My husband and I are in the early stages of building a house. As we modify our floor plans, the amount we will have to borrow to build is in our minds. It is probably the most expensive thing we will ever buy, and we have to decide what we want to borrow and what loan term we are going to want.
The main differences between 15 and 30 year loans are simple. Fifteen-year loans have higher monthly payments, but you pay less interest, while 30-year terms have lower monthly payments, but you pay much more for the long-term home. As with most areas of personal finance, however, this decision is more than just math. There are other important considerations, such as retirement savings, risk tolerance and discipline.
First, let’s take a look at the difficult figures.
Let’s say a 30-year-old borrower is buying a house for $ 160,000, and his marginal tax rate is 25 percent. At the time this article was written, 30-year loans were at 5 percent and 15-year loans at 4.5 percent.
Using the Calculators4Mortgages amortization program calculator, we will compare the two terms of the mortgage by connecting the mortgage amount and the 15 and 30 year interest rate.
A 30-year term would grant a monthly payment of $ 859 (payment does not include taxes and insurance, which vary by location).
The borrower would pay $ 149,211 in interest and $ 309,211 during the term of the loan.
A 15-year term would grant a monthly payment of $ 1224.
She would pay $ 60,318 in interest and $ 220,318 during the term of the loan.
The 30-year period reduces the monthly payment by $ 365 and will save the borrower $ 238 per year in taxes, but it will cost $ 88,893 more in interest during the term of the loan, and she will own her home when she is 60 years old. The benefits of the 15-year term are the substantial savings in interest and the fact that she will own her home when she is 45 years old. The drawback is that your monthly payment will be higher.
The maneuver margin option
But what about the option of taking a period of 30 years and paying it in 15 years? A 30-year period paid in 15 years would generate a monthly payment of $ 1265. The borrower would pay $ 67,749 in interest and $ 227,749 during the term of the loan. She will own her house at 45, assuming she makes the extra payment every month. But if it fell at a bad time, it would not be caught in a larger payment.
Here is a comparison of each option:
It is easy to see that the borrower will pay less for his house with the 15-year loan. But mortgages are not one size fits all . There are other factors to consider when deciding what is right for you.
How much can you pay?
In our example, the 30-year term is equivalent to a monthly payment of $ 365 less than the 15-year term. If you could not comfortably make the payment within 15 years, the 30 year term is the best option. You can always make additional payments whenever possible.
What is the status of your emergency fund?
Once you sign the loan, you are expected to make the same payment each month. If you take a 15-year period with a larger payment, you must have an important savings account to mitigate the risk of significant unexpected expenses or loss of work.
If you don’t have much of an emergency fund, you’ll be better off with a 30-year term, using the extra money to build your savings.
Can you meet your retirement and other savings goals?
If you are inclined for a period of 15 years, make sure you can still maximize your retirement accounts and meet your other savings goals. If you can’t, stay with the 30-year term.
If retirement is still decades away, you can invest more aggressively. It should be able to withstand the volatility of relatively aggressive investments.
If the retirement is less than 15 years away, it might be better to cancel the mortgage in advance to have security and peace of mind.
How do you feel about debt? What is your risk tolerance?
Many people are reluctant to debts of any kind, and with good reason. Dave Ramsey is firmly in this field, saying:
Do not borrow money. Point. If I can’t get you to postpone the purchase for so long, I suggest you save a down payment of 20 percent or more, choose a fixed-rate mortgage of 15 years (or less) and limit your monthly payment to 25 percent. or less than your monthly net salary.
Debt management is not easy, and for many people, Ramsey’s anti-debt stance is the way to go.
But others are in a different place on the financial trip, and they are comfortable with the mortgage debt if the borrowed funds can get a higher rate of return elsewhere. The risk-adjusted returns should be taken into account, but, essentially, if you opt for the 30-year term at 5 percent, it is reasonable to think that you can get a better return with a portfolio of indexed funds. Consider tax deductions, and 5 percent is even lower.
While it is possible to obtain a higher return elsewhere, it all comes down to your appetite for risk. You can get a better return by going within 30 years, but putting the money in the mortgage is safe. In addition, you have to decide if the extra money you could earn by investing elsewhere is more important to you than the peace of mind of owning your home.
If you can pay the payments on a 15-year loan, but you are concerned about the possibility of job loss or other significant financial impacts, you may hesitate to commit to higher payments. Another option is to take a period of 30 years and pay it in 15 years. You will pay a little more in interest than with the 15-year interest rate, but still significantly less than with the 30-year loan.
The downside is that most people lack discipline. According to the Federal Deposit Insurance Corporation (FDIC), 97.3 percent of people do not consistently pay more on their mortgages. Many people lack the discipline to send extra money every month when the bank does not demand it. What this statistic does not mention is how many of the 97 percent would have been left behind in their mortgages if they were trapped in a 15-year mortgage.
However, if you are already saving regularly and have only used your emergency fund for significant unforeseen expenses, you may have the discipline to pay your mortgage in 15 years. But consumers who spend any monthly savings are better with a shorter term, if they can afford it.
What about the tax cut?
While it is true that you get more than one tax exemption from a 30-year loan, it should not be the main consideration when deciding on a term. The 30-year borrower will pay less in annual taxes than the 15-year borrower, but that is because the 30-year borrower is paying much more interest.
In our example, the borrower would save an average of $ 238 per year in taxes with the 30-year loan, but will pay $ 88,893 more in interest during the term of the loan than he would pay with the 15-year term.
Which one is right for you?
In the end, your financial situation will determine the correct term of the mortgage. If you can make a larger payment, have a substantial emergency fund and meet retirement goals and other savings goals, a 15-year mortgage is a good way to own the house in half the time and pay substantially less interests. If one of these conditions is not met, or if you feel comfortable with debts and risk and want to obtain a higher rate of return with other investments, the money saved each month with the 30-year mortgage payment can be better used in another place. You can always send additional payments.
I’m still not sure which option is for us. What about you? Do you have a 15-year mortgage or a 30-year mortgage? Prepaid? What are your thoughts about risk versus higher returns?