15-Year Mortgage vs. 30-Year Mortgage: An Overview
There may be a bewildering variety of mortgages, but for most homebuyers, there is practically only one. The 30-year fixed rate mortgage is practically an American archetype, the apple pie of financial instruments. It’s the path that generations of Americans have taken to homeownership.
But many of these buyers might have been better served had they opted for a 15-year fixed rate mortgage instead.
The loans are structurally similar – the main difference is the term. While a 30-year mortgage can make your monthly payments more affordable, a 15-year mortgage generally costs less in the long run.
Key points to remember
- Most homebuyers choose a 30-year fixed rate mortgage, but a 15-year mortgage may be a good choice for some.
- A 30-year mortgage can make your monthly payments more affordable.
- If the monthly payments on a 15-year mortgage are higher, the cost of the loan is lower in the long term.
Impact of Mortgage Terms on Cost
A mortgage is simply a special type of term loan – a loan secured by real estate. For a term loan, the borrower pays interest calculated on an annual basis on the outstanding balance of the loan. Both the interest rate and the monthly payment amount are fixed.
Since the monthly payment is fixed, the part that will pay the interest and the part that will pay the principal change over time. In the beginning, as the loan balance is very high, most of the payment is made up of interest. But as the balance decreases, the interest share decreases and the principal share increases.
A short-term loan means a higher monthly payment, which makes the 15-year mortgage seem less affordable. But the shorter term makes the loan cheaper on several counts. In fact, over the life of a loan, a 30-year mortgage will end up costing more than double the 15-year option.
Because 15-year loans are less risky for banks than 30-year loans – and because it costs banks less to make short-term loans than long-term loans – a 30-year mortgage is usually with a higher interest rate.
Mortgage over 30 years
In the case of a 30-year mortgage, of course, this balance shrinks much more slowly – in effect, the homebuyer is borrowing the same amount of money for more than twice as long. In fact, the term is more than twice that of a 30-year mortgage, because the principal balance doesn’t decline as quickly as a 15-year mortgage.
The higher the interest rate, the greater the difference between the two mortgages. When the interest rate is 4%, for example, the borrower is actually paying nearly 2.2 times more interest to borrow the same amount of principal over 30 years as a loan over 15 years.
The main advantage of a 30-year mortgage is the relatively low monthly payments. And while affordability isn’t an issue, there are other benefits..
- The lower payment may allow a borrower to buy more home than they could afford with a 15-year loan, since the same monthly payment would allow them to take out a larger 30-year loan.
- The lower payment allows the borrower to build up savings.
- The reduced payment frees up funds for other purposes.
90%
The percentage of homebuyers who chose a 30-year fixed rate mortgage in 2019, according to Freddie Mac.
15 year mortgage
Consumers pay less on a 15-year mortgage – between a quarter of a percent and one percent (or point) less, and over decades, it can really add up.
The government-backed agencies that underwrite most mortgages, such as Fannie Mae and Freddie Mac, impose additional fees, called loan-level pricing adjustments, that make 30-year mortgages more expensive. These fees generally apply to borrowers with lower credit ratings, lower down payments, or both. The Federal Housing Administration is also imposing higher mortgage insurance premiums on 30-year borrowers.
“Some of the loan-level pricing adjustments that exist over a 30-year period don’t exist over a 15-year period,” says James Morin, senior vice president of retail lending at Norcom Mortgage in Avon, NY. Connecticut. Most people, Morin says, build those costs into their mortgage as part of a higher rate, rather than paying them outright.
So imagine a $300,000 loan, available at 4% for 30 years or 3.25% for 15 years. The combined effect of the faster amortization and the lower interest rate means that a loan for just 15 years would cost $79,441, compared to $215,609 over 30 years, almost two-thirds less.
Of course, there is a catch. The price of saving so much money over the long term is a much higher monthly expense: the hypothetical loan payment over 15 years is $2,108, or $676 (or about 38%) more than the monthly loan over 30 years ($1,432).
For some experts, being able to afford to pay more means setting aside a reserve for bad weather. What many financial planners like about the 15-year mortgage is that it’s actually a “forced saving” in the form of participation in an asset that normally appreciates (well that, like stocks, the value of houses goes up and down).
If an investor can afford the higher payment, they should opt for the shorter loan, especially if they are approaching retirement when they will be dependent on a fixed income.
Special Considerations
In some cases, the borrower may be encouraged to invest the extra money spent each month on a 15-year mortgage elsewhere, such as in a 529 account for college tuition or in a 401(k) plan. ) tax-deferred, especially if the employer matches the borrower’s contributions. And with mortgage rates this low, a savvy and disciplined investor could opt for the 30-year loan and put the difference between the 15-year and 30-year payments into higher-yielding securities.
Continuing with the previous example, if the monthly payments for a 15-year loan were $2,108 and those for a 30-year loan were $1,432, the borrower could invest that difference of $676 elsewhere. The calculation of the envelope consists of determining whether (or how much) the return on the outside investment, less the capital gains tax due, exceeds the interest rate of the mortgage loan, after deducting mortgage interest. For someone in the 24% tax bracket, the deduction can reduce the effective mortgage interest rate by, say, 4% to 3%.
Basically, the borrower wins if the after-tax return on the investment is greater than the cost of the mortgage minus the interest deduction.
This scheme, however, requires a risk appetite, according to Shashin Shah, a certified financial planner in Dallas, Texas, because the borrower will have to invest in volatile stocks. “Currently, there are no fixed income investments that would produce a high enough return for this to work,” says Shah. This risk might not always pay off, if it coincides with the type of stock market crash that has occurred during the COVID-19 pandemic. It also takes the discipline to consistently invest the equivalent of those monthly spreads and the time to focus on investments, which most people lack, he adds.
Lenders require private mortgage insurance when the down payment is less than 20% of the home’s value.
The best of both worlds
Obviously, most borrowers also can’t – or at least think they can’t – afford the higher payments demanded by a 15-year mortgage. But there’s a simple solution that delivers a lot of the savings from a shorter mortgage: Just make the higher payments of a 15-year term on your 30-year mortgage, assuming the mortgage has no prepayment penalty.
The borrower has the right to allocate the additional payments to the principal, and if the payments are regular, the mortgage will be paid off in 15 years. If deadlines are tight, the borrower can always revert to the normal, lower payments of the 30-year schedule.
Choosing between a 30-year or 15-year mortgage affects your finances for decades to come, so be sure to weigh the pros and cons before deciding on the best option. If your goal is to pay off the loan faster and you can afford higher monthly payments, a 15-year loan might be a better choice. In contrast, the lower monthly payment on a 30-year loan can allow you to buy a bigger home or free up funds for other financial goals.
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