Should you use a 15- or 30-year mortgage loan? Which one is better for your particular situation? These are common questions among home buyers and homeowners alike. In this financing tutorial, we will examine the pros and cons of using the shorter 15-year mortgage, versus the longer (and more popular) 30-year fixed-rate home loan.
The pros and cons can be summarized in a couple of sentences: You’ll have a larger mortgage payment with a 15-year versus a 30-year, for the same amount borrowed. But you could also save a lot of money in total interest costs over the life of the loan. This is true whether you are buying or refinancing a home. So it’s important to consider the long-term costs, and not just the size of the monthly payment.
There are two reasons why you would pay less interest with a shorter-term loan:
- Borrowers who use the 15-year fixed-rate mortgage (FRM) usually end up with a lower interest rate, compared to borrowers who use the more popular 30-year loan. So you could pay less in interest each month, if you choose the shorter-term product.
- With a 15-year mortgage, you are also paying interest for a shorter period of time because the repayment term is shorter.
The shorter payment term, combined with the lower interest rate, could reduce your total interests costs by tens of thousands of dollars — or even hundreds of thousands. This is the primary appeal of using a 15-year versus a 30-year mortgage to buy or refinance a home. Which one is better for you? Consider the following…
With a 15-Year Mortgage, You’ll Pay Less Total Interest
If you choose the shorter loan option, your mortgage will amortize (or reduce principal) over a shorter period of time. This will greatly reduce the total amount of interest you pay on the loan. Remember, you are paying interest on every one of your monthly payments. So when you spread those payments out over a longer period of time, you end up paying more money in total interest costs.
The table below shows the difference in cost between a 15-year and 30-year mortgage loan. Notice that the amount being borrowed is the same in both scenarios ($250,000), while the terms are different.
Explanation: The 15-year fixed-rate mortgage typically has a lower interest rate than its 30-year counterpart. The size of this “gap” varies, but it’s usually somewhere between half a percentage point and a full percentage point. In the example below, I used the average rates reported by Freddie Mac at the time of publication (summer 2014).
|Details||15-year loan||30-year loan|
|Total Interest Expense||$70,152||$200,684|
In the example above, you’ll notice the 15-year fixed mortgage has a lower interest rate than the 30-year loan. This is typical. But the monthly payment is still higher on the 15-year loan, because you are essentially cutting the payback period in half. That’s the primary disadvantage of using the shorter-term product. You will have a larger monthly payment than you would if you used a 30-year loan.
But you will only be paying interest for 15 years versus 30 years, so the total amount of interest will be significantly lower on the 15-year fixed mortgage. As you can see in the example above, there’s a huge difference in the amount of interest paid over the terms of these two loans. By using the shorter-term product, this borrower would save more than $130,532 when compared to the longer term.
All of this assumes that you will keep the loan for the full 15 or 30-year term, which is rare these days. So you have to think about your long-term plans, along with everything else.
With a 30-Year Loan, You’ll Reduce Your Monthly Payments
Can you afford the larger payment that will result from a shorter repayment period? That’s the first question you need to ask yourself, before using a 15-year mortgage to buy or refinance a home.
It’s basically a matter of priorities and affordability. What is your number-one priority, where your mortgage loan is concerned? Do you want to (A) reduce the monthly payment as much as possible; or (B) reduce the total amount of interest paid over time, and pay off the loan sooner?
- If you want to minimize your monthly payments, you should consider using a 30-year fixed-rate mortgage. You’ll pay a higher interest rate than you would with a 15-year loan. But you’ll also spread your payments out over a longer period of time, thereby reducing them. The table above shows how this can result in a lower monthly payment, even with the higher rate.
- On the contrary, if you can afford the higher payment but want to pay off the debt sooner, you should consider the 15-year product. This strategy could greatly reduce the total amount of interest you pay over the life of the loan.
Melissa Cohn, president of the Manhattan Mortgage Company, describes the ideal candidate for a shorter term: “It’s people who are established in their residences and are not going to be moving and are comfortable in their income stream.”
Summary and Conclusion
Let’s sum up the key points discussed in this article. Using a 15-year versus a 30-year fixed-rate mortgage (FRM) has certain pros and cons. You will have a larger monthly payment than you would with a longer-term loan. But you could also save a lot of money in interest costs, especially if you remain in the house for the full 15-year term. This is the number-one reason people choose a 15-year loan over a 30-year term when purchasing or refinancing a home.
Think about your long-term plans and your financial priorities. Are you most concerned with minimizing your monthly payments, or paying less interest over time? How long do you think you’ll keep the loan? This will help you decide which product is a better choice for you.