Why thirty years is the default for mortgages
This is the first post on mortgages, and I hope it highlights the kind of analytical approach I’d like to take on this blog.
A few months back, No Debt Plan took a look at fifteen year versus thirty year mortgages. There was a lot of discussion and debate on the topic, and No Debt Plan came down on the side of a thirty year mortgage, as it allows more flexibility in your monthly payment.
One of the issues that came up was why the default option is thirty years anyway. One commenter asked why not forty? Why not fifty?
I think there are two good reasons why thirty years is the default mortgage length, and I will address both, but my primary focus will be the second one.
The first reason is that thirty years is a reasonable proxy for a working career. Get out of school, get a job and save up for a few years and buy your first home in your late twenties or early thirties. A thirty year mortgage would then be paid off around your 60th birthday, which is when many people hope to retire. A forty year mortgage would not be paid off until you are in your 70s, which is not realistic for most people.
The second, and more interesting, reason is that the benefit from extending the mortgage term drops off quickly after 30 years, as shown in the following chart. which uses $100,000 as the loan amount and an interest rate of 6%.
I/O is an interest only loan, which is mathematically equivalent to an infinite term loan. It sets the floor for the lowest possible payment for a given interest rate. One thing to note is that lenders typically charge a higher rate the longer the term of the loan. This next chart shows what happens when the interest rate is 1/8th of a point higher for each additional five years of term (starting at 6%) for a fifteen year loan. This shows that the benefit from extending the loan is even smaller as you get out past thirty years.
I think these charts illustrate that the selection of 30 years is not an accident, and is based on a balance between a low payment and a reasonable term. After thirty years, there simply is very little benefit to extending the term, especially if you have to pay a higher rate for doing so.
As a borrower, what should you do? In general, I agree with No Debt Plan – unless the interest rate is significantly lower for a fifteen year loan, go with the thirty and commit to paying the difference in extra payments to pay off the loan faster. That way you still may be able to pay off the loan in fifteen years, but if a financial emergency strikes, you have the flexibility of a lower payment. However, if you don’t think you will actually pay extra, it may be wise to get a fifteen or twenty year mortgage, so that you are forced to pay it off more quickly.
What do you think? Does taking a thirty year loan with the intention of paying it off more quickly just set you up for failure? Is it better to commit to a quicker payoff, since that commitment will make it more likely that you actually do it?
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Comments
Thanks, NDP. I really enjoyed that article, so I am glad I was able to take it in a different direction while still focusing on the original topic.
“Is it better to commit to a quicker payoff, since that commitment will make it more likely that you actually do it?”
I think yes; there are some economic articles specifically related to this and I’ll try and find them. Anytime you have an option to cheat, you’re going to. Whether it’s diet/exercise or paying off your credit card in full every month, etc.
Am I wrong to think that 30 years may be the default (instead of n>30) because of expected interest rates? The long bond is the only predictor I know of long-term interest rates and it only goes 30 years out.
But didn’t we stop selling the long bond for a while in the 1990s? I thought we did because of the budget surpluses. Even when that was going on, they were able to make a market in 30 year mortgages, so I wouldn’t think that alone could explain it, but it might provide part of the answer.
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