UPDATED: May 19, 2022
You’ve decided to buy a home. Congratulations! Next you will need to get a mortgage. Especially if you’re a first-time home buyer, it’s important to know the differences between a 15 vs 30 year mortgage.
In order to pick the right loan, you need to consider the monthly payment, interest rate, overall costs of borrowing the money, and equity.
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Get Your Finances In Order
It’s important to know how much you can afford to pay each month. Experts generally recommend that you not spend more than 30% of your monthly income on housing, and this applies whether you are renting or buying the home. For homeowners, this includes the cost of paying your mortgage, property taxes, utilities and other expenses related to home ownership.
Since you’re likely looking at moving from renting (or living with someone) to purchasing a home, the first consideration is how much of a monthly payment you can afford. Individual circumstances vary, but making a household budget to get a complete view of your income and expenses is an essential first step.
If you do not have a personal or household financial plan, our 6 Steps to Financial Freedom series can help with that.
Total debt is one reason why people have a hard time getting a mortgage. While landlords can evict quickly when tenants get in trouble, there’s a lot more money at stake with a mortgage, and foreclosures take a long time. Lenders consider your total debt to income ratio to a greater extent than landlords. After all, landlords just want their rent, and while they won’t take an undue risk, they can always replace tenants. Banks want to avoid a default and foreclosure.
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Monthly Mortgage Payment
How does this play into loan terms? Well, with a 30-year mortgage the payments tend to be the lowest. You’re spreading out the repayment of money borrowed over decades. As a result of this lower payment, you might be able to afford to borrow more money than if you only get a 15 year mortgage. Remember, the banks are focusing on the amount you’re paying each month. That includes principal, interest, mortgage insurance, property taxes, relative to your income and financial assets.
Let’s look at how this plays out. If you buy a $130,000 house with 20% down and a 30-year fixed at 3% interest, you’ll end up paying around $1250 per month. Change that to a 15-year fixed at 2.5% and you’ll pay $1700 per month (these figures roughly include a payment for property taxes and homeowner’s insurance). That’s a lot of cash upfront, and it’s going to take a good bit more monthly income to get yourself qualified for it.
Here’s the trade-off: Less money borrowed for a shorter time, or more money borrowed over a longer period of time. The lender evaluates your total payment and ability to repay the loan.
All else equal, the shorter time period of the mortgage term, the lower the interest rate. In the above example, the 15 year mortgage had a lower rate than the 30 year term. The lender is taking on a lower risk by loaning out the money for less time. When money is out of the bank for a shorter time period, there’s less time for things to happen in the customer’s life that can cause hardship. Job losses wreak havoc on a budget, whether it’s a single individual, a couple, or a family. Unemployment insurance doesn’t generally cover all of the lost income, and depending on your level of savings mortgage payments can become harder to afford.
Conversely, you’ll pay a higher rate with the 30-year loan. A lot can happen in 30 years: chances are that you will change jobs at least once, and likely more than that. You might have to relocate, selling the house and buying another one somewhere else. Remember, banks charge more money for assuming a greater amount of risk. You’ll see this in credit cards, too, because those are unsecured loans.
Here’s the trade-off: lower payment or lower interest rate.
Let’s assume that you put down 20% of the home’s value at purchase. This figure is desirable because it means you don’t need to purchase private mortgage insurance. Mortgage insurance is required when you don’t have a 20% down payment. Mortgage insurance is generally added to your total payment, and remember, the payment is critical to determining what you can afford.
You can usually get rid of private mortgage insurance when the loan-to-value of the property reaches a certain threshold (usually 80%).
All things being equal, the borrowing cost differences between a 15 vs 30 year mortgage come down to one thing: interest. With a 15 year fixed, you’ll pay a lower interest rate for fewer years. The 30-year mortgage offers higher interest rates over a long period of time.
Some experts say that it’s always better to save money on borrowing costs. While that’s ideal, that might not fit your personal situation. For instance, if you need more home to accommodate a growing family the lower payment is important. On the other hand, if you are looking to retire soon then you’ll want that loan paid off sooner. Plus, you can then take that money you didn’t spend on borrowing costs and invest it somewhere.
For maximum flexibility, a borrower could use a 30-year mortgage and pay extra each month. This allows you to maintain the cushion of a lower monthly payment, but lower your interest cost by prepaying when you have extra cash.
Equity is the amount of ownership you have in your home, compared to its value. Let’s say you put $40,000 down on a $200,000 house. In this case, your equity at the beginning of the loan is $40,000 or 20%, with the rest of the money being borrowed. Over time, your equity should increase as the balance of your loan is paid back.
Since borrowing costs are higher for the 30 year note, and lower for the 15 year note, you will build equity faster for the shorter loan term. This is for a very simple reason: you pay more of the amount borrowed with each payment on the 15 year note. Each payment reduces the amount owed much faster than it does with longer loans.
The difference in the payment size between a 15 vs 30 year mortgage is the amount of the loan principal that’s paid each month. You’ll pay down the loan in half the time, so there has to be more principal paid in a shorter amount of time.
30 Year Mortgage:
Select a 30 year mortgage for the lower payments, increased cash flow, and the ability to buy a bigger house for your level of income. However, the drawbacks are increased borrowing costs, less equity in the short term, and paying a mortgage for decades.
15 Year Mortgage:
Choose a 15 year mortgage for lower borrowing costs, both due to the lower interest rate and shorter time you’ll pay the interest. You will also build equity faster and own your home outright in 15 years. Drawbacks are the higher payment amount, reduced cash flow, and less flexibility.
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