Homeowners tend to flock to thirty-year mortgages. After all, that is the standard, with 90 percent of borrowers choosing the thirty-year option (according to the Federal Home Loan Mortgage Company, commonly known as Freddie Mac).
Many potential borrowers may not even realize that there are other choices for mortgage loan terms, and that going shorter can save them tens of thousands of dollars (or more!) over the lives of their loans.
How Mortgage Terms Impact Cost
Mortgages are typically secured by real estate and are part of the term loan category. On a term loan, the borrower pays interest based on the outstanding balance of the loan. Interest rates and payments are both fixed.
Time affects the total cost of your loan in a few different ways. A longer loan term offers smaller monthly payments. A shorter loan term offers lower interest rates, lower total lifetime interest paid, and faster equity buildup.
On paper, a shorter loan term may seem like the obvious winner, but it will limit your financial flexibility and the opportunity to build a more liquid nest egg. The term that’s better for you is the one that fits into your overall financial plans and your monthly budget.
Thirty-year mortgages are the gold standard in the lending world, mainly because of the more affordable monthly payments than loans with shorter terms. That’s not the only difference, but it is the most noticeable one.
Lower payments mean there’s more money in your budget available to go toward savings (retirement, emergency funds, college)—but that’s only a benefit if you funnel the difference (or at least part of it) into savings. Smaller payments may also allow you to buy a bigger house or take out a bigger mortgage than you could with a shorter loan term.
On the downside, your mortgage will come with a higher interest rate and you will pay substantially more interest over the life of the loan. That money goes straight to the bank, instead of funding your future.
Shaving fifteen years off your loan term can make a huge difference in the life of your loan. If you can afford those steep monthly payments, it will be better for your overall financial health to go with the shorter loan.
For one thing, banks love shorter loans (they’re lower risk) and reward these borrowers with lower interest rates, sometimes as much as a full percentage point lower than their thirty-year counterparts.
That combined with the much shorter time period means huge savings on interest costs. Another big benefit: You’ll build equity at a much faster pace, as a larger portion of your payment will go toward principal every month.
More equity means you’re much less likely to end up underwater if housing prices drop and you need to sell. You’ll also be in a better financial position if you ever want to take out a home equity loan. The big (very big) drawback with fifteen-year mortgages is the oversized monthly payment.
The average payment on these loans runs anywhere from 35 to 50 percent larger than it would with a thirty-year mortgage, putting these loans out of reach for people on tight budgets. The bigger payment can also make it harder to save for retirement, though the lifetime interest savings and earlier pay-off date can help offset that.
If you do go with a fifteen-year mortgage, make sure to have a very large emergency fund (a full year’s worth of expenses) available to cover your payments if necessary.
The Difference Between 15-Year and 30-Year Mortgage
Seeing the numbers and how they compare can help you figure out which loan term will work for you. To start simple, we’ll look at a $200,000 loan and keep the rate the same at 4 percent for both terms.
Using that information: For the thirty-year loan, the monthly principal and interest payment will be $955, and you’ll pay lifetime interest costs of $143,739. For the fifteen-year loan, the monthly principal and interest payment will be $1,479, and you’ll pay lifetime interest costs of $66,288.
By going with the shorter loan term, you’ll have to come up with an extra $524 every month to cover the mortgage payment.
On the other hand, you’ll save $77,451 in total interest costs. Realistically, though, the payment would likely be a little smaller and the total interest savings even bigger because fifteen-year loans have lower interest rates than thirty-year loans.
If the borrower’s employer matches the borrower’s contributions, they may have incentives to invest in 529 college savings accounts or tax-deferred 401(k) plans with the extra money they spend on a 15-year mortgage.
With mortgage rates, so low, savvy, and disciplined investors could opt for the 30-year loan and invest the difference between the 15-year and 30-year payments in higher-yielding securities.
The borrower could invest that $676 difference if, for example, the monthly payments on a 15-year loan were $2,108 and those on a 30-year loan were $1,432. A back-of-the-envelope calculation measures whether (or how much) the return on the outside investment is greater than the mortgage interest rate after accounting for the mortgage interest deduction. The deduction reduces the effective mortgage interest rate, for example, from 4% to 3% for someone in the 24% tax bracket.
As a general rule, the borrower wins if the investment’s after-tax returns exceed the mortgage cost less the interest deduction.
Shashin Shah, a certified financial planner in Dallas, Texas, says this gamble requires a high level of risk because the borrower will have to invest in volatile stocks.
According to Shah, there are no fixed-income investments that would yield a high enough return to make this work. In the case of sharp stock market declines, such as those experienced during the downturn of 2020, this risk may not always pay off. The discipline to invest those differentials systematically, as well as the time to focus on the investments, are also needed, according to him.
If the supersized monthly payment of a fifteen-year loan makes you queasy, but you don’t want to be on the hook for thirty years’ worth of interest, consider a compromise.
There are two main ways you can have your mortgage and pay it off too: Choose your own payment or apply for a twenty-year loan. Either way, you won’t be saddled with budget-busting mortgage payments, and you’ll save tens of thousands of dollars in lifetime interest costs (compared to a full thirty-year loan).
T-Minus Thirty and Counting
Just because you took out a thirty-year mortgage doesn’t mean you have to make payments for thirty years. You can enjoy the comfort of a smaller mandatory mortgage payment but make bigger or additional payments if you want to pay your loan off earlier.
Every extra dollar you pay reduces the next month’s interest charge, which means more of every following payment will go toward paying down principal, and you’ll pay less interest over the life of your loan.
Since you’re making these extra or bigger payments voluntarily, you can skip that whenever life throws you a curveball, and pony up just the regular monthly payment.
The Twenty-Year Compromise
Most people aren’t aware that twenty-year mortgages exist. In fact, these little-known gems make up less than 1 percent of total mortgage loans. They combine the best parts of the more popular thirty- and fifteen-year mortgages:
- More manageable monthly payments than fifteen-year loans Better interest rates than thirty-year loans (but not quite as low as fifteen-year rates)
- Significantly lower lifetime interest costs than thirty-year loans (just a little higher than with fifteen-year terms)
- Fast equity building
Though they’re not heavily advertised, most commercial lenders do offer twenty-year mortgages. You just have to ask for the information.
If you are debating between a 30-year or 15-year mortgage, make sure you crunch the numbers first before choosing. A 15-year loan may be the right choice if your goal is to pay off the mortgage sooner and you can afford higher monthly payments. A 30-year loan, on the other hand, has lower monthly payments, allowing you to buy more houses or use the funds for other financial goals.