Pros and Cons: 30-Year Mortgage vs. 15-Year Mortgage
Published on - September 30th, 2009 (Modified on - October 5th, 2009) (by April Dykman) This post is from GRS staff writer April Dykman.
My husband and I are in the early stages of building a house. As we modify our floor plans, the amount we’ll need to borrow to build is on our minds. It’s probably going to be the most expensive thing we’ll ever purchase, and we need to decide what we want to borrow and what loan term we’ll want.
The main differences between 15- and 30-year loans are straightforward. Fifteen-year loans have higher monthly payments, but you pay less interest, while 30-year terms have lower monthly payments, but you pay significantly more for the house in the long run. As with most areas of personal finance, however, this decision is about more than just the math. There are other important considerations, such as retirement savings, risk tolerance, and discipline.
First, let’s take a look at the hard figures.
Crunching the numbers
Let’s say that a 30-year-old borrower is buying a house for $160,000, and her marginal tax rate is 25 percent. At the time this article was written, 30-year loans were at 5 percent and 15-year loans were at 4.5 percent.
Using Calculators4Mortgages’ amortization schedule calculator, we’ll compare the two mortgage terms by plugging in the mortgage amount and the 15- and 30-year interest rate.
- A 30-year term would give a monthly payment of $859 (payment does not include taxes and insurance, which vary by locale). The borrower would pay $149,211 in interest, and $309,211 over the life of the loan.
- A 15-year term would give a monthly payment of $1224. She’d pay $60,318 in interest, and $220,318 over the life of the loan.
The 30-year term lowers the monthly payment by $365 and will save the borrower $238 per year in taxes, but will cost $88,893 more in interest over the life of the loan, and she will own her home when she is 60 years old. The benefits of the 15-year term are the substantial savings in interest and the fact that she will own her home by the time she’s 45. The drawback is that her monthly payment will be higher.
The wiggle-room option
But what about the option of taking a 30-year term and paying it off in 15 years? A 30-year term paid in 15 years would yield a monthly payment of $1265. The borrower would pay $67,749 in interest, and $227,749 over the life of the loan. She’ll own her home at age 45, assuming she makes the extra payment each month. But if she fell on hard times, she wouldn’t be locked into the higher payment.
Here’s a comparison of each option:
It’s easy to see that the borrower will pay less for her home with the 15-year loan. But mortgages aren’t one-size-fits-all. There are other factors to consider when deciding what is right for you.
What can you afford?
In our example, the 30-year term works out to a monthly payment of $365 less than the 15-year term. If you couldn’t comfortably make the payment on the 15-year term, the 30-year term is the better option. You can always make extra payments when possible.
What is the state of your emergency fund?
Once you sign the loan, you’ll be expected to make the same payment each month. If you take a 15-year term with a higher payment, you should have a substantial savings account in place to mitigate the risk from major unexpected expenses or job loss.
If you don’t have much of an emergency fund, you’re better off with a 30-year term, using the extra money to build your savings.
Will you be able to meet your retirement and other savings goals?
If you’re leaning toward a 15-year term, be sure that you can still max out your retirement accounts and meet your other savings goals. If you can’t, stick with the 30-year term.
If retirement is still decades away, you are in a position to invest more aggressively. You should be able to ride out the volatility of relatively aggressive investments.
If retirement is less than 15 years away, it might be a better to pay off the mortgage early for security and peace of mind.
How do you feel about debt? What is your tolerance for risk?
Many people are strongly averse to debt of any kind — and with good reason. Dave Ramsey is firmly in this camp, saying:
Don’t borrow money. Period. If I can’t get you to postpone the purchase that long, I strongly suggest you save a down payment of 20 percent or more, choose a 15-year (or less) fixed-rate mortgage, and limit your monthly payment to 25 percent or less of your monthly take-home pay.
Managing debt isn’t easy, and for many people, Ramsey’s hardcore anti-debt stance is the way to go.
But others are in a different place in the financial journey, and are comfortable carrying mortgage debt if the borrowed funds can earn a higher rate of return somewhere else. Risk-adjusted returns need to be factored, but essentially, if you opted for the 30-year term at 5 percent, it’s reasonable to think you can earn a higher return with a portfolio of index funds. Account for the tax deductions, and the 5 percent is even lower.
