| by Glenn J. Downing, MBA, CFP® |
This is a really good Frequently Asked Question. Instead of taking out a 30-year mortgage, should I take out a 15-year loan? How much more are the payments? How much would I save? Can I afford it?
A Sample 30-Year Mortgage
Let’s use a sample mortgage. $400,000 borrowed, at 4.5%, over 30 years. The monthly payment is $2026.74. That means over the life of the mortgage you will have paid $729,626.85 in principal and interest payments to repay that $400,000 loan – and, of course, $329,626.85 of that amount is interest.
You pay interest each month on the unpaid balance. That means in early years your payment is mostly interest, with very little principal repayment. In later years, situation reverses: you pay mostly principal, with much of the interest having been paid in the earlier years.
Using our sample 30-year mortgage, in the first year you will have paid $24,320.88 – your monthly payment times 12. Of that amount, $17,867.98 is interest, and only $6,452.90 is principal. 73% of the payments went toward interest.
The Same Mortgage over 15 Years
Now let’s look at the same $400,000 mortgage, but with a 15-year repayment schedule. Since you’re repaying the loan more quickly, there is less risk to the bank or lending institution, so the rate is lower. At this writing, the difference is .61%, so for our example we’ll use a rate of 3.89%. Now the monthly mortgage payments are $2936.75.
Using our sample 15-year mortgage, in the first year you will have paid $35,241.00 – your monthly payment times 12. Of that amount, $15,205.31 is interest, and $20,035.69 is principal. Only 43% of the payments went toward interest, compared with 73% in the first year of a 30-year mortgage.
Compared to the 30-year mortgage, the monthly payments are $910.01 more. Over 15 years you would have paid $528,615.13 to buy your $400,000 house, of which $128,615.13 is interest. With the 30-year mortgage you made total payments of $729,626.85, so you’re ahead by a whopping $210,011.85.
Clearly, if you can afford the extra $910.01/month payment, the shorter mortgage term is the way to go.
Are There Other Options?
There’s nothing to say that a mortgage must be 15 years or 30 years. You can negotiate pretty much any term you like – even up to 40 years in some cases. Just remember that the shorter the term, the less risk to the lending institution, so the lower the interest rate.
What if Your Income Varies?
Build in some flexibility for yourself. Have an adequately funded emergency fund before taking on a mortgage. If both spouses work, consider having 3 months of fixed and variable expenses in a bank account. If only one spouse works, double that to six months. That is a lot to save we know – down payment PLUS emergency fund – but set a goal and make it happen.
Then, once the emergency fund is largely in place, consider taking out the 30-year mortgage, but make the 15-year payments. Then, if things get tight at some point in the future, you have some flexibility.
You may also find When Does a Refi Make Sense? useful.
