June 29, 2018
June 29, 2018
When looking for a new home or refinancing your mortgage the number of loan options can be overwhelming. There’s conventional or FHA, fixed-rate or adjustable-rate, points or no points, and 30-year versus 15-year term?
But one of the most significant decisions you will make is the ‘term’ of your loan. More simply put, this is the number of years you will pay on your mortgage. For most people that is the decision between a 30-year or 15-year fixed-rate mortgage.
There are pros and cons to each and much of the decision comes down to your financial goals. So, let’s dig into the arguments for each.
A 30-year mortgage offers the most flexibility for homeowners because your monthly payment will be lower. Since you are financing the cost of your home (the loan amount) over a longer period of time, each monthly payment will naturally be less. The flexibility comes in because you can still pay extra on top of your minimum payments, or opt instead to pay the regular payment and put that extra money toward retirement or other investments.
Payments can be significantly higher for a 15-year mortgage compared to a 30-year. For example, a $200,000 loan at 4.250% at 30 years will cost you about $1230 a month. Whereas the same $200,000 loan at 15 years with a lower interest rate of 3.625% will cost about $1803 a month. That’s more than $573 extra a month.
(Scenarios are based on the prevailing rates and terms at the time of publication. You can always check current rates and your exact loan scenario on our Mortgage Rates & Calculator Page.)
If there is any question or stress in your mind about making the higher payment required of a 15-year mortgage, our loan officers will advise you to prioritize “flexibility and choice” and recommend a 30-year mortgage. It offers more options with your money and still allows you to make extra payments on the mortgage.
For example, you still have the option to pay off your mortgage earlier. Simply making one additional payment a year on a 30-year mortgage can typically reduce the duration of the loan to about 18 years.
If you do want to make extra payments on a 30-year mortgage, make sure your loan has no prepayment penalties.
Of course, the downside of this strategy is that the reality is that while many people say they’ll invest the difference between the 30-year and 15-year mortgage or make extra payments, few actually do.
In the real world life gets in the way and even with the best of intentions the difference often times never gets invested. Unexpected bills come up, kids, pets, or you just splurge and spend the money. Discipline is key if your stay with a 30-year mortgage, but want to pay it off early.
If you want to take advantage of the extra flexibility offered by the 30-year mortgage I recommend setting up auto payments to a retirement account or schedule an extra mortgage payment once a year.
A 15-year mortgage often has lower interest rates than a 30-year mortgage. Not only will that save you interest because of the lower rate, you’ll also pay less interest because your loan is half the length.
For example, let’s imagine a $300,000 loan, available at 3.250% for 15 years compared at 4.00% for 30 years. The combined effect of the shorter term and the lower interest rate means that your cost of borrowing for 15 years is only $79,441, compared to $215,609 over 30 years—a savings of $136,168!
The fact is, the 30-year mortgage will end up costing you nearly two-thirds more at the end of its term.
A 15-year mortgage can also be a good choice if you are nearing retirement. The sooner you pay off your loan, the sooner you’ll be debt free and in a better place financially.
A 15-year mortgage, like shorter term adjustable rate (ARMs) mortgage, can also be a savvy choice if you’re not planning on staying in your home until the loan is paid off. Since, in this scenario, you will pay less interest than people in a 30-year mortgage, you’ll put more toward principal and gain more equity in your home.
The extra amount you pay down in principal can be forced savings to be used to put a bigger down payment towards the next home.
A final rule of thumb is that a 15-year mortgage is only best if the monthly payments are about a third of your take-home pay or less. There’s no point in saving money on interest if you can barely afford to make the payments, which could lead to trouble in the future.
The bottom line really boils down to whether the significant savings in loan costs over the life of the mortgage is manageable and makes sense to meet your financial goals.