While it’s certainly possible to earn a higher return elsewhere, it comes down to your appetite for risk. You might get a better return by going with the 30-year term, but putting the money toward the mortgage is risk-free. Also, you have to decide if the extra money you might gain by investing elsewhere is more important to you that the peace of mind that comes with owning your home outright.
Personal discipline
If you can afford the payments on a 15-year loan, but you’re concerned about the possibility of job loss or other major financial hits, you might be hesitant to commit to the higher payments. Another option is to take a 30-year term and pay it off in 15 years. You’ll pay slightly more in interest than with the 15-year interest rate, but still significantly less than with the 30-year loan.
The drawback is that most people lack the discipline. According to the Federal Deposit Insurance Corporation (FDIC), 97.3 percent of people do not consistently pay extra on their mortgages. Many people lack the discipline to send in the extra money every month when it’s not mandated by the bank. What this statistic doesn’t mention is how many of the 97 percent would have fallen behind on their mortgages if they were locked into a 15-year mortgage.
If you are already saving regularly and have only tapped your emergency fund for major unexpected expenses, however, you might have the discipline to pay your mortgage off in 15 years. But consumers who spend any monthly savings are better off with the shorter term, if they can afford it.
What about the tax break?
While it’s true that you do get more of a tax break from a 30-year loan, it shouldn’t be the main consideration when deciding on a term. The 30-year borrower will pay less in yearly taxes than the 15-year borrower, but that’s because the 30-year borrower is paying significantly more interest.
In our example, the borrower would save an average of $238 per year in taxes with the 30-year loan, but will pay $88,893 more in interest over the life of the loan than she would with the 15-year term.
Which is right for you?
In the end, your financial situation will determine the right mortgage term. If you can make the higher payment, have a substantial emergency fund, and can meet retirement and other savings goals, a 15-year mortgage is a good way to own the home in half the time and pay substantially less interest. If just one of those conditions is not met, or if you are somewhat comfortable with debt and risk and wish to get a higher rate of return with other investments, the money saved each month with the 30-year mortgage payment may be better used elsewhere. You can always send in extra payments.
I’m still not sure which option is for us. What about you? Do you have a 15-year mortgage or 30-year mortgage? Do you prepay? What are your thoughts on risk versus higher returns?
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We are in a 25 year loan after refinancing, we do prepay but I agree that most people lack the discipline to prepay on a mortgage (including us). While we are prepaying, we don’t prepay every month or the same amount every month.
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We split the difference. We did a 30-year fixed at 5.5% and pay a bit more every month. The exact amount varies depending on what the expenses are for the month. Basically, we set up a payment that brings the amount in our checking account down to $1000 at the end of the month. Right now, we are on schedule to pay off in 23 years.
My husband was just laid off, so extra payments will probably need to stop until our modified budget is settled. Severance pay and unemployment have not started to come in, but depending on how disciplined we are, we may still be able to pay a little extra on the mortgage.
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I took out a 35 year loan because my spouse was in school, and I’m glad we did. After school it was decided to start a business rather than going to work for someone and the lower payment has really helped our finances. Once the income becomes more stable (and hopefully much higher) then we can start doing some major over-payments to hopefully have things done in 15 years anyway. Though our house was only 102K, so it’s fairly easy to keep up with.
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“97.3 percent of people do not consistently pay extra on their mortgages. Many people lack the discipline to send in the extra money every month…”
To me, the reason the number is so high is not lack of discipline, but so that few understand the benefits of paying down loans. They get a bill from the mortgage company, an they pay it. Just like any other bill.
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I’m in the 8th year of 30 year (95/5) mortgage. I pay the higher payment each month and then, at the end of the year, pay at least an extra payment. Net result is two extra payments a year. The result is basically what you show: I’ll pay off the mortgage about 10 years early.
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We have a 40 year mortgage (got at the very end of the bubble, when that was “normal”) and in one year of payments we have brought it down to 23 years remaining. Our plan is to continue to be as aggressive as possible and bring the down the time even more.
Note: I’m in Canada, not the USA, so things work a bit differently here.
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We bought a house in March. We chose a 30 year mortgage over a 15 year so that we would be comfortable with our payments over the long haul. We are diligent savers so we plan to make a 13th payment (or pre-pay a larger chunk of money) each year to get it paid off sooner. We are very happy about the decision we’ve made to do a 30yr and pre-pay.
