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Are you in a quandary whether to get 15-year or a 30-year mortgage? Many people do not make an effort to try and understand how their choice would impact their financial situation. In this article, we provide the advantages and disadvantages of both to help you decide what is best for you.
We agree that buying a house could be pretty exciting. You drive all over the city, checking different homes in different locations, appreciating their fine features and perhaps picturing yourself living in one of them. This part of home buying can be a lot of fun but what about searching for a mortgage? It doesn’t sound too enchanting but it’s something you have to go through.
Shop Around, Understand The Market
You might be familiar with the saying “No pain, no gain” – this applies as well to mortgage hunting. You must endure the whole process to make sure that you can get the best possible deal because eventually, it will be for your long-term benefit. During the shop-around, you will surely come face-to-face with so many different choices for every aspect. You have to pick one lender from among so many, decide how much down payment you want to put in, choose whether you want to buy points or not, etc. However, probably nothing is more important than selecting the mortgage term for your loan.
Technically, the mortgage term sets the number of years the lender will allow you to pay off your loan if you don’t make extra or early payments. Nowadays, most lenders will give borrowers a menu of short, intermediate or long mortgage terms.
However, the most common is the standard 15-year and 30-year mortgages.
This is what often happens: First-time buyers (or those who want to refinance) would initially pick a 15-year mortgage because of the interest rate. Of course, being able to fully pay for your house in 15 years sounds like a great idea.
But, as soon as they compute for the monthly payment and see that it’s a lot higher, they back off. “Maybe this is not what we really want to do.”, many would often say.
15 Vs 30 Year Mortgage: How They Work
Since basically, the loan will be spread out throughout the entire loan period, the term would affect how much the borrower should pay every month. Throw in the interest rate and you will see the big difference between a 15-year and a 30-year mortgage. This is how they generally affect your loan: with a 15-year mortgage, you’ll pay more every month but pay less interest overall.
For the 30-year mortgage, you’ll have to pay more interest. This will cause you to pay more for your house because of the additional interest although you would be paying a smaller monthly amortization.
In choosing your mortgage term, you should always consider how it will fit your budget and how it will impact the overall costs.
Let’s look at some figures so you can have a better picture. Say you want to borrow $150,000 to buy a new home and your options are a 15-year mortgage at 4% or a 30-year mortgage at 4.5%. If you choose the 15-year plan, you will pay about $1,110 a month (exclusive of insurance and taxes). Eventually, you would end up with a total interest payment of $50,000 over the entire life of the loan.
Using the same scenario but using the 30-year mortgage, you’ll be paying just $760 a month. It may look a lot cheaper but in reality, your interest would be 250% bigger. On a monthly basis, that would be an extra of about $350, money that you could spend to pay other debts, build your emergency stash or contribute for your retirement. The lower monthly payment would appear to be an advantage but your home would ultimately come with a higher cost.
Why Would You Go For a 30-Year Fixed-Rate?
It can minimize your monthly payment
The primary reason for picking a 30-year mortgage is that you can buy a home and make a lower monthly payment than you would if you have taken a 15-year mortgage.
It’s like this: using the current average interest rates, for a $200,000 15-year mortgage, you would be paying in the neighborhood of $1,460 per month. Comparatively, you will just pay approximately $1,043 for the same principal on a 30-year mortgage. You can always calculate the difference by 15 years vs 30-year mortgage calculator.
It’s snug and calculable
A 30-year mortgage is quite popular because it is snug, safe, and very predictable for a home buyer. The 30-year mortgage allows buyers to have a lower monthly payment and therefore does not eat up too much of the family budget.
So, should some unexpected crisis happen such as a job loss, medical emergencies, natural disasters and other events that could adversely affect your finances, it won’t automatically put your home mortgage at a terrible risk.
It can boost your homebuying budget
Majority of lenders use your debt as a percentage of your income (or debt-to-income ratio) to evaluate your loan application. Most of them will set your principal using this ratio. Your monthly mortgage payment should not exceed 28% of your gross (pre-tax) monthly income.
So, if we assume that you’re earning $5,000 a month, you can afford to pay a maximum of $1,400 mortgage payment. This would include payment for the principal, interest, taxes, and insurance. With this monthly figure, you would be able to allocate more for the house if you use a longer-dated mortgage such as a 30-year term.
You may be able to increase your loanable amount
As we said before, your debt-to-income ratio is one of the major criteria that lenders use to evaluate your loan proposal. How much they will lend you will largely depend on this figure. So, it is important to see how much you are paying in debt vis-à-vis how much income you are bringing in.
