When Does It Pay to Accept a Mortgage at a Higher Rate?

A loan with a lower rate isn't always the best option.

When you're borrowing to buy a home, you want to shop around and compare interest rates to try to keep your borrowing costs as low as possible. After all, a mortgage is a large debt paid off over a long time, and if you are charged interest at a high rate, your loan could be very expensive to repay.

But while shopping for low rates is a crucial part of finding the right home loan, there are times when it makes sense to accept a higher rate.

Don't just pay attention to loan rates

Choosing a higher rate loan over one with a lower rate can make sense in circumstances where the loans have different repayment timelines.

Mortgages are offered with different payoff terms, including 15-year, 20-year and 30-year fixed-rate mortgages. Loans that have shorter payoff timelines tend to have lower rates than those with longer ones -- even for the same buyer, from the same lender. This happens for a few reasons, including the fact that there's less risk for the lender when a loan has a shorter payoff period.

So when deciding between different loan options, chances are good that you'll see the 15-year loan has a cheaper interest rate than the 20-year or 30-year and that the 20-year's rate is lower than the 30-year.

You'll also notice that the loans with the shorter payoff times have much lower total interest costs over time. This happens because of the reduced rate but also because you won't pay interest for nearly as long of a time. If you pay interest for an extra 15 years or an extra 10 years, you'll always end up with higher total borrowing costs -- especially if your loan also comes at a higher rate.

Say for example, you are borrowing $200,000 and you have to choose between these two loans:

• A 15-year mortgage at 2.323%
• A 30-year mortgage at 3.072%

The 15-year loan has a much lower rate, and your total interest costs over time would be much lower. You'd pay a grand total of $37,056 in interest. The 30-year loan, on the other hand, has a higher rate and you're paying interest for longer so your total costs would be $106,358.

While the 15-year loan seems like the better deal, your monthly principal and interest payments on that loan are $1,317 compared with $851 on the 30-year loan. Such high payments could make your loan unaffordable.

Which loan term is right for you?

While those low-interest loans with short payoff times seem good when you look at rates and total costs, you also have to look at monthly payments. And typically, because you are making so many fewer payments, each one must be a lot higher.

And those high monthly payments are a big reason why it can pay to accept the higher rate loan with the longer payoff time. If you don't, you're going to be committing a lot of money to your monthly mortgage payment -- perhaps more than you want to.

With mortgage rates very low right now, even for 30-year loans, choosing a loan with a short payoff time may not make sense, even if it does come with rock-bottom rates. You could likely earn a much better return on your investment by putting extra money into the stock market rather than devoting extra money to a mortgage payment that's hundreds of dollars more per month.

So when you compare loans, be sure to look not just at which loan is offering the lowest rate, but at the big picture of the entire loan. Chances are good that you'll find a loan with a longer term is a better fit, even if it does mean that your interest rate isn't the lowest it could possibly be.