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We just recently made this decision. We bought a house a year ago with only 5% down (I know, not Dave Ramsey’s advice). We put a good chunk of our tax incentive to principle and pay an extra $100 every month to principle. The interest rate just got to a point where it made sense for us to refinance. We could have gone with a 15 year term and not had any increase in payment (since we were paying an extra $100 each month), but we decided to go with the 30 year term and continue to aggressively pay it off. We’re trying to get rid of PMI as fast as possible. I feel much safer knowing that I have a smaller required monthly payment should we need to tap our emergency fund.
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Very interesting timing on this post. I’m closing on my first house in about an hour.
I was right at the borderline of feeling comfortable with a 15 year loan, but in the end I decided to go with a 30 year loan and the intention of paying it off in fewer than 15 years. The reasoning was all about risk aversion. I don’t know what the rest of this year holds for me, let alone the next 15 or 30.
I feel confident in paying off the mortgage early because I’ve never carried a balance on my credit card and I’ve paid only cash for the two cars I’ve owned. My brother got into serious credit card trouble when I was very young, and it pushed me to shun the use of credit. I hate having to borrow money for this house even…
My individual situation is this: I don’t own much furniture or anything like that. So, for the first 3 – 6 months of owning, I will use all of my “extra” money to buy what I need to live. Once that is settled, and once the tax credit comes in, I’ll shift to a 15 or fewer year payment schedule.
Crossing my fingers*
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Excellent post April. Really topical and well worded.
I live in a country where rates are not as low as in the US. Typical lending rates are nearer to 11.5%, which gives differences in absolute terms that are much higher, ie 20 yr vs 30yr. Our interest rate volatility is also quite high, giving extra thought for reasons to go longer term on the home loan to ride out volatility in interest rates.
Michael (Cape Town – South Africa)
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Just did this, and decided to go with the 30 year fixed at 5% and prepay. The lower monthly requirements were the biggest factor – we knew we could still make them on one salary if we had to; not true of the 15 year payments.
We’re able to round the payment up to an easily subtracted number on our automated withdrawls. The $110 extra per month will let us pay off our 30 year mortgage in 17 years.
I totally do not get the ‘tax writeoff’ argument. If I had enough cash, I would pay off the entire debt tomorrow. At that point, I’m saving $1000/month, so who gives a *!+” about the minor tax savings?
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I bought my house in 2001 with a 30-year mortgage, which I’ve been paying extra on, not absolutely every month but pretty consistently. I’m now in the process of refinancing the remaining balance to a 15-year loan.
One thing to consider is that the taxes and insurance are variable. If your house appreciates in value, the taxes go up, and any number of things can cause your insurance to do so. So allow for a decent cushion.
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Here’s my issue. If you’re talking about the difference of 0.5% interest, I’m having a hard time understanding how it’s worth it. I know personal finance isn’t always about the math, but the math is still an important component. With high yield savings accounts even offering very low interest rates right now, you still for example would make 1.4% interest if you stuck that extra money in let’s say ING right now, and there are better and safer investments besides savings accounts than your home that could result in even better returns than 1.4%, especially when locking your money up in the long run. Plus, you preserve liquidity and flexibility that can allow you to take advantage of opportunities that come your way.
Am I missing something?
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When I told the banker I wanted to pay off the mortgage in 10 years, he tried to get me to sign a 25 year agreement. Luckily, I learned early on to read all my contracts, so I caught the amortization term he snuck in there. Using small words because I’m a girl and I was young at the time, he said the 25 year mortgage would be more prudent and I could make extra payments to bring down the amortization. After raising a single eyebrow, I told him I know my finances and I would take my business elsewhere if he didn’t change the amortization term to 13 years (I gave myself some wiggle room just in case something unplanned happened).
Fast forward three and a half years and I’m exactly 3 months from paying off the mortgage because I kept my lifestyle inflation in check and threw my annual raises at my only debt.
As a side note, the banker was a condescending, sexist jerk because he snickered and looked at me like he was indulging an imaginative child and her invisible friend when, at 23, I told him I would give him a down payment of $100k in 20 months when the construction on my home completed and I took possession.
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My mind has always been wired to think in terms of paying off a debt as fast as possible. The sooner its gone, the less interest you pay, the more secure your asset is, and the greater your peace of mind.
However this often comes at the opportunity cost of setting aside other worthwhile goals.
