Shopping for a new home can be fun. You get to drive around town, check out different homes, and decide what will work best for you. Shopping around for a mortgage? Slightly less fun.
But, still, it’s what you need to do if you want to make sure you’re getting the best possible deal on your mortgage. The shopping-around process comes with lots of different choices. You’ll need to choose a lender, decide on your down payment amount, and choose whether or not to buy points. But one of the biggest choices you’ll make is on your mortgage term.
The term is how long you’ll pay on the mortgage if you don’t make any extra payments. While lenders offer loads of different terms, the most common are still the old stand-bys: 15 years and 30 years.
Some home-buyers (or those looking to refinance) see the interest on a 15-year mortgage and assume that’s the way to go. After all, who wouldn’t want to make payment on their mortgage for 15 years less?
But then they see the higher mortgage payment, and think, Wait, maybe this isn’t what I want to do.
Actually, both options have pros and cons. Let’s lay them out here. Then we’ll talk about some situations in which each option might be appropriate.
Pros and Cons of 30-Year Mortgages
The federal government standardized the 30-year mortgage during the Great Depression. The idea was that borrowers would pay off their mortgage before retirement when their earning potential disappeared.
These mortgages are still the norm for the majority of home buyers. However, they’ve always had some disadvantages. And those disadvantages have increased as housing has become proportionately more expensive, and as homeowners have stopped staying in a single home for more than 30 years.
Advantages of 30-Year Mortgages
1. It’s safe and predictable
The primary reason 30-year mortgages are popular is that they’re safe and predictable for home buyers. When you’re paying off your home over 30 years, you’ll generally have a lower payment. This makes it easier to ride waves of economic turmoil, job loss, medical issues, and other unexpected financial issues without putting your home at risk.
2. It ties up less of your budget
Depending on the size of your mortgage and the interest rate difference, a 30-year mortgage could cost significantly less per month than a 15-year option. This plays into the first advantage of a 30-year mortgage. They’re cheaper per month, making it easier for you to lower your payment.
3. You may be able to borrow more
Your debt-to-income ratio is one of the major factors lenders use when determining how much to lend you. This means how much you pay in debt each month versus how much income you bring in. Since a 30-year mortgage payment is relatively smaller, you have more wiggle room and can likely afford a larger mortgage. This can get you into a larger, nicer home or a home in a more expensive area.
4. Investors can work it to their advantage
Mortgage interest rates are still pretty low these days. Say you get a 5% mortgage interest rate but could earn an average of 8% through investing. You can invest the money you save each month by locking in a lower mortgage payment. Over time, you could easily out-earn the additional interest you’re paying on your mortgage.
5. You can always pay it off more quickly
With the additional budget flexibility of a 30-year mortgage, you can always decide to make extra payments. If you come into some extra money or get a raise, put the money towards your mortgage payments. You’ll pay it down more quickly, and pay much less interest over time. But if you don’t have extra cash, you’re not locked into that higher payment amount.
Disadvantages of 30-Year Mortgages
1. Interest rates are higher
Longer mortgage terms are a relatively higher risk for lenders. That means they’ll charge higher interest on a 30-year mortgage versus a 15-year mortgage. Sometimes the difference is significant.
As of this writing in August 2017, I could get a 30-year mortgage on a $100,000 mortgage for about 4.288% with a decent credit rating. A 15-year mortgage would cost more like 3.555%. That doesn’t seem like a big difference, but later we’ll look at exactly what that means.
For current rates, check out this table:
2. It costs a lot of interest over time
Again, we’re going to do the math on this in some examples below. But know that the higher interest rate stretched over a payment period that’s twice as long means 30-year mortgages cost a lot in interest. It’s not unusual to pay twice as much as the original principal amount by the time your mortgage term is over.
3. You’re stuck with mortgage payments for longer
Even if you make extra payments on your 30-year mortgage, you probably won’t pay it off 15 years early. So you’ll be stuck making those minimum mortgage payments for up to twice as long. If you’re less than 30 years from retirement, this could pose a serious problem!
4. You’re more likely to pay additional fees
Again, remember that 30-year mortgages are riskier for investors. Many are government-backed to give lenders some additional peace of mind. Because of this additional risk and need for more backing, these loans often come with additional fees, either upfront or paid on a monthly basis. That can eat into some of the monthly payment difference between a 15-year and a 30-year mortgage.
