rates will not take a big jump over the next year, leaving you with a new rate after one year much higher than 6 percent.
While the mortgage formula cannot make this decision for you (it depends on risk and return discussed in Chapter 12), it does give you the risk you are facing in higher monthly payments. In 1981, mortgage rates were around 20 percent!

Question 6.14: Choosing the Mortgage Term Earlier we pointed out that while...

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