I’m interested to know how much inflation plays a role in how much you “pay” for your mortgage. The straight math says a 15 year mortgage saves you a ton of money, but what about the additional 15 years of inflation that you’ll benefit from with a 30 year mortgage?
With an assumed %3 rise in in inflation each year, the effective amount you’d be paying in year 30 would be 45% less than in year 15.
I haven’t found an equation or calculator yet that really takes that into consideration, but it sure makes me wonder just because I almost never hear it mentioned except in passing.
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Interesting comparison. That’s a tough choice – the 15 yr payments are a lot more than the 30 yr. On the other hand – saving 0.5% interest each year is pretty huge as well.
In Canada, the whole mortage industry is quite different than the US.
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I agree, on the terms of what you pay in interest it will always be more with the 30 year mortgage. But, we always forget to take inflation and Net Present Value of money into account when making these calculations. (Same applies to prepaying your mortgage)
Remember, a dollar today is worth more than a dollar tomorrow. Assuming inflation is 2% and you have a 5% rate on your mortgage, you’re carrying cost of the debt is really only 3% as you are using tomorrows dollars to pay off your obligation so it is cheaper for you.
Quick example:
$1800 / month payment
2% Inflation
Value in today’s $ of payment 1: $1800
Value in today’s $ of payment in year 30: $993
By spreading the payments out into the future you are actually saving yourself some money.
So what does this all mean? It means that the closer the spread is between your mortgage rate and the rate of inflation, the less sense it makes to pay off the note early.
What you have to ask yourself is this: can I get a better rate of return on the difference between my mortgage rate and the inflation rate by doing something else with my money?
My difference is ~3%, I think I can do better than that over the next 25 or so years.
Money is a resource, use it wisely.
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I have a $165,000 mortgage at 5.5% 30-year. My plans are to pay extra to the principal and hopefully be done with my mortgage in 15 years.
I like this method because, if something does happen to me or my wife or our jobs, then we can always go back to the lower monthly payments.
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The borrower would be entitled to a standard deduction of $5,700 (single) or $11,400 (married filing joint). If the borrower is married filing joint there is no incremental tax benefit as a result of the mortgage interest deduction as interest never more than $11,400.
If the borrower is single, interest payments for the first 12 months are $7,946 and $7,044 for the 30-year and 15-year mortgages, respectively (assuming loan incepts 1/1).
Thus in the first year the incremental tax benefit for the 30-year is (7,946 – 5,700 std deduction) x 25% marginal tax rate = $562. 15-year: (7,044 – 5,700) x 25% = $336.
However, the interest deduction phases out as the principal balance declines and interest expense declines. The 15-year mortgage only generates sufficient interest expense to result in an incremental deduction for the first 4 years; thereafter interest expense is less than $5,700 standard deduction. The 30-year mortgage only generates an incremental deduction for 14 years.
The total incremental tax saving for the 30-year mortgage is $4,464 (an “average” of $148 per year) and for the 15-year mortgage is $800 (an “average” of $53 per year).
This illustration obviously excludes the effect of other deductions, such as state and local taxes, that may extend the deductability of mortgage interest. However, I think too often illustrations that consider the tax benefit of mortgage interest do not consider the marginal benefit that is derived in excess of the standard deduction. Where there are other deductions, the standard deduction should be “allocated” among the deductions to determine the marginal tax benefit of the deduction. And god help you if you are subject to AMT, then it all goes out the window as a portion of your state and local taxes no longer generate a tax benefit.
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Great post! I found this really helpful as I’m thinking of getting a modest place in a year or so. (I want to beef up the emergency fund first). The discussion here is helpful too! It’s great to hear from people who are a few steps ahead of me.
I think I like the flexibility of a longer term and paying it off early. Ideally, I’d like to rent out a room and use that money to pay down the mortgage early, but I know rental income isn’t always stable.
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I think Scott has a great post, as he correctly identifies a discounting process on the value of a loan. We’d have to go further however and discount tomorrow’s payment vs. today’s (simply paying today vs. tomorrow, tomorrow is less valuable).
Scott’s conclusion is correct. As one approaches the expected inflation rate, the value of prepaying a mortgage vs. the next best use approaches 0.
It is VERY important to discount your mortgage payments using NPV calculations, something I have seen no free mortgage calculator do online.
