15-year or 30-year mortgages: which is better for me?
15-year mortgages and 30-year mortgages appeal to different audiences. One helps you lower the overall cost of your mortgage in exchange for a higher monthly payment, while the other offers lower monthly payments if you’re willing to pay the lender more over the life of the loan.
The most popular loan term is 30 years, but that’s not always the best choice. For some people, a 15-year term may be more appropriate. Here’s a quick example illustrating the monthly and overall cost differences between the two loan terms.
Let’s say you’re interested in buying a house for $250,000 and you can afford to put down 20% down, so you won’t have to pay for it. private mortgage insurance (PMI). This means you will need to borrow $200,000. The average interest rate on a 30-year mortgage today is around 4.7%. This means that your monthly payment would be approximately $1,037 and you would pay a total of $423,000 over the term of the 30-year loan, including your down payment and interest.
Fifteen-year mortgages often have a lower interest rate because the shorter loan term reduces the risk for lenders. This helps reduce the amount you will pay over the life of the loan. However, your monthly costs will be higher because you pay for the house in half the time.
The average 15-year mortgage interest rate is now 4.1%. This equates to a higher monthly payment of $1,489. However, you will only end up paying a total of $318,000 when all is said and done. That’s a difference of $105,000.
How to decide
A 15-year mortgage may be the right decision if you’re looking to minimize the overall cost of your mortgage. However, you need to make sure you can afford the higher monthly payment. You don’t want to put yourself in a position where you struggle to cover your monthly expenses. If you were unable to make your payments, you could lose your home.
When you choose a 30-year mortgage, you are resigned to paying a lot more over the life of the loan. But you have a lower monthly payment, and that can help you in two ways. First, it may allow you to buy a more expensive home than you could afford if you used a 15-year mortgage. Second, it frees up your money so you can spend it on other goals, like building a emergency fund or save for retirement. If you invest that money, your investment returns may be higher than the interest rate you pay on a 30-year mortgage, especially if your portfolio is rich in stocks.
It’s not fixed
You’ll have to decide how long you want the loan when you buy the house, but you’re not locked into that decision forever. If you find that your 15-year mortgage payment is starting to eat into your budget, you can always refinance and switch to a 30-year mortgage down the road. Keep in mind, however, that you will have to pay closing costs again when you do.
Another option is to take a 30-year mortgage, but make larger monthly payments in order to pay it off sooner than expected. You could even pay off a 30-year loan in just 15 years if you pay enough each month. This would save you a lot of money over the life of the loan, although it would probably cost you more than a 15-year mortgage, since 30-year mortgages tend to have higher interest rates.
Let’s take our previous example. If you were to pay off the 30-year mortgage with an interest rate of 4.7% in 15 years, you would pay $1,551 per month. Over those 15 years, you’ll end up spending just $329,000. You’d save $94,000 by paying off the loan in half the allotted time – although the 15-year loan with a rate of 4.1% would cost $11,000 less overall.
The advantage of this approach is that if for some reason you find yourself unable to make the highest monthly payments, you can always fall back on your standard monthly payments without fear of losing your home. However, you must ensure that your mortgage does not have a prepayment penalty. These generally don’t come into effect unless you pay off more than 20% of your mortgage balance in a single year, but be sure to consider this before you sign on the dotted line, as the penalties for prepayment can significantly reduce the savings made on prepayment of a mortgage.
It’s important to think carefully about how much you can afford to pay per month when deciding on the length of your loan. But you also need to think about the best use of your money. For most people, a 30-year mortgage is the smart approach because it gives them more money to spend on their other financial goals, and they can always pay off the loan sooner than expected if they want to.