Refinancing homeowners may be attracted to 20-year loan terms, but these loans can also be valuable for homebuyers who want to save money and build equity more quickly.
"Loans with 20-year terms are more popular with refinances than purchases," says Joel Kan, director of economic forecasting for the Mortgage Brokers Association in Washington, D.C. "Less than 1 percent of purchase applications were for loans with 20-year terms, compared to 7 percent for refinances."
Twenty-year loans have declined a little in popularity for refinances, down from 8 percent in April 2014 compared to one year ago, but the share of 20-year loan applications has remained the same for buyers, according to Kan.
At Quicken Loans, 20-year mortgages represented about 6 percent of all loans in 2013 and are equally popular with move-up buyers and refinancing homeowners, says Bob Walters, chief economist for Quicken Loans in Detroit. He says few first-time buyers opt for a 20-year term because the payments are higher than a 30-year loan.
Cameron Findlay, chief economist for Discover Home Loans in Irvine, California, says 20-year loans, primarily used for refinancing, are about 10 percent of their loan production.
Why choose a 20-year term
"The benefits of a 20-year term are that you pay down your principal more quickly and build your equity faster, which is great if you have to sell your home," says Findlay. "The interest rate is a little lower than a 30-year loan, and because you repay the loan over a shorter term you pay a lot less in interest."
The difference in the mortgage rates between a 20-year and a 30-year loan varies, but averages about one-quarter to one-half of 1 percent, says Walters. For example, on a $200,000 30-year fixed-rate loan at 4.5 percent, you would pay $164,813 in interest, but with a 20-year loan at 4.25 percent, you would save $67,580 in interest along with 10 years of payments. However, your monthly payment will be $225 higher.
Qualifying for a 20-year loan
Qualifying for a 20-year loan requires documentation of your income and assets and similar credit score requirements to a 30-year mortgage, but you will have to factor in the higher payments to make sure your debt-to-income ratio doesn't exceed 43 percent.
If you find that the payments on a 20-year loan will stretch your budget too much but you still want to pay off your mortgage faster, you have several alternatives. Findlay recommends making biweekly payments.
Alternatives to a 20-year loan
For example, if you have a $200,000 30-year fixed-rate loan at 4.5 percent your mortgage principal and interest payment would be $1013 per month," says Findlay. "If you split that into $506 biweekly payments you'll save $28,000 in interest over the life of the loan and shave off about 53 months of payments.
"At Quicken Loans, customers can choose their own loan term from 8 to 30 years.
"Choosing a different loan term can be a psychological as well as a financial decision," says Walters. "Our most popular term for refinancing baby boomers is the 8-year loan because they want to pay off their house before they retire, but the second most popular loan term is a 29-year loan. The payment is about 50 cents a day higher than a 30-year loan and yet you shave off a year of mortgage payments and save $7000 in interest on a $200,000 mortgage."
The important thing for consumers to realize is that they don't have to stick to a 30-year or 15-year loan and that they can match their loan term to the payment that fits their budget, says Walters. He says borrowers should always be careful not to lock themselves into a payment that's too high, especially if they lack cash reserves.
If you're not ready to refinance or don't want to pay closing costs, you can essentially make your mortgage any term you want with HSH.com’s "It's My Term" calculator. Plug in your loan amount and test out the impact of sending extra money to your lender until you find the sweet spot where the monthly payments and loan payoff date meet your needs.