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We have a 30-year that we’re paying like a 15. Like some others above, we went with the 30 for the risk factor – if one of us lost our job we could still pay the minimum with a single income. But while we have two incomes we’re being fairly aggressive about paying it down, while still leaving money for emergency fund, home improvements and fun.
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I would say that, if you can only afford the home on a 30 year mortgage, then you can’t afford the home.
Also, I would say that advising people to take a 30 year mortgage and pay extra would only apply to ADVANCED frugality. No, most people are not capable of comprehending the benefits of prepayment, let alone of having the discipline to follow through.
We have a 15 year mortgage at 5.5%. We have paid additional money on the principal ranging from $200/month to $500/month. Currently we are not paying additional because of underemployment.
We bought less house than we could “afford”. We only used HALF of the loan amount that we had pre-qualified for. Our realtor kept trying to push us into a more expensive house. But, because we bought something modest, we have had more money to pay extra on the principal, the ability to chose 15 year over 30 year (we would never pick 30 year), the ability to put some money into improvements around the house, and the ability to afford our mortgage when un- or under-employed.
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I would jump all over a 15-year mortgage if I could afford to–I simply can’t at the moment.
The next best thing however is to pay extra every month that I can. Sometimes its $25, sometimes its $100.
I loved the chart at the top–it really spells everything out
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Timely post to something related – Sallie Mae loan repayment documents were sent out today, indicating the monthly payment. After I picked myself up off of the floor from shock, I mused about what to do – attempt to refinance (unlikely to get a better rate today!), pay early, graduated income payments, etc. Your take-30 and pay-in-15 option sounds like the best (in the student loan case take 10 and pay in 5) for awhile.
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I think the right strategy is to get a 15-yr mortgage if you can handle the extra payments, and pay it off sooner in 10 years.
But, the more digestable strategy is to just get a 30-yr mortgage and pay it off in 15 years.
Best
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I find arguements about payment differences very basic. Anyone can say they spend less on a 30 versus a 15. Everyone should be able to say they spend more on interest on a 30 versus a 15, or they never read the loan disclosures.
An asset versus liability, or balance sheet, approach needs to be viewed when making these decisions. I liked #17s approach but #4 states clearly the behavioral side of personal spending/savings.
If one can not make extra payments or save the extra they would have been paying on a 15 versus a 30. Then they should go with a 15. This will provide more options in the future which are more valuable than going out for dinner a few more times per month or buying some other non-essential items. If your concerned about not putting dinner on the table due to a 15 year payment, buy a less expensive home!
I strongly believe in reducing your personal leverage because when your chips are down you need as many options as possible. The current economy clearly shows housing prices fluctuate. This can leave you upside down or reduce your loan to value ratios. The result could reduce your ability to borrow or sell your house. Eliminating your future options.
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we did a lot of things that other people have suggested:
1) we saved up a large down payment — enough that we did not have to have mortgage insurance added to our loan: immediate savings that we could add to our monthly payment.
2) we didn’t buy all the house we could, but we bought a house big enough for our needs, and then some — it had a “mother in law apartment in the finished basement.
3) we didn’t remodel right away (sigh, I lived with a kitchen and bathroom I didn’t like for 7 years)
4) instead, we rented out the apartment and used those funds and some of our own to
5) pay off the mortgage as soon as possible.
It’s been great. We paid off the mortgage, which made us not as interested in buying another house and going back to mortgage payments. Instead, we’ve done some remodeling (the basement apartment is gone, I now have a great library and exercise room down there and a laundry room instead of the second kitchen…) and we have a lot of savings. The house is available to us if we needed to withdraw some equity from it, and I’m not concerned about any capital we might have lost through inflation, the peace of mind/security of having the house paid for is worth it.
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Mod Casper up. I got married this year, and now my mortgage/property tax deductions go to zero because they are less than $11,400. And if we decide to file separately but married, we both have to either itemize or take the standard deduction. If you have a business or regularly itemize, then yes it’s still a good deal, but for everyone else I feel the benefits are overstated.
The tax benefits are always bandied about, but really you are paying 3 times what you are “saving.” (For example, $8,000 in interest/prop. taxes will reduce your taxable income by $8,000, netting you 25% of that: $2,000. You’ve still paid $6,000.)
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We custom built our home 12 years ago. We had a 25% down payment and used a HELOC secured by the property to fund the remaining 75%….did not take a ‘mortgage’ at all.
