While a 15-year mortgage seems a bit scary because you'll have higher monthly payments, the long-term interest savings make it a great deal if you can afford it. But it's important to make sure you're not overextending yourself in the hopes of paying off your loan more quickly.
A 15-year mortgage could save the average homeowners tens of thousands of dollars in interest -- but it could also increase your monthly payment by 28% and keep you from meeting other financial goals. Here's some advice on whether a 15-year mortgage is right for you and how you could make the most of one
What is a 15-year mortgage?
Traditional home loans last for 30 years. In most cases, offering to take the shorter 15-year term comes with a better rate. It offers a chance to pay off your home more quickly and spend far less in interest.
As with any loan, a 15-year mortgage requires that a lender consider you worthy. In a broad sense, that means meeting the 28/36 rule, which has two requirements:
- A household must not spend more than 28% of its gross monthly income on complete housing expenses.
- A maximum of 36% of gross monthly income can be allocated to debts and lingering loans.
A 15-year loan may also require a little more scrutiny than a traditional 30-year mortgage, because the bank will want to be very sure you can make the higher payments.
A quick calculation at current rates
The best way to put this all into perspective is to consider a couple of calculations at the current mortgage rates. Let's say you're looking to purchase a $300,000 home and you plan to put down a 20% down payment, or $60,000. Remember that your credit score also effects the interest rate. Assuming you have a credit score between 720 and 739, with a 15-year fixed mortgage, you'd be looking at an interest rate of about 2.65%. (Your actual interest rate could be lower or higher based on your creditworthiness.) Your monthly payment would be $1,984, according to Zillow's mortgage calculator.
The principal and interest -- i.e., the total amount you've borrowed to buy the home and the interest you owe on that principal -- works out to be 81% of your payment, while the rest will go toward your homeowners insurance and property taxes (assuming your mortgage includes an escrow account, as most do). In the first month you'll be paying $1,086 on the principal, $534 in interest, $300 in property taxes, and $67 on insurance.
Now, let's switch that to a 30-year fixed mortgage. The interest rate rises to approximately 3.39%, but your monthly payment decreases to $1,430. Meanwhile, the principal and interest works out to be 74% of your payment. So you'll be paying a total of $384 on the principal and $681 in interest -- yes, you'll be spending nearly twice as much on the interest as you spend paying down your principal. Again, you will pay $367 in taxes and insurance.
So even though you'd pay less money per month on a 30-year loan, in the long run, you'd be sinking plenty of extra money into your mortgage, because you'd be paying more interest over a longer period. For approximately $555 more a month, you can save yourself tens of thousands of dollars in the future. The difference in interest alone is a whopping $91,562.
Why it's not for everyone
Not everyone can afford the more expensive monthly mortgage payment. So while a 15-year mortgage may sound appealing to those looking to save in the long run, those who need to save in the short term might not like the monthly cost.
Other factors to consider include financial stability and emergency funds for those unexpected moments that life hands you. One option, if you're on the fence, is to take a 30-year-year loan but pay extra each month to work the loan down more quickly. That won't get you a lower interest rate, but you will reserve the right to go back to the smaller mandated payment if your financial situation changes.
There's also the fact that a 15-year mortgage leaves you with less money for retirement savings and other long-term investing goals. For many people, the smarter option is to take out a 30-year mortgage and invest as much as possible for the future. After all, the stock market has historically averaged 7% per year, whereas paying down the 15-year mortgage in our example would only "earn" you 2.65% per year in savings. You'd also be missing out on plenty of compound interest over the years.
Using the numbers from our example, let's say you took the 15-year mortgage, saved nothing for retirement throughout the term of the loan, and then invested your former principal and interest payment ($1,620) for 15 years after that, earning an average of 7% per year. You'd have $507,000 after 30 years.
On the other hand, if you took out the 30-year mortgage and invested your monthly savings of $555 throughout the term of the loan, then you'd end up with $653,000. Even after accounting for the extra interest you would have paid, you would come out $54,000 ahead by taking the 30-year loan.
And the better your returns, the better the 30-year loan is. If you earned 8%, you'd end up with $145,000 more if you took the 30-year loan. With a 9% return, you'd have an extra $262,000. So, while a 15-year loan can save you a lot of money in interest, it can cost you even more in retirement savings.
Be very careful before taking a 15-year loan
The overall savings of a 15-year loan are tempting, but it does come with significant risk. The higher monthly payments leave less room for financial disruption. So if you're buying a house you can easily afford, and you have stable income and a strong rainy-day fund, then taking the better deal on a shorter mortgage could make sense. But if you don't fit that profile, then taking the 30-year loan would be a safer way to make your monthly payments on time without worrying about dipping into your emergency funds or savings accounts.
Only take a 15-year mortgage if you get an improved interest rate on your loan that makes it worth your while. If the 15- and 30-year offers are close, you can always take the 30 but pay off the mortgage in 15. Whether the term is for 15 or 30 years, the sooner you pay it off, the less you pay in interest.
And if a 15-year mortgage would prevent you from saving enough for retirement, then it's not for you. Making sure you'll have enough income when you're no longer working should be your top financial goal.