I’ve had mortgages on the brain recently. When assembling our mortgage history the other day, I was struck by the decisions that we face along the way. Aside from deciding when to refinance, the biggest decision that we faced was what type of mortgage to get.
While we could’ve (arguably) saved some money by opting for adjustable rate mortgages, we already have enough unknowns in our life. Thus, we quickly narrowed our options to fixed rate products. While there are some 20 (and even 40!) year fixed rate mortgages out there, 15 and 30 year mortgages are far more common.
So… Which to choose?
Advantages of a 15 year mortgage
Aside from being amortized over half the total time (15 vs. 30 years), mortgage rates are usually significantly lower for 15 vs. 30 year terms. This combination of a shorter term and lower interest rate means that, while your monthly payments will be higher, you’ll pay far less interest over the life of the loan.
Advantages of a 30 year mortgage
The primary advantage of a 30 year fixed rate mortgage is that it will have a lower monthly payments. As noted above, 15 year mortgages typically have significantly lower rates, but 30 year mortgages have much lower monthly payments. Thus, many people opt for them, as they make home ownership more afforfable on a month-to-month basis.
A subtle difference here is that a far greater proportion of your monthly payment (especially at first) will go toward mortgage interest with a 30 year mortgage. Thus, you’ll have more mortgage interest to deduct with a 30 year vs. 15 year mortgage. Of course, that also means you’ll be paying far more in interest over the life of the loan, so be careful.
15 vs. 30 year mortgages by the numbers
Consider the following scenario… You’re in the market for a $200k mortgage, and you learn that you can get a 15 year fixed rate mortgage at 5% or a 30 year fixed rate mortgage at 5.5%. Which should you choose?
Running the numbers
For a $200k, 15 year mortgage at 5%…
Your monthly payment will be: $1581.55 (principal + interest)
Your total cost over the life of the mortgage will be: $284, 685
Your total interest paid will be: $84, 865
For a $200k, 30 year mortgage at 5.5%…
Your monthly payment will be: $1135.58 (principal + interest)
Your total cost over the life of the mortgage will be: $408, 807
Your total interest paid will be: $208, 807
As you can see, the 30 year mortgage is significantly more costly, but it frees up an additional $446/month that can be used for other things (living expenses, investing, additional principal payments, and so on).
The best of both worlds
What if you’ve decided that you want to be mortgage free as soon as possible? A 15 year mortgage is a no-brainer, right? Maybe, but maybe not.
Depending on a number of factors, such as your income, job stability, and level of self-discipline, you might be better off taking out a 30 year mortgage and then simply over-paying it every month.
The advantage of this approach is that you you get the best of both worlds… You can pay your mortgage of in 15 years (give or take) while still having the flexibility to fall back to the lower payment level if you ever run into financial problems.
Another look at the numbers
Let’s say you went ahead and took out the 30 year mortgage detailed above with one exception… You dedicded to send an extra principal payment of $446/month, making your monthly payment equal to the 15 year mortgage.
If you did that, you’d end up paying off your mortgage in 15 years and 10 months at a total cost of $299, 698. That’s an extra 10 months and $15, 013 as compare to the 15 year mortgage, but it’s a savings of roughly $109k vs. following the 30 schedule, and it also comes with significantly more flexibility than a 15 year mortgage.
If you wanted to achieve the same 15 year payoff period with the 30 year mortgage, you’d need to send roughly $500/month in additional principal payments ($1635/month), making your monthly obligation $54 higher than with the 15 year mortgage.
Once again, however, you’d have the freedom to fall back to that $1135.58 base payment if you really needed to. Of course, this flexibility is a double-edged sword. It could be a blessing to those who wind up needing it, or a curse to those who lack the self-discipline to send extra principal payments.