We were able to take advantage of a lower interest rate, had the option to make interest only payments in the event of a financial crisis (we never did) and could make bulk payments whenever we were able without any penalties. We paid it off in 12 years–3 years shy of our goal of 15 years.
This strategy can work if you are disciplined in making your payments (we automated a payment out of our chequing account that was equal to what a mortgage payment would have been) and pay close attention to rates. (we were prepared to jump into a mortgage if interest rates started moving up quickly…they never did)
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I do not agree with Sarah A. (#22) about “if you can only afford the home on a 30 year mortgage, then you can’t afford the home”. My husband and I bought our first home in 2007 when the market was still at top. We didn’t even have any down payment (20% down = 70K), however we were lucky to get a 100% loan in 30 years, and only had to pay around 11K in closing costs. Should we choose 15-year loan? We could, but we didn’t feel comfortable with the idea. To us, the idea of having some money in our pockets NOW is ways better than having little money and knowing that we are going to own the house in the next 15 years. The bank will still own our house next year, the year after.. and years after.. and no one can say how we would be next year yet.
By the way, from all little saving here and there after purchasing the first house, we had been able to purchase a vacation home this year with another 30-year loan and 20% down. Since this new loan is fairly small, we are planning to pay off early (just like the snowball strategy JD mentioned yesterday).
In summary, had we chosen the 15-year loan for our first house, we would probably (hopefully) own 1 expensive house in Maryland in the next 15 years. However, with the same amount of monthly payment, we are now “owning” 2 houses and will probably (hopefully) own the vacation house soon. The 30-year loan (and 0-down) is working for us.
I really like Scott’s comment above – good thinking! We didn’t think about the word “inflation” at the first time buying, just thought that tomorrow would be another day for the market and no one knows which way: up or down it would go. If it would go down, it would be buy-opportunities for people who are ready to catch those opportunities. If it would go up.. hey, we are making some good investment.
Have a nice day!
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What should i do?
Currently my better half and I have $77,000 in CDs saved for a down payment towards a house. Our rent is currently $812 a month – brand spanking new apartment complex, pool, hottub, fitness center, gated entrance, great location outside Knoxville. We are on pace to add $24,000 in the next year to our down payment. We plan to continue this trend for the next year maybe two.
Would it be better to keep paying rent, thus saving for another three to five years? Or would it be better to buy in a year – assuming all is equal? We are looking to spend around $1200 a month on a mortage when the time comes. Would it be better to stay where we are until we have enough to purchase a house out right?
I’m not sure if it would be better to pay $48,720 towards rent for the next 5 years or to buy in a year or two?
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I find that the bank may make it hard to instill some of the discipline to pay extra on the mortgage. With my mortgage company, if I set up extra payment automatically as part of the monthly auto-pay, the bank will change the payment back to the basic mortgage payment anytime the mortgage amount changes (usually changes in the escrow account). They do this even if the new amount owed monthly is less than what I set up my auto pay for. I can end up calling again to reset the pay 2 or 3 times a year which means I’ll forget at least one of those and let it ride for months without checking.
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I got a sense of deja-vu reading this article.
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@Stephen
It really depends on your plans. Are you going to be in Knoxville for a while? Or could you move in the next 12 month?
In terms of paying outright vs a mortgage I would point you to my post (#17). You gain financial flexibility by purchasing outright as you have no required payment to a bank every month, but you do lose flexibility in terms of the liquidity of your investments.
Assuming you can get a ~5% mortgage and again assuming inflation is around 2%, can you find an investment vehicle that would give you a return of around 3%? If this is the case, then you have access to cash and you get the same (or better) return on your money as if you had the mortgage.
Use the mortgage as leverage (remember not all leverage is bad). Assuming your jobs are stable and you have a sufficient emergency fund, use your remaining funds to create a well balanced and well diversified portfolio of investment products (CDs, bonds, index funds). You’re using other peoples’ money to purchase your house while you use your own capital to invest and grow. If you can grow your capital at a rate greater than (mortgage rate – inflation rate) you are doing yourself a favor.
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I have a 30yr @ 5.5 and while I can afford the 15yr route (either via extra payments or an actual 15yr loan), I much prefer to keep that extra $400ish each month for now to beef up my emergency fund. Once I have about a year’s worth of income in there, then I’ll start paying more on the mortgage. I think, as many have said, it’s not just about the math – for me, as a single woman at 40 years old, it’s as much about what I’m comfortable with since I’m my only source of income, and cash + retirement right now seem more important.
