In the last episode of Finance Friday we talked about refinancing.
This week, let’s go a little deeper on a few things to consider when choosing between a 15-year or 30-year mortgage.
Is there a big difference in rate between a 15 and 30-year?
The answer to this is no.
It used to be that there was close to a 1% difference between these rates.
With how suppressed rates are today, there is very little difference.
It many cases they may be the exact same.
This offers very little advantage to the 15-year by way of rate.
Interest Savings on a 15-Year
The main case for doing a 15-year is overall interest savings.
Remember, that you are likely getting a very similar rate with both options.
If rates are the same, why the difference in interest savings?
Your loan term is twice as long on a 30-year.
Let’s use an example:
Let’s say you have a loan amount of $250,000 and interest rate of 2.75% - on a 15-year mortgage.
If you take that loan to the full 15-year term, you will have paid $55,000 in interest.
Conversely, let’s look at if you have the same $250,000 loan amount, rate of 2.75% - on a 30-year.
If you take this loan to the full term of 30-years, you will have paid $117,000 in interest.
That is a staggering $62,000 more in interest you will pay on a 30-year.
Seems like a 15-year is the obvious choice?
Not so fast.
There are two primary drawbacks to a 15-year mortgage.
Let’s look at them.
Increased Monthly Payment
Because of the shorter term of your mortgage, your payment will be much higher on a 15-year.
Depending on all factors, it will likely be at least 50% higher.
With the many factors that change when it comes to people’s lives and their finances, that extra 50% can be significant.
You will want to consider how easy that payment will be to make in the future – not just today.
If there is a loss of job, recession, medical issues, etc…that payment doesn’t change.
And with the potential for income changes, you may not be able to refinance if your income drops in the future.
If home prices drop as well, there may not be the equity to refinance without mortgage insurance.
This is something you will want to take into account when committing to a 15-year.
It may not be easy to switch back later on – and rates definitely may not be as low as they are now.
So, with rates being nearly the same on both options, the risk may not be worth the reward on a 15-year.
You can always treat your 30-year mortgage as a 15-year and then default back to the lower 30-year required payment if your situation changes.
To me this is a great benefit.
This may be the last time we ever see these rates so close to each other.
If rates go up, the spread between the two will likely increase as well.
This is a very important factor to take into account.
When you spend money on X, you now forego the opportunity to spend it on Y.
That means the extra 50% spent on your 15-year, now cannot be spent on other areas – and specifically investing.
This is opportunity cost.
Your cost of doing a 15-year is missed investment income/opportunities.
Money cannot be spent on both at the same time.
We will want to consider the power of compounding interest when looking at opportunity cost.
Compounding interest means you are earning interest on your interest.
If that interest is reinvested, you then earn interest on that interest.
That becomes very powerful if you compound that money over a long period of time.
Remember with a 15-year you are saving $62,000 in interest by paying off your loan early.
Let’s look at the other side.
The difference in a 15-year and 30-year based upon the $250,000 loan amount is about: $675
What if that money was invested for 15 years instead of put into your mortgage?
Let’s assume we can invest that in the S&P 500 with a very realistic average of 8%.
At the end of 15 years, with that $675 invested monthly, your investment would be worth: $235,000
If invested for 30 years it would be $1,012,699.
That is well over the $62,000 extra you pay in interest.
That’s the power of compound interest.
There are pros and cons to both approaches.
With both terms offering the approximate same rate, there is security in going with a 30-year.
You can always treat it like a 15-year but give yourself the flexibility to default back if your situation changes.
Conversely, if your cash permits, I think it is wise limit your loan term as much as possible by paying extra towards your mortgage.
There is a lot of peace of mind being debt free.
That being said, don’t let it be at the expense of investing.
When it comes to the market, there is no guaranteed return.
So even though the S&P 500 has returned 8% historically, there is no guarantee it will continue.
With rates being so low, you likely won’t need that high of a return to make the investing route more beneficial.
This additional cash flow can also be used to buy investment properties, start a business, etc.
There is a lot to consider and everyone is different.
I offer these alternatives to help you with a few other points to consider.
I hope that helps.
As always, if you have any questions, please don't hesitate to reach out.
Thanks for reading,
CO-Founder 1911 Apparel
This is not financial advice. Contact a licensed mortgage professional in your area to see what makes sense for your unique situation.