Is a long-term loan really affordable?

Question: We are about to contract a long-term loan in buying our dream home. We are choosing between 15- and 30-year mortgages. We tend to favor the longer term loan because the monthly loan amortization will be more affordable. We were also thinking that with a low monthly amortization, we could save more to make advance payments on our loan or even fully pay it off. Are we correct in thinking this way? Please note that I am currently 35 years old.

Answer: To better answer your question, let us simulate a housing loan. But get your facial tissue ready as this may lead to a nosebleed.

Let us assume that you are going to avail of a maximum loanable amount of P1 million and that you had already put up the required equity. If the loan collateral value or the maximum percentage of the value of the property that a bank can lend to you is equal to 70 percent, your property would be valued at P1,428,571 (i.e. P1 million divided by 0.70) and your equity would be P428,571.

For simplicity’s sake, let us assume that there is one effective interest rate of 8 percent per annum for P1 million for the two loan terms you cited. Normally, interest rates go higher the longer the loan term is. So, given the loan terms of 15 and 30 years, the monthly amortizations will be P9,557 and P7,338, respectively. In this case, the longer loan term generates a cashflow savings of P2,219 per month.

But let us look at the total interest that you will be charged for the duration of the loan. For the loan terms of 15 and 30 years, the total interest will be P720,174 and P1,641,552. Not only will the total interest on a 30-year loan be more than double that of a 15-year one, but the former’s total interest will also amount to 164 percent of your original loan amount. The resulting numbers do not look inexpensive or affordable at all.

To your point on borrowing longer term to allow for savings to pay your loan in advance or in full prior to the loan maturity date, let us make a further assumption. Let us assume that you are targeting to save P200,000 from the lower amortizations on the 30-year loan to make an advance payment. My computations show that your cash flow savings of P2,219 per month will allow you to save a total of P200,000 only by the 30-year loan’s 90th amortization period.

The remaining interest from the 91st to 360th loan amortization periods is P1,063,543. Prepaying the 30-year loan with P200,000 on the 90th period will lower the remaining interest to P462,064, thereby leading to savings in total interest of P601,480 (i.e. forgive the rounding-off error). You will also be able to shorten the loan term to roughly 21 years, only nine years short of the original 30-year term assuming you maintain the original monthly loan amortizations.

On the other hand, you will be able to save enough to pay off your loan also in roughly 21 years. But that means you will only be able to save P225,085 in remaining interest.

Now, remember that the total interest on the 15-year loan is already lower by P921,379 than that of the 30-year loan. Plus, you get to finish your loan earlier. Moreover, promising to save is one thing; actually saving is another.

My recommendation is to go for the 15-year loan provided the resulting amortization is within 20 percent of your gross monthly household income. This way, you get to finish your loan obligation by age 50 instead of 65. You are also afforded more time to focus on other goals like a dream family vacation, retirement and even passing on your estate. Having a shorter loan term also builds the habit of saving more (to service the higher monthly payments), a habit that will serve you well throughout your life. INQ

Send questions via “Ask a Friend, Ask Efren” free service at www.personalfinance.ph, SMS, Viber, Twitter, LinkedIn, WhatsApp, Instagram, and Facebook. Efren Ll. Cruz is a registered financial planner and director of RFP Philippines, seasoned investment adviser, bestselling author of personal finance books in the Philippines and a YAMAN Coach. To consult with a YAMAN Coach, email [email protected]. To learn more about personal financial planning, attend the 98th RFP Program this October 2022. To inquire, e-mail [email protected] or text 09176248110.