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Loved this post – every prospective homeowner should read it. The one other item I’d throw into the discussion pot is how much home should a person be striving to buy in the first place. My favorite rough rule of thumb is to keep the total purchase price of your home to no more than 3x your income (which in a normal interest rate environment gets you to essentially the same place as Dave Ramsey’s advice). If you’re not fascinated by personal finance the way those of us who read PF blogs are
having a simple guidepost like that can help keep you from biting off more home than you can chew. It breaks my heart to see how many Americans are in a financial pickle because they did not know how to answer the basic question “How much house can I comfortably afford?”
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I don’t agree with the logic of giving yourself “wiggle room”. If you think you might need wiggle room, it’s probably because you are trying to buy more house than you can really afford.
If you go with the 30 year term with plans to pay it as if it was a fifteen year, make sure that your payments are already less than 25% of your income at the 15 year amortization.
$7,400 is a lot of money to pay for some “wiggle room.” Instead, why not self-insure the risk by ramping up your emergency fund savings and making a substantial down payment? If that isn’t enough to allay your fears, then you’re probably buying more house than you can afford.
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The decision between a 30- and a 15-year mortgage doesn’t have to be set in stone for the length of the loan.
When we bought our house 20 years ago, we started with a 30-year loan at 9.75%. We refinanced a couple years later to another 30-year loan when rates dropped to 7.75% For a few years, we also participated in the bank’s bi-saver payment plan in which we paid half our monthly payment every two weeks, ending up with 13 payments a year.
As our incomes rose, we could afford a larger payment. So when rates dropped into the 6% range, we refinanced to a 15-year loan. I think it was about two years later, in 2004, we refinanced to a 10-year loan at 4.625%. If we don’t make any prepayments on this loan (which we’ve thought about doing with an inheritance my husband is receiving), we’ll have the house paid off about 24.5 years after buying it. I’ll be 60 then and my husband will be 62, so eliminating our biggest monthly expense is a major factor in considering at what age we want to and can retire from full-time work.
Each time we refinanced to a lower interest rate, we looked at how long it would take to recover any refinancing costs and made sure we wanted to stay in the house that much longer. The increased mortgage payments were never more than $100-200 so we could easily afford that as our incomes rose. The same could be true for the 30-year-old in the example used. The income that person will have at age 40 or 45 or 50 should be higher. Taking advantage of lower rates or shorter loan terms is an opportunity that can be explored at that point.
I have to add that we have friends who bought their house within a month or so of when we did. Taking a totally opposite approach, they refinanced their mortgage within the last year to take cash out to pay off credit card debt. Rather than paying their house off in 30 years, I’m afraid they’ll be paying for it much, much longer than they would like to.
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My DH and I did something a little different this time when we refinanced, so I thought I’d add this to the mix.
We’ve always been pretty conservative financially, and bought a mortgage we could pay on one salary. DH lost his job and took a new one at half the take-home pay, so I wanted to get the mortgage down even lower.
We refinanced with a 30 year (again, to maximize our monthly security) with payments just under $700/month and will pay $850/month for two years as we rebuild savings and take care of a major project.
Here’s the different item: in two years, we’re increasing the monthly payment to $1600 and then we’ll annually increase our monthly payment $100. We expect to be paid off in 2015.
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One issue to consider is how your income and expenses might change in the future. If you have no kids but plan on having them after you’ve purchased the house, you need to factor in either losing one income, or the added expense of child care. (In my area, daycare costs more than the mortgage.)
I’m glad I did this, because one of my kids was born with a medical issue which required intensive medical treatment for a year. My husband ended up quitting work for that year to take care of her, and it did not create a major financial burden on our family. (Thankfully our daughter is fine now.)
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Depending on your age, I think 15 years is a good time frame. However, if that will prevent you from having an emergency savings account or meeting other goals, I’d look for a 20-25 year mortgage or a 30 year that you can pre-pay w/o penalty. Also, my daughter is an architect & she says that the biggest mistake that homeowners make regardless of income is building a house that is too big. Wasted space = high utility bills, rooms that appear to need a lot of furniture, high maintenance costs etc. An architect or designer can help design a somewhat smaller but more efficient and elegant house. If you think you need a 2,000 sq. ft. house ask a designer for an 1800 sq ft plan that has all the amenities you want. What you pay in design fees will be made up for in construction costs. Not to mention all those housekeeping expenses over the years.
