Pay it off or take it easy? The mortgage term dilemma facing first-time buyers

I MET an individual recently who was aged 32 and he had just gone sale agreed on a property he was buying with his partner.

They had loan approval in place in the amount of €279,000 and his query was, what term should they arrange their mortgage over?

A 25 year term they thought was fine right now but should they take into account any future unknown expenses like having kids and play it safe and go for a longer term with lower monthly repayments or should they just ignore the what if scenarios that were playing around in their head and just proceed ahead with the shorter term.

And if they did run with the 25 year term, I calculated that the mortgage monthly repayment would account for about 21% of their current net monthly income which I thought was well below what I would consider an acceptable percentage.

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Which meant I thought they had plenty of room to account for any future expenses that may come their way but it was reassuring for him to hear this from someone else.

Their gut was telling them they would be fine but there were relatives and friends telling them to take things easy and choose a longer period of time and why were they putting themselves under pressure with a shorter term?

But they were under no pressure with a 25 year term anyway and they could, if they wanted to, even stretch to a 20 year term but 25 years for sure was absolutely fine.

I still wanted to run the numbers for them so we put the monthly repayment costs alongside each other over two different time periods, and it looked something like this:

€279,000 at 4.15% over 30 years = €1,356 per month
€279,000 at 4.15% over 25 years = €1,496 per month

The difference between both from a cost per day perspective was just €4.60. So, could they afford to pay €4.60 more every day to have a mortgage term which was 5 years shorter? And the answer was they could.

I wanted to put two more figures in front of them to confirm they were making the right decision and that was to look at what the total interest cost would be over the two different terms and this is what I found:

€279,000 at 4.15% over 30 years = total interest payment of €209,242
€279,000 at 4.15% over 25 years = total interest payment of €169,761

So, another way of looking at this is that over 30 years the average daily interest cost would be €19.10 whereas over 25 years it would be €12.03, so they would end up paying €7.07 less in interest payments each day because their mortgage is 5 years shorter.

And the decision about how long your mortgage term should be, isn’t only based on what monthly repayments are going to be or what the total interest paid will be either. The term can also influence things like when you can retire, what your current monthly cashflow will look like, how much you can save and so on.

So, the decision on the length of a mortgage term shouldn’t be taken lightly and it’s something you want to get right and give a lot of thought to. And choosing a mortgage term is an area that I think is often overlooked particularly by first time buyers. They’re more concerned about interest rates and who is offering the best rate and whether they should choose a fixed or a variable rate or a combination of both, and they’re absolutely right to be thinking about these things.

They find it hard to get past just comparing one lenders monthly repayment against another’s and sometimes they can discount the shorter term because they believe the monthly repayments would be too much for them, so they default to the longest term possible. And they do so, without even giving the shorter term a chance.

But I think if you’re taking on such a big commitment, which a mortgage clearly is, it’s certainly worth spending a little bit of time finding out what the difference of say a mortgage term of 20 years is, versus a term of 25 or even 30.

What impact would having 60 or 120 fewer or greater monthly repayments, have on your present and future finances?

If I go back to the young man I was telling you about at the beginning of this article, he now knew what the difference was going to be in terms of monthly repayments and what the total interest repayments over a 25 or 30 year term were going to be, but there were some other numbers I wanted to put in front of him. And the first was €29,920.

This is what the annual gross cost of servicing a mortgage over a 25-year period was going to cost this couple. That’s the amount they had to earn each year to service the monthly repayment of €1,496. Don’t forget, mortgage repayments come from after tax income.

The advantage of having no mortgage means in this instance someone who’s mortgage comes to an end after 25 years, could earn €29,920 less each year for five years, than someone who chose a 30-year term. Which means they could pivot and change careers, or they could earn or work less because they have no more mortgage repayments to make or worry about.

The next number I wanted to reveal to them was 57. The average age of a first-time buyer I think is 35 and they were 32. So ,if they took out a mortgage for 25 years, they’d be mortgage free at age 57, rather than being 62 if they chose a 30 year term.

Even just saying and hearing they’d be mortgage free in their 50’s sounds a lot better than saying, mortgage free in their 60’s. The next number I wanted to tell them about was €165,283.

And that was the amount they would add to their pension fund for those 5 years they aren’t paying a mortgage anymore. Those mortgage repayments could be directed to a pension fund and when tax relief is included they are turning €1,496 into €2,493 and when you add annual returns of 4%, you’d end up with a fund of €165,283.

The next number was €6,611 and that was the extra annual amount they would be in receipt of each year in retirement, from diverting the amount they had previously being paying on their mortgage, to your pension funds i.e. €165,283 x 4% = €6,611.

The next number was €9,294 and this number is the difference between they’d owe in year 5, based on a 25 and 30 year term.

If they chose a 30-year term, in year 5 they’d still owe c. €252,955 whereas with a 25 year term, the amount outstanding would be c. €243,661.

So, they can build equity in their home much faster if they choose a shorter term and they are also protecting themselves should the property fall in value. And both are important considerations particularly if this property isn’t going to be the first one they ever buy.

The next number was 26%. And this number is the difference between the amount of their monthly repayment being used towards capital payments in the first year of their mortgage.

With a 30 year mortgage only 29% of their monthly repayment is going towards reducing the capital whereas with a 25 year term, it’s 55%. There are advantages and disadvantages to any term you choose.

The downside to a shorter term is that your monthly repayment will be higher and your mortgage and housing related costs will account for a higher % of your income each month which could impact other areas of your finances and life i.e. you won’t have as much disposable cash while you’re paying down your mortgage over a shorter period of time.

Which means you’ve got to ask yourself, what’s more important to you from a financial perspective i.e. would you prefer to have perhaps more holidays each year and have more flexibility and wriggle room in your monthly cashflow and be able to save more which is something you might struggle to do if you’re aggressively paying off a mortgage over a shorter term?

I guess you have to figure that out for yourself and knowing the difference between different terms under some of the headings I just outlined, will hopefully help you come to that decision.

Some people are fine with putting in a tough number of years right now and are willing to make sacrifices because the sooner they are mortgage free, the more options they’ll have when they’re still relatively young.

And I guess everyone wants to become financially secure, the speed at which you get there and the reasons why and choices you make along the way, one of which is a mortgage term, is up to you.
My, non-emotional, financial gut, always tells me that it makes sense to pay off any mortgage as fast as you can.

However, if you decide to take out a 30 or 35 years mortgage, there’s nothing wrong with that either. Houses are expensive and having three or more decades to pay back the amount you borrowed along with interest is a necessity for most particularly when you consider other life events that may happen along the way i.e. marriage, children and the costs associated with them, illness, career change, divorce, redundancy etc.

But, if you can stretch yourself a little and employ strategies like a regular monthly or annual lump sum overpayment, along with how frequently you repay your mortgage, you could start off with a 30 year term but end up with a 20 year one.

Liam Croke is MD of Harmonics Financial Ltd, based in Plassey. He can be contacted at liam@harmonics.ie or www.harmonics.ie