A bewildering variety of mortgages may be available, but for most homebuyers, there is, in practice, only one.
The 30-year fixed-rate mortgage is practically an American archetype, the apple pie of financial instruments. It is the path that generations of Americans have taken to first-time home ownership. According to the Mortgage Bankers Association, the majority of people who apply for mortgages apply for the 30-year variety: In February 2015, more than two-thirds of all mortgage applications, and 86% of all purchase applications.
But many of those buyers might have been better served if they had opted instead for a 15-year fixed-rate mortgage, the 30-year’s younger, and less popular, sibling.
The loans are structurally similar – the main difference is the term of years. A shorter-term loan means a higher monthly payment, which makes the 15-year mortgage seem less affordable. But, in fact, the shorter term makes the loan cheaper on several fronts. In fact, over the full life of a loan, a 30-year-mortgage will end up costing more than double the 15-year option.
How the Mortgage Term Affects the Cost
A mortgage is simply a particular kind of term loan – one secured by real property – and in a term loan, the borrower pays interest calculated on an annual basis against the outstanding balance of the loan. Both the interest rate and monthly payment are fixed.
Because the monthly payment is fixed, the portion going to pay interest and the portion going to pay principal change over time. In the beginning, because the loan balance is so high, most of the payment is interest. But as the balance gets smaller, the interest share of the payment also declines, and the share going to principal increases. (For further explanations, see Site Edit’s tutorial Mortgage Basics and Complete Home-Buyer Mortgage Guide)
In a 30-year-loan, of course, that balance shrinks much more slowly – effectively, you’re renting the same amount of money for more than twice as long. (It’s more than twice as long, rather than just twice as long, because in a 30-year mortgage, the principal balance does not decline at as fast a rate as in a 15-year loan.) The higher the interest rate, the greater the gap between the two mortgages. When the interest rate is 4%, for example, a borrower actually pays almost 2.2 times more interest to borrow the same amount of principal over 30 years compared with a 15-year loan.
Differences in Interest Rates
Moreover, because 15-year loans are less risky for banks than 30-year loans, and because it costs banks less to make shorter-term loans than longer-term loans, a 30-year mortgage typically comes with a higher interest rate. Consumers pay less on a 15-year mortgage – anywhere from a quarter of a percent to a full percent (or point) less, and over the decades that can really add up.
The government-supported agencies that back most mortgages, like Fannie Mae and Freddie Mac, impose additional fees, called loan level price adjustments, which make 30-year mortgages more expensive. These fees typically apply to borrowers with lower credit scores, smaller down payments or both. The Federal Housing Administration also charges higher mortgage insurance premiums to 30-year borrowers.
“Some of the loan level price adjustments that exist on a 30-year do not exist on a 15-year,” says James Morin, senior vice president of retail lending at Norcom Mortgage in Avon, Conn. Most people, according to Morin, roll these costs into their mortgage as part of a higher rate, rather than paying them outright.
Imagine, then, a $300,000 loan, available at 4% for 30 years or at 3.25% for 15 years. The combined effect of the faster amortization and the lower interest rate means that borrowing the money for just 15 years would cost $79,441, compared to $215,609 over 30 years, or nearly two-thirds less.
Of course, there's a catch. The price for saving so much money over the long run is a much higher monthly outlay: The payment on our hypothetical 15-year loan is $2,108, $676 (or nearly 50%) more than the monthly payment for the 30-year loan ($1,432).
In Defense of the 30-Year Mortgage
The chief advantage of a 30-year mortgage is that relatively low monthly payment. And even if affordability isn't an issue, there are other pros to going with it:
- The lower payment may allow a borrower to buy more house than they would be able to afford with a 15-year loan, since the same monthly payment would allow you to take out a larger loan over 30 years.
- The lower payment allows a borrower to build up savings.
- The lower payment frees up funds for other goals.
Other Uses for the Money
There are some instances where a borrower may have incentives to invest that money elsewhere, as in a 529 account for college tuition or in a tax-deferred 401(k) plan, especially if employer matches the borrower’s contributions. And with mortgage rates so low, a savvy and disciplined investor could opt for the 30-year loan, then take the difference between the 15-year and 30-year payments and invest it higher-yielding securities.
Using the previous example, if a 15-year loan monthly payment was $2,108, and the 30-year loan monthly payment was $1,432, a borrower could invest that $676 difference elsewhere. The back-of-the-envelope calculation is how much (or whether) the return on the outside investment, less the capital gains tax you owe on it, exceeds the interest rate on the mortgage, after accounting for the mortgage interest deduction. For someone in the 25% tax bracket, the deduction might reduce the effective mortgage interest rate from, say, 4% to 3%.
Broadly speaking, then, you come out ahead if the investment's returns after taxes are higher than the cost of the mortgage less the interest deduction.
This gambit, however, demands a propensity for risk, according to Shashin Shah, a certified financial planner in Dallas, because the borrower will have to invest in volatile stocks. “Currently there’s no fixed-income investments that would yield a high enough return to make this work,” says Shah. It also requires the discipline to systematically invest the equivalent of those monthly differentials and the time to focus on the investments, which, he adds, most people lack.
If You’re About to Retire
If you can afford the higher payment, it is in your interest to go with the shorter loan, especially if you are approaching retirement when you will be dependent on a fixed income.
For some experts, being able to afford the higher payment includes having a rainy day fund tucked away – according to Bob Walters, chief economist for Quicken Loans, your liquid savings should amount to at least a year’s worth of income. What financial planners like about the 15-year mortgage is that it is effectively “forced saving,” in the form of equity in an asset that normally appreciates (although, like stocks, homes rise and fall in value.
A Best-of-Both-Worlds Option?
Most borrowers evidently also lack – or at least think they lack – the wherewithal to make the higher payments required by a 15-year mortgage. But there is a simple solution for the 30-year folk to capture much of the savings of the shorter mortgage: Simply make the larger payments of a 15-year schedule on your 30-year mortgage, assuming the mortgage has no prepayment penalty.
You are entitled to direct the extra payments to principal, and if you make the payments consistently, you will pay the mortgage off in 15 years. If times get tight, you can always fall back to the normal, lower payments of the 30-year schedule.
The Bottom Line
With mortgages, the primary driver of higher costs is time. That's why many buyers would be well-served if they opted for a 15-year fixed-rate mortgage instead of a 30-year mortgage. A lower interest rate and shorter term mean that you will pay considerably less for your loan. Do the math yourself by using Site Edit's mortgage calculator.
The rub remains the higher monthly payment. Also, it is sensible to weigh the value of a less costly mortgage against other savings priorities, like college, retirement and a rainy-day fund. Still, as Shah says: “There’s not a single client that we have who’s paid off their house that has ever felt bad about it.”