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?
This article is about Debt, House and Home
SEARCH FOR RECENT ARTICLES
Who would you rather be Bob or Jim?
http://evolutionofwealth.com/2009/10/02/bob-or-jim/
This is all about mortgages and I wonder where people really want to be. What’s your vote?
loading....
We are in the process of purchasing a home and are currently under contract. We feel very versed in the pros and cons related to the 15 and 30 and ultimately decided that paying of our home as quickly as possible was our number one goal.
We ultimately chose the 15 for the cheaper rates as well as “forcing” us to pay the higher payment. We will hopefully have a paid for house in 5 – 10 years!
loading....
@EvolutionOfWealth
Banks make less money when you pay off early. They don’t want your principal, they want your interest. If they wanted the principal they wouldn’t have loaned it to you in the first place.
As far as Jim vs. Bob… It’s a nice story, but the only thing it shows is that you need some kind of emergency fund before attempting to pay off the mortgage early.
loading....
I highly recommend the wiggle-room method. You can make extra payments, but you’re not obligated to. The goal of paying off the mortgage is more freedom, not more stress.
Here’s how I’m doing it… first things first:
Only debt is my mortgage.
Throw enough in the 401k to get full matching funds from my employer.
Max out Roth IRA.
Modest non-retirement stock account (I use this as my back up emergency fund).
With all of the above, I feel comfortable putting extra payments into my mortgage. I’m on the modified wiggle room method:
7/1 ARM. This is a 30 year mortgage with a “teaser” rate for 7 years that is lower than the 15 year fixed rate. This works for me because, if I stay on target, I’ll have the loan payed off in about 10 years. This means only 3 years will be “risky” as far as interest rates go… but they’re only relevant in the final 3 years (according to plan) when the interest portion of the payment is lowest anyway.
The reason I like 30 yr over 15 is I can adjust my payments as needed. Some months I put over $1000 extra in, others I put $0 extra in (like this month when I got both my property tax bill as well as my auto-insurance bill). Flexibility is key. Also if things go south, it’s a lot easier to make the 30yr payment than the 15.
loading....
A couple of points on the effect of inflation on later years’ mortgage payments:
Bill in NC points out that this is only useful to you if your wages have kept up with inflation and this is true, but even that is not enough.
Let’s say that you are in the early stages of a 30 year 5.5% fixed rate mortgage and want to decide whether to make an extra $1,000 principal payment. You think to yourself: Inflation will make that $1,000 equivalent to only $500 within 10 years. (This means you are assuming that inflation will be as bad over the next 10 years as it was between 1970 and 1980). So you decide not to make the extra payment. Fine, but –
What are you going to do with that extra $1,000 instead? Somehow, you have to protect it from the ravages of the inflation you are predicting, PLUS earn enough extra to cover the annual 5.5% mortgage interest, before you actually come out ahead. This is easy to do with hindsight (in 1970, you could have bought 25 oz. of gold for $1000 and by 1980 you’d have close to $20,000), but not with foresight (if you’d bought $1,000 worth of gold in 1980, it would have been worth about $500 in 1990, while inflation during that time would have left you with more than that).
Almost certainly $1,000 in the last years of your mortgage will be worth less than $1,000 today, but the basic question remains the same – what is the best investment of that $1,000 to make today?
$1,000 invested today at a 100% guaranteed, almost* totally risk-free, largely tax-free 5.5% rate compounded monthly has a nominal (non-inflation-adjusted) value of almost $4,000 in 25 years. Could you quadruple your money in gold in that time, or rental housing, or stocks? Maybe, but it wouldn’t be guaranteed, or risk-free, or tax-free. (I leave out bonds and CDs because they would be ravaged by the inflation you are assuming.)
Besides, even though I think inflation is a far more likely scenario than deflation, Rule No. 1 of personal investing is to diversify so as to allow at least part of your portfolio to benefit from whatever is decimating the rest of it. A 25-year guaranteed 5.5% non-callable tax-free bond would be great deflation-protection.
(*I say “almost” risk-free because paying down your mortgage does carry a small risk of loss if your house value is lost through an uninsured disaster, seizure, or near-total price collapse – think Detroit – and you can no longer live in it).
loading....
single, almost 50, bought my 1st home, I took a 20 year loan at 5% and have been adding $350.00 more to the loan, I would like to pay the home off in ten years if everything go alright. I have three saving accounts for the what ifs in life. I took a lot of classes on home buying, saving, and living with the money I make, as long as I stay in good health this home will be paid off in then years.
loading....
“““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.”
Yet, this lack of understanding of the benefits of paying down the loans is really a lack of self-discipline as well, in terms of the refusal to take the time to understand it.”
~~~~
I think it’s both, and I also think that people might not be paying extra because they have other debt that needs to be paid first.
loading....
“97.3 percent of people do not consistently pay extra on their mortgages.” This includes a lot of people who intended to pay off their 30-year mortgage in 15 years. My wife and I paid off our house a year ago, and we’ve enjoyed newfound freedom such as my wife being able to stay at home with our 2-year-old daughter. I’ll choose financial freedom (i.e. debt free living) over a tax deduction any day of the week and twice on Sunday.
loading....
I recently refinanced to lower the payment on my mortgage because my job situation had become unstable. Though I have a 30 year mortgage, I triple the principle and will be able to pay it off in 10 years, but if I lose my job or experience any other financial setbacks, I have a payment that I know I can make easily. Still will pay off the house in less than 15 years if I continue to make the extra payments. This article was very informative and reaffirmed what I believe to be true. So much of this is what old folks used to tell us, it might be better to get lower payments and pay more if you can.
loading....
Great article! I wasn’t expecting the pay a 30 year off in 15 years breakdown, that is exactly what I was looking for. Now its decision time!
loading....
“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.”
Compare apples to apples. If she’s saving $238 *per year* in taxes, how much is she paying *per year* in extra interest? ($88,893/30=$2963) — THAT is how you measure savings, especially with such big numbers.
loading....
15 year and we’re paying it off early. We may be 35 by the time the mortgage is done. Of course, we’re weird and can’t wait to be on BS7.
loading....
As somebody who makes a living as a mortgage underwriter, let me say, if you ever need “wiggle room” in your monthly mortgage payment, then you are probably already living on the verge of financial disaster.
Consider the following:
http://underwriterconfessions.blogspot.com/2012/03/buying-your-first-home-safely.html
loading....