Today, when most people are choosing the type of loan to get in order to finance the purchase of their home they are choosing among a 30-year mortgage, a 15-year mortgage, and sometimes a 5 or 7 year adjustable rate mortgage. If you choose a 30-year mortgage, you will pay the mortgage on your home off in 30 years if you make the minimum monthly payment. If you choose a 15-year mortgage, your time to pay off the loan drops to 15 years. An adjustable rate mortgage (ARM) starts off with a lower interest rate (and likely lower monthly payment) during the initial 5 or 7 year period but then it adjusts (usually upwards) based on the loan terms.
So, which mortgage should you choose to finance the purchase of your home?
Avoid the ARM
First off, avoid the temptation to select the ARM if it has a lower initial interest rate and monthly payment. We are at historically low interest rates and so you should be selecting a loan with a fixed interest rate for the entire loan period. I would still recommend avoiding an ARM even if you plan to sell the property before the ARM interest rates resets. Why? Life happens and sometimes you stay somewhere or hold an investment property longer than you initially planned. I speak from experience – I selected a 7-year ARM for one of my properties because it had a lower interest rate and I planned to do something with the property long before the ARM’s interest rate would reset. Things changed, I decided to hold onto the property, and when the ARM interest rate reset I went from a 3.5% to a 5.25% interest rate and an increase in my monthly payment of over $300 per month. It took my property from being cash-flow positive to slightly cash-flow negative. I refinanced to a 30 year mortgage and a 3.75% interest rate but not everyone will be able to refinance at the time the ARM adjusts and you still have additional loan costs from the refinancing that you would not have to incur if you initially selected a fixed mortgage.
Whether to choose a 30 or 15-year mortgage?
Today, a 30-year fixed mortgage for someone in my area with good credit has a 3.75% interest rate and a 15-year fixed mortgage with the same assumptions has a 3.25% interest rate. If you use these interest rates on a $500,000 home where you put 20% down and finance the rest with a $400,000 mortgage:
- On a 30-year mortgage, your estimated monthly payment on your mortgage would be $1,852 and you would pay $267,026.87 in interest over the life of the loan.
- On a 15-year mortgage, your estimated monthly payment on your mortgage would be $2,810 and you would pay $105,956.26 in interest over the life of the loan.
The trade-off is a much lower monthly payment with the 30-year loan ($958 less in this example) but significantly less in total interest payments