Average 15-year mortgage rates in the U.S. are often about a full percentage point less than the average 30-year rate. Currently, the 15-year rate is 3.25%, quite a bit lower than the 4.21% average for a 30-year mortgage. Now, this rate difference wouldn't make a ton of difference if we were comparing the same type of loan. For example, the difference between rates of 3.25% and 4.21% on a $200,000 15-year mortgage payment is less than $100 per month.
However, the real benefit of a 15-year mortgage is not only the lower rate, but the shorter time frame during which your interest is compounded. The amount of interest you pay over the life of the loan is drastically reduced thanks to this double benefit. A 30-year mortgage may tempt you, due to the lower monthly payment, to buy a bigger house; but as far as your financial future is concerned, I think the numbers speak for themselves.
Mortgage interest is more than just a percentage
More of a factor than the lower interest rate is the length of time during which the interest is calculated. When calculating a mortgage payment, banks use a somewhat complex formula that depends exponentially on the length of the loan.
In other words, a loan that's twice as long will cost more than twice as much in interest. With a shorter loan term, more of the monthly payment immediately goes toward paying down principal, which has a big effect on the total cost of the loan.
While the formula itself isn't necessary for you to know, as a homebuyer, the implications of the formula are important to understand. Let's consider an example.
Let's say that you want to borrow $250,000, and you want to compare your 15- and 30-year loan options. At current rates, your monthly payment would be just $1,224 with a 30-year loan as opposed to $1,757 per month on a 15-year loan. The 30-year option sounds pretty good, right?
Well, over the course of the 30-year mortgage, you'll end up paying $190,641 in interest, while the total interest on the 15-year mortgage will only add up to $66,201. So, the cost of borrowing the $250,000 over 15 years is 65% cheaper than borrowing over 30 years.
Build equity faster
By taking on the larger payment, you can build equity in your home much faster. Going back to our earlier example, let's say the home's value is $312,500 when you made the purchase. This would make a $250,000 mortgage exactly 80% of the home's value, a pretty standard amount.
Let's assume that the home appreciates in value by 4% per year on average, which is very reasonable by historical standards. Take a look at how much more quickly you could build equity in your home with a 15-year mortgage.
A winning deal
In a nutshell, a 15-year mortgage is simply the better value, and it is definitely worth considering searching for homes that you can afford with a 15-year mortgage. You'll pay about 40% more per month to pay off the home twice as fast.
The 15-year mortgage rates are much more attractive than 30-year rates, and the shorter time frame means you'll pay much less interest and build equity in your home faster. Even though the payment is a bit higher, it is, by far, the cheaper way to buy a home.
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