When it comes to financing a home purchase, the 30-year mortgage is the most popular choice among buyers, and by a wide margin. In fact, according to September's Ellie Mae Origination Insight Report, only 9.1% of all mortgages originated were of the 15-year variety.
It's easy to see the appeal of a 30-year loan. The monthly payments are lower, which allows buyers to qualify for a more expensive home than they could with other financing options. However, 15-year mortgages have some very good benefits that are hard to ignore. In fact, the length of your mortgage affects greatly what you end up paying for your home.
Lower interest is just the start
The most visible advantage to a shorter mortgage term is a lower interest rate. Generally, a 15-year mortgage has an interest rate that's around one percentage point less than a buyer would qualify for with a 30-year loan.
As of this writing, the average 30-year mortgage rate is 4.01%, and the 15-year rate averages 3.20%. So the interest is definitely charged at a lower rate, but it's understandable that a relatively small difference in rates might not look appealing enough to persuade you to accept a higher monthly payment.
However, the final difference is due not just to the difference in the actual interest rates, but also to the difference in the timeframe.
The shorter amortization period means a lot less interest
Specifically, a 15-year mortgage means that your mortgage is only accumulating interest for half as much time. This may be a little tough to visualize, so let's look at an example.
Let's say that we want to buy a $250,000 home with 20% down, so our mortgage amount will be $200,000. Using the rates I mentioned, a quick calculation with Bankrate's mortgage calculator shows that our monthly principal and interest payments will be $956 and $1,400 on a 30-year and 15-year loan, respectively.
Over the lifetime of the loan, despite only a slight difference in interest rates, this adds up to a huge difference. The 15-year loan will end up costing about $252,000, or $52,000 in interest. However, the 30-year loan's payments, although lower, will add up to nearly $345,000, which is about three times the amount of interest paid of a 15-year mortgage.
Can you afford the higher payment, or should you choose a cheaper home?
Before getting a 15-year mortgage, there are a few things you should consider related to the affordability of the loan.
Choosing a 15-year option will significantly reduce your buying power. For example, in one calculation using the standard 28% income ratio used by many lenders, a buyer with an annual income of $80,000 can qualify for a $335,000 30-year mortgage, while choosing a 15-year loan drops the maximum mortgage amount to less than $230,000. The exact difference will vary according to several factors such as property taxes, insurance costs, and your other debts, but the difference is substantial.
So, if you already have a particular house in mind, you'll need to determine whether you're comfortable with a higher mortgage payment. And if you haven't picked out a home yet, you need to ask yourself whether you're willing to buy a house that's in a lower price range than you can "afford" with a 30-year mortgage.
Why isn't the 15-year mortgage the most popular?
The 15-year mortgage isn't more popular because people tend to want the largest, most luxurious home they can qualify for, and the lowest possible monthly payment they can get.
Another reason is that with 30-year mortgage rates at such low levels, the difference in interest rates doesn't seem like such a big deal. However, after reading this, you know that choosing a 15-year loan can save you $100,000 over the life of the loan on a $200,000 mortgage.
Could you use an extra $100,000 or more to save for retirement, or pay for your child's college education? Maybe a 15-year loan is worth considering for your next home.
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