5. It takes much longer to build equity
With a 30-year mortgage, it’ll take much longer for your loan principal to decrease. Smaller payments and a higher interest rate mean less of your payment goes towards principal each month. This can be especially problematic if you plan to sell the house in the near future, as it’ll take you longer to make a profit on the home. Depending on your down payment amount, this may also mean that you pay private mortgage insurance (PMI) for much longer.
Pros and Cons of 15-Year Mortgages
Although most consumers still opt for a 30-year mortgage, the 15-year option is popular among the financially savvy. This may be especially true if you live in an area with more affordable housing options. When you aren’t spending a fortune on housing, you can more easily afford to take advantage of a shorter mortgage term.
Wondering what’s so great about a 15-year mortgage? Or why in the world someone wouldn’t take advantage of this option? Here are its pros and cons:
Advantages of 15-Year Mortgages
1. They have a lower interest rate
As I mentioned in the example above, 15-year mortgage rates are lower than 30-year rates. The difference may not seem like much. But well look in a moment at how just a percentage point can make a huge impact over time.
2. You’ll save a lot of interest over time
This one is kind of a no-brainer, but it still needs to be said. Because a 15-year mortgage has lower interest, to begin with, and gets paid down more quickly, you’ll save a load of interest. This is, of course, if you only make the minimum payments over time. Again, examples are coming soon.
3. You’ll pay down your principal more quickly
Since you’re paying less in interest and making larger payments, you’ll build up equity in your home a lot more quickly. This can be helpful if you’ve started off with a low-down payment. You can build up 80 percent equity and get rid of those pesky PMI payments much more quickly. Building equity more quickly is especially helpful if you’re planning to move in the next few years.
4. You’ll be mortgage-free 15 years or more sooner
Obviously, there’s something to be said for becoming mortgage-free sooner, even without making extra payments. Sure, maybe you don’t save quite as much for retirement while you’re paying down your mortgage. That does mean you’ll miss out on a few years’ worth of compounding interest payments. However, you could easily be mortgage-free decades before retirement, which is a huge advantage.
Disadvantages of 15-Year Mortgages
1. They’ll tie up more of your monthly budget
With their higher payment, 15-year mortgages can be relatively riskier. In the event of financial instability, you may find it more difficult to pay your mortgage. And even when you are financially stable, the mortgage payment will take more money that you could devote to other items, like saving, investing, or paying down higher-interest debt.
2. So you’ll have less left over for saving or investing
If you’re otherwise in good shape with debt, the primary disadvantage of a bigger mortgage payment is that you won’t have as much to invest. As we noted earlier, with interest rates so low, investing extra cash may be a better move than paying off your mortgage more quickly.
3. You’ll likely have to buy a less-expensive home
Since your payments will be higher, you’ll be locked out of more expensive mortgage options. This means you’ll either need to bring a larger down payment to the table, or you’ll wind up in a less-expensive home.
Examples of Interest Over Time and Amortization
The points above can largely seem abstract until you see them in action. So let’s look at how the differences in payments, interest amounts, and amortization work over time with 15- and 30-year mortgages.
Note: For purposes of this example, we’re using estimated interest rates from our mortgage rates calculator. These examples are for a consumer with a 700-719 credit rate and are current as of August 16, 2017. Your situation may vary.
First, let’s look at just how big a difference there is in payments between these two options. We’ll use two scenarios throughout this section, just to keep things consistent. One is for a $150,000 mortgage, and the other is for a $300,000 mortgage.
On a $150,000 mortgage, you the example home buyer could expect to pay around 3.808% interest on a 30-year mortgage. This leads to a $913 per month payment (not including property taxes or insurance). On a 15-year mortgage, the buyer would pay 3.486% interest with a $1,054 per month payment.
That’s a payment difference of just $141 per month.
The differences are amplified on a larger mortgage, though. On the $300,000 mortgage, the home buyer could expect to pay 4.408% interest on a 30-year mortgage. That’s a $1,607 payment. On a 15-year mortgage, the interest drops to 3.422%, but the payment skyrockets to $2,108.
That’s a payment difference of $501 per month.
