by Michael Totten

Created on: March 01, 2011   Last Updated: March 02, 2011

A term mortgage is a mortgage that is amortized over a fixed period of time of up to 40 years. "Term" refers to the length of the mortgage agreement. In most cases, "term mortgage" is only used to refer to mortgages which are amortized over 25 years or more, but which have a term of 5 years or less. These mortgages are also known as short-term mortgages or balloon payment mortgages.

Short-term mortgages are usually negotiated for terms of between 6 months and 5 years, and are usually amortized over 25, 30, 35, or 40 years. During this period of time, the interest rate is fixed. However, some term mortgages may offer introductory teaser rates and then raise the interest rate later.

At the end of the mortgage term, the balance of the principal is due. At this point, the buyer may pay off the balance in full. Alternately, the buyer may choose to refinance the mortgage, which usually means another term mortgage.

Most buyers choose short-term mortgages when they expect interest rates to fall. That way, they are only locked into the higher interest rate for a few years, rather than for the entire amortization period. As a result, they may end up saving thousands of dollars in interest. However, if interest rates rise instead, the current lower interest rate expires at the end of the mortgage term, and the buyer will have to negotiate the new mortgage at the higher interest rate.

Another reason to choose a short-term mortgage is if the buyer expects to sell the house soon. For example, a long-term contract employee may choose to buy a house or condo instead of renting, then sell it at the end of his contract when he plans to move away. In the mid-2000s, a common reason for choosing a short-term mortgage was to cash in on rising real estate values.

Prior to 2007, many term mortgages were not amortized at all. Instead, mortgage payments only covered the interest over the period of the term. At the end of the mortgage term, the principal was due in full as a single balloon payment, which many buyers expected to meet by selling the house for a higher price than the purchase price.

Some of these mortgages were even based on negative amortization, where the scheduled payments over the term of the mortgage covered less than the interest. Teaser rates often create an equivalent situation over the first year of the mortgage. In both cases, payment shock is likely.

These practices contributed to the severity of the real estate crash in 2007. As a result, they have become much less common in recent years.

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