One of the most important decisions you can make when shopping for a home loan is one that most home buyers don’t even think about. Should you get a 30-year mortgage, or a 15-year? A 30-year mortgage is amortized over 30 years, while a 15-year mortgage carries a lower interest rate but has much higher minimum payments because you must pay it off in half the time.
Long-Term Savings or Monthly Cash Flow?
Think of this decision as a trade-off: Do you want to pay the least amount of money over time or have the lowest payment? There isn’t one right answer for everyone. Consider these things as they relate to your own personal situation.
Can You Qualify?
A 15-year mortgage has a higher payment than a 30-year mortgage. Before you can even consider a 15-year mortgage, you have to determine if your income supports the higher payments. A competent mortgage professional should be able to tell you this.
What Would You Do With the Extra Cash Flow?
Having greater cash flow because you have a 30-year mortgage is only desirable if you know what you’ll do with the extra money. Will you invest it? Will you use it to fix up or expand your home? Will you blow it enjoy having more dinners out? If you have a purpose for the extra cash, maybe it’s a good idea even if you pay more interest in the long run.
Is Your Income Reliable?
The minimum payment for a 15-year mortgage might seem like a stretch, but you’re willing to take the chance. But is your job secure? Can you count on your current income in the future? The higher minimum payment might seem doable now, but could be terrifying if you lose your job or your income declines in the future.
How Much Higher is the Payment?
Let’s look at an example. You need a $200,000 mortgage. You can qualify for either loan.
Interest rates change over time (well, all the time), so we’ll assume that your rate on a 30-year mortgage is 5.000 percent. Your payment on a $200,000 30-year mortgage at 5.000 percent would be $1,073.64.
Fifteen-year mortgages carry less risk for lenders because they’re getting their money back faster, so they offer better rates to you than they do for 30-year mortgages.
Fifteen-year mortgages carry less risk for lenders because they’re getting their money back faster, so they offer better rates to you than they do for 30-year mortgages. That difference changes over time and is different for each lender, but on average you can expect an interest rate between 0.750 to 1.000 percent lower for a 15-year mortgage.
Let’s assume for this example that the interest rate would be 4.125 percent. Your payment on a $200,000 15-year mortgage at 4.125 percent would be $1,491.94. That is $418,29 more, or nearly 40 percent higher than a 30-year fixed! Can you afford that higher payment? Every month for the next 15 years?
How Much More Will You Pay Over Time?
In our example, you’ll pay $386,512 in total payments for your 30-year mortgage, and $268,548 for your 15-year mortgage. Does that seem like a lot? Wait. Remember that $200,000 of that is principal in both scenarios.
Let’s look at just interest. You will pay $186,512 in interest for your 30-year mortgage, and only $68,548 for your 15-year. Taking the risk of a 15-year mortgage can save you nearly two-thirds of the interest you pay over your lifetime. Yikes!
What if You Can’t Afford the 15-Year Payment?
If you can’t qualify for or commit to the higher payment without losing sleep, you have other options.
Pay a little extra on a 30-year mortgage each month. You’ll still pay the higher interest rate, but in months where you are tight on cash you can make only the minimum payment. Your risk of missing a payment is considerably reduced.
There are 20-year mortgages. The interest rate is closer to the 30-year rate than the 15-year, but you’ll still be paying it off faster than a 30-year mortgage and have a lower minimum payment than the 15-year.
Use an adjustable-rate mortgage if you are confident that you can make the higher payment, but would still like the safety of being able to make the lower payment. You will get the lower initial interest rate and can pay extra. If the interest rate rises down the road, your balance will have gone down faster, so the effect on your minimum payment will be lessened.
Lower Interest Rate and Fast Repayment = Lower Cost
The bottom line is that the lower the interest rate and the faster you pay off your loan, the lower your lifetime cost will be. There are downsides to the faster payoff and you may not qualify, but you should inform yourself and at least consider it. Being debt-free as fast as possible is a very good thing.