Differences in Interest Over Time
Not only do the payments differ between these two options, but the total interest you’ll pay over time also differs dramatically. Here’s what you can expect on these four loan options if you make only minimum payments, using this calculator:
|Mortgage Term||Original Principal||Interest Rate||Total Interest|
Differences in Amortization
Amortization is how a loan gets paid off on a set repayment schedule with a fixed interest rate. As your loan amortizes, you’ll build up equity in your home. That means that you own a larger percentage of your home, compared with what the bank owns through your mortgage.
In each of these examples, we’ll assume that you put 10 percent down on your home, meaning you start out with 10 percent equity. We’ll use the exact mortgage and interest amounts from the examples above. Well check-in on the loan’s principal balance after one, three, five, and ten years. Check out the table below for the results, which are from this calculator*:
|Mortgage Term||Original Principal||Balance at One Year||Balance at Three Years||Balance at Five Years||Balance at Ten Years|
*Note: We removed PMI, property tax, HOA, and homeowners insurance fees from the calculation, just for simplification purposes.
Related: How to Buy Your First Home
A Few Scenarios
Now that you’ve seen how these scenarios play out, you probably have a better idea of which mortgage option would be best for your needs. But let’s look at a few specific situations, as well, that might affect your ultimate decision.
Lots of Other Debt
If you have a lot of other debt, you’ll already be constrained in your ability to get a mortgage. As I mentioned above, lenders look at your total minimum monthly debt payments versus your total income. If that ratio is too high--usually above 30 percent, including the new mortgage payment--you may be out of luck for a loan.
But in some cases, it does make sense to buy even while you’re trying to pay off other debts. For instance, if homeownership is significantly cheaper than renting in your area, buying might put you on better financial footing.
However, you’re going to need the smallest possible mortgage payment. In this case, you’re likely better off finding the cheapest home that will work for you. Get a smaller mortgage, and finance the home for 30 years.
Use the money you’ll have saved to pay down your higher-interest debts. Then, you can consider either making extra payments or refinancing to a 15-year mortgage once you’re out of debt. This is especially beneficial as mortgage interest rates stay low.
Plans to Move in the Near Future
If you think you’ll move in the next three to five years, buying a home may not be the best option, to begin with. But maybe it does turn out to be a good choice in your situation.
However, if you want to make money on your home when you move in a short period, you’ll need to do one of three things:
- Put down a larger down payment. A bigger down payment means you start out with more equity in your home. This makes it more unlikely you’ll be underwater when you sell in a few years.
- Take out a shorter-term mortgage. As you saw in the example below, you’ll build equity in your home significantly more quickly with a 15-year mortgage. This can make it much easier to get back out of the home within three to five years without losing money.
- Buy in a rising-value area. This is a riskier proposition and one that depends partly on chance. But if you buy a home in an area where home values are increasing rapidly, you could have more equity in your home either way. This isn’t because of paying down your mortgage alone, but because the home could be worth much more when you decide to sell.
A Larger Mortgage Amount
As you can see, the 30-year versus 15-year mortgage differences are amplified by a larger starting principal. If you have a larger mortgage, you’ll need to do the math carefully. And this situation is less cut-and-dry.
That extra $500 per month is a lot, and you could invest it to out-earn the additional interest you’ll pay on a longer mortgage term. But the quicker equity build-up on this loan could also be hugely beneficial, depending on your circumstances.
Here, the most important factor is likely what mortgage you can afford. If you can easily afford the 15-year mortgage payment, even if you run into financial difficulties, you might decide to go for it. Or maybe you split the difference. Take the smaller payment on the 30-year mortgage. Then split the $500 you’ve saved between investing and paying down your mortgage a bit more quickly.
Settling in For the Long-Term
What if you’re likely to settle into this home for the next ten years or more? In this case, it’s more a matter of preferences.
You have time to build up equity, so you might opt for a 30-year mortgage and save or invest the difference. Or maybe this smaller payment just gives you budget flexibility. You can always make extra mortgage payments when you have the money, but won’t lock yourself into the higher payment rate.
On the flip side, owning your home free and clear in 15 years is an attractive idea. This can be especially true if you’re planning to stay in the home until you retire or even into retirement. Just be sure you can handle the larger payment amount, come what may.
The Bottom Line
As with all things personal finance, this is a very personal question. Neither option is inherently better than the other. The best you can do is determine what your mortgage options are, and use the calculators linked above to run the numbers for your scenario. Then, you’ll be equipped with the knowledge you need to make this important home buying decision.