Since you pay a smaller monthly amount for a 30-year mortgage, you have a lot more latitude and can probably afford a bigger mortgage. You could then buy a much larger house, a nicer home, or live in a more affluent neighborhood.
Why Would You Pick a 15-Year Mortgage?
Pay off your mortgage a lot earlier
We’ve all been there – the state of wanting to get out of debt.
If you are the kind who do not want to be paying off any debt for a long time, this is for you.
After all, a home mortgage payment would probably constitute the biggest chunk of your monthly expenses. More so if you are nearing retirement or you have a strong inkling that you will lose a stable income stream in less than 30 years.
Save on your interest payment
Here’s the deal: you may have to make a bigger monthly payment in a 15-year mortgage but you will save a considerable amount in interest consequently.
How much? Well, let’s illustrate using some figures.
Example: The Difference Between 15 to 30 Year Mortgage
If you purchase a $200,000 home with a 30-year mortgage on the current average interest rate of 4.75%, you will have to pay a total of $375,588. This is the total principal and interest by the time the 30 years are over. On the other end of the scale, if you take a 15-year mortgage in the current average interest rate of 3.82%, it will just cost you $263,052.
In other words, a 15-year mortgage will ultimately save you $112,536 in interest payments—serious money, which might add up to a very good reason to tighten your belt and give it a try. One thing to consider is your job situation. If you have a stable career and don’t expect your income to drop significantly at any point, then a 15-year mortgage may be the right call. But what if you were to unexpectedly lose your job and couldn’t make your mortgage payments? You wouldn’t have enough income to qualify for a refinance. This situation would spell serious financial trouble.
Just take a look at the overall difference between the two: a whopping $112,536 in interest.
This is some serious amount that you could have used for other important things. If this argument does not make you think and seriously consider giving it a try, I don’t know what will.
Interest Rate: Things To Consider
If you have a stable job right now and you don’t foresee any adverse changes in your income happening at any point in the near future, a 15-year mortgage may be the right choice. However, if you were to unexpectedly lose your job and defaults on your mortgage? You might be able to qualify for a refinancing. This situation could put you in a very critical financial trouble.
You should also consider that your income today should also go to other important things and not solely on the home. After all, owning your own house is just part of your overall financial goals and not the only goal.
Yes, paying off your mortgage faster could be a good idea but you need to balance things. If channeling most of your monthly income to pay your mortgage means sacrificing your child’s college fund or your retirement fund, then you might have to reconsider.
Is 30 Year Mortgage More Flexible Than 15 Year?
A 15-year mortgage’s greatest advantage is that it could let you pay off your home early. A 30-year mortgage’s most compelling selling point is its flexibility. The conditions of the mortgage allow you to choose some options: you can pay off your mortgage earlier than the 30-year period or you can opt to invest. Since you are paying a lower monthly amortization, it means you would have free funds. In times of financial hardships, it would be relatively easier to meet your obligations because you might have some savings or just because the monthly amount is not too burdensome for you.
You should also look at your spending and saving habits. If you’re the type who would spend all rather than scrimp to save a few bucks, a 15-year mortgage can sometimes be a better option. You might be allocating more of your monthly income to the mortgage payment but at least, you are investing them in a tangible asset that increases in value rather than probably in an asset that fully depreciates after 3 years.
However, as we previously mentioned, if a 15-year mortgage would exhaust your monthly income and cause you to set aside other financial goals, it’s better for you to take a 30-year mortgage. A home is a good investment but it is not something that you can turn to cash immediately in case of an emergency. It also won’t necessarily provide an income stream in your senior years so paying it off early is not too high a priority if it will push all other important priorities to the back of the line.
But let’s say you have the cash to pay for a higher mortgage without scratching off your other financial needs, is it always wise to go for a 15-year mortgage? Well, not necessarily. Here’s a tip: if you have the discipline and a little knack for investing, you can get a 30-year mortgage and use your extra funds to invest, make it grow and perhaps, pay off the loan much earlier.
Try to Make Extra Payments
If the issue about a 15-year mortgage’s higher monthly payment is a cause for concern, don’t despair. There are other options you can take that can somehow even up things.
One technique is to take out a 30-year mortgage but make monthly payments as you would to a 15-year loan. Yes, you’ll be paying a higher interest rate but in the long run, you’ll still save if you pay off the loan early. And when you have a month when finances are tight or some urgent expenses come up, you can always revert to paying just the regular monthly amount and you’ll still be good.
A word of caution: Make sure that your loan agreement does not contain any prepayment penalties and see to it that the early payment applies to the principal, not to the interest.
Sit down with your financial advisor and discuss the best plan for your situation.