With modern lenders providing more financing options for homebuyers than ever before, the mortgage landscape can be confusing and overwhelming at times. However, understanding the primary differences between a 30-year mortgage and a 15-year mortgage can provide a solid foundation on which to base your borrowing decision.
Due to its lower monthly payments, a 30-year mortgage with a fixed interest rate has always been the standard choice for first-time homebuyers. However, those who are looking to pay less in total interest charges will be wise to consider 15-year terms. To gain a more in-depth understanding of which mortgage length provides the advantages you are looking for, carefully review the guide below before speaking with your next potential lender.
Understanding the 30-Year Mortgage
The largest advantage that a 30-year mortgage has over a 15-year mortgage is that it provides a longer time on which to pay off the principal amount of the loan. In some cases, however, the interest paid over the life of a 30-year mortgage can be double or even triple that of a 15-year mortgage. Despite bearing the burden of much larger interest charges over time, 30-year borrowers will have lower monthly payments than 15-year borrowers. In addition, a borrower with a 30-year mortgage may be able to more easily refinance their arrangement if interest rates decrease.
Why do many lenders charge so much more interest for the privilege of borrowing on 30-year terms? A lender not only takes on the risk of a borrower defaulting on the mortgage over 30 years, but they also take on the risk of lost opportunity cost for any fixed-rate terms provided. If a mortgage provider creates a fixed-rate loan with a payback time of 30 years at an interest rate of 4.5%, for example, then they will effectively lose the opportunity cost of an extra 2% if the market rate for a 30-year mortgage climbs to 6.5% during the loan period.
In summary, a 30-year mortgage is primarily for those who are most concerned about keeping monthly payments low. In addition to being used by millions of first-time homebuyers every year, 30-year mortgages are also a popular choice for financing investment properties.
Understanding the 15-Year Mortgage
The interest rate on a 15-year mortgage may only be several decimal points less than on a 30-year mortgage, but these small differences can add up to a significant discount. For example, the total interest paid on a 15-year mortgage for a $250,000 home with a down payment of $50,000 will be approximately $130,000. A 30-year mortgage with a 5.5% interest rate with the same down payment for the same principal amount, however, will bear total interest charges of approximately $258,000.
In the example above, a rate difference of only .5% between the two-term lengths produces an increase in interest paid of nearly 100%. How does such a seemingly small rate increase create such a significant spread between the borrowing costs? The answer lies in compounding. The 30-year mortgage has 15 more years for the interest charges to multiply themselves.
Since less of the 15-year mortgage’s monthly payments go towards interest, the borrower builds up equity in the home at a significantly faster rate. This equity can make the borrower an attractive candidate for opening a home equity line of credit (HELOC) or taking advantage of other financing opportunities.
In exchange for decreased interest charges, the 15-year mortgage’s total monthly payments can be more than 25% higher than those of a 30-year mortgage. To illustrate, a 15-year mortgage with a principal amount of $300,000 and a down payment of $75,000 will have a monthly payment of $1,779 at an interest rate of 5%. Even at an interest rate of 6%, the same mortgage with a 30-year duration will have monthly payments of $1,349. However, the 30-year mortgage will carry over $260,000 in interest charges compared to under $100,000 for the 15-year mortgage.
In Conclusion
While an immediate equity buildup and savings on interest charges can make a 15-year mortgage the right choice for borrowers that are confident in being able to make monthly payments, a 30-year mortgage can provide a much more attractive monthly payment schedule. Before making a final decision on which mortgage type to choose, it’s always prudent to take a complete inventory of all current income sources and existing liabilities. With all of your finances in full view, you will be able to confidently secure the appropriate terms for your situation.