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Good numbers but one of the biggest advantages the 15 year note (or paying off the 30 year in 15 years), in my opinion, is the ENORMOUS overall value in having the mortgage paid off relative to each borrowers age at the time of payoff.
Example: Borrower buys a house at age 25 when getting married and gets a 15 year mortgage. Has a baby at age 28 and 32. The mortgage is paid off entirely by the time the borrower is 40 and when the kids are still relatively inexpensive at ages 12 and 8 . Conversely, same borrower with a 30 year mortgage pays on it until age 55. Borrower is more likely to be “strapped” for a good amount of time paying for expensive kids (driving, college, etc) while still paying their mortgage.
It’s all a question of who to you want to be in the relatively near future and the long future
Example (con’t): Sitting at your 12 year-olds soccer game with your home paid off, positive and increasing net worth, not living paycheck to paycheck, with disposable income to use for pleasure, etc. Or do you want to be in the 95% of couples at that same game who have a newly refinanced 30 year mortgage, 2 SUV payments, no savings each month, in panic mode for their job whenever the economy dips, etc…
That differences in the above compound exponentially when you look further down the line…..the 15 year borrower at their youngest’s college graduation hasn’t made a mortgage payment in 14 years. Having been free from mortgage debt for 14 years, that person will most likely have had a marked difference in overall quality of life during those college tuition years compared to the borrower juggling expensive kids with their mortgage on which they will be paying for the next 16 years.
One more point lacking in the article….
The suppositions of the post (and my examples) are predicated upon a borrower purchasing their “long term house.” Should a borrower be purchasing a “transition home” in which they plan to stay only 1-3 years, the lowest fixed payment possible should be sought (which most likely will be a 30 year). That leverage will allow for a better ROI on any appreciation. If there is no appreciation or depreciation at the time of sale of the “transition home”, the difference in the principle owed after 3 years will be negligible with any mortgage. Also, any monthly payment savings being saved for the down payment on the “long term house” (or invested somewhere else for a return).
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To answer the original question “What about you? Do you have a 15-year mortgage or 30-year mortgage? Do you prepay? What are your thoughts on risk versus higher returns?”
We were older when we bought a house together: 42 and 43. Had 40% downpayment saved, so hadn’t completely been frittering away our money on fun and games. LOL. Took a 15 yr mortgage and have been pleasantly surprised at the effect of throwing extra money at it whenever we can. In 2 years and 3 months we expect to have paid it off completely (6 yrs 9 months total), and we’ll both be under 50. Caveats: no kids, 1 car, centretown house, not too big, 1 of us works from home, we eat in almost exclusively, travel overseas only every two years.
Hubby is very risk-averse, and I’m less so. We do keep a 4-6 month emergency fund/new vehicle downpayment fund on hand.
We’d like more tips on higher returns, but would rather put sweat into something than accept high risks. Suggestions?
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I had a 30-year at 5.375% for monthly payments of about $1400. When I refinanced to 4.875% (will recover closing costs in 1.5 years), payment went down about $200, but I still pay $1400 as that’s what I was used to/had budgeted for years. This shaves off 8 years (2 off the original loan’s). As the principal decreases and tax benefit no longer a benefit (eg. standard deduction is greater), that’s the time to accelerate paying it off.
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The one thing to note guys is inflation. If you believe inflation is going to be huge, then it ironically makes sense to have as much debt as you can b/c inflation simply inflates away your debt. Essentially, you are going short bonds b/c rates will go up if inflation arrives.
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Samurai, I don’t care about inflation. I care about owning my own home outright. Debt of any kind — home or car — just means that you’re just renting your lifestyle from the bank.
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Great discussion (some deep numbers thinking about future dollars). Two things:
- Read your mortgage for an early pay-off penalty and make sure to factor that it (though it will still probably be much, much less than the interest over 30 yr).
- I am looking for a calculator to help me figure the impact of my extra payments – any recommendations?
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@Cindi C–What about this calculator? http://www.bankrate.com/calculators/mortgages/loan-calculator.aspx
It gives you a few options for calculating additional payments.
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