There was a time when mortgages were 4 years long. You agreed to buy a house, you moved in, and then you had 4 years to pay it off. It that was still the standard today, then many of us would be renting and/or living in much less expensive homes. Stretching out the length of time on a mortgage has been the single biggest reason that home-ownership rates skyrocketed through the middle part of the 20th century. While the 30 year fixed rate mortgage certainly has become the most common type of mortgage, the 15 year fixed rate mortgage often times makes more sense, but not always.
By their nature, 15 year fixed rate mortgages will always have a lower interest rate than 30 year fixed rate mortgages. This is just the way that debt and liquidity work. For instance, you let your bank borrow your money for 6 months (via a 6 month CD), they may only pay you .5% interest. But if you let them borrow your money for 5 years (via a 5 year CD), then they may pay you 2.5%. This is because you will have much less liquidity if you have your money locked up for 5 years. This liquidity, or lack thereof, is the primary factor of being able to charge a higher interest rate.
Let’s look at a 30 year mortgage at 4% on a $200,000 loan (no taxes and insurance)
As you can clearly see, you will have paid $343,739.01 to payoff a $200,000 loan. You would have paid the bank 72% more than you borrowed originally if you complete the entire mortgage. But in exchange for this large amount of interest that you will pay, you will have a relatively low monthly payment. As you will see in my next example, the low payment isn’t a product of anything other than “spreading out” your repayment over 30 years. And as I have suggested time and time again, you need to keep your mortgage payment around 25% of your take-home pay.
Now, let’s look at a 15 year mortgage at 3.25% on a $200 ,000 loan (no taxes and insurance)
Like I said before in the CD example, the shorter period of time that money is borrowed, the less the rate of interest charged to borrow. So just for having “full access” to the equity in your home 15 years sooner, you will pay .75% less in interest rate. But how much less will you pay in interest? Try $90,778.25. That’s 63% less interest than the 30 year fixed rate mortgage. But, your payment is 47% higher on a monthly basis.
But in my estimation is comes down to one thing. You guessed it, your budget. If you can afford to be smart, then be smart (15 year mortgage). If you can’t afford to be smart, then don’t be stupid. Trying to get a 15 year mortgage when the payment would hurt you financially on a monthly basis is one of the stupidest things you can do. You need to be realistic. If you can’t afford it, you can’t afford it. You don’t need liquidity if your cash flow is tight, you need “stretched out” payments. Is this the best technical financial advice in the world? Nope. But it’s realistic financial advice. And that’s what you get here at PeteThePlanner.com.
Peter Dunn a.k.a. Pete the Planner® is an award-winning financial mind and a former comedian. He’s a USA TODAY columnist, author of ten books, and is the host of the popular radio show and podcast, The Pete the Planner Show. Pete is considered one of the foremost experts on financial wellness in the world, but he’s just as likely to talk your ear off about bass fishing.
Im looking at buying my first home and the 30 yr loan is how i am going to have to work it based on my budget. If i pay extra when i have it does it go directly to principal like it did with my car so i can over time shorten the loan.?
Great question. You have to specify that you want the “extra” to go to principal. If you don’t, your mortgage company decides how they want to apply the “extra”.
Great article! Let’s say you can afford the 15-year mortgage within 25% of your budget but choose to take out a 30-year mortgage instead. If you invest the $450.51 difference into stocks each month (assume an estimated ROI of 7% based on S&P historical avgs) wouldn’t you make more from investing than you would have saved from lower interest rates? Just curious if investing money instead of paying down the loan faster could be an option.
Hey Allyson, thanks for your question. Yes, but there’s a few big buts. I’m comfortable suggesting a person could expect 7% over 30 years, but there certainly are no guarantees. The bigger issue is the follow-through. “Buy X, and invest the difference” has all sorts of applications in the financial world, but the follow-through is what matters. What I typically see is people setting out with the invest the difference strategy, and then doing absolutely nothing. They never invest. As long as you can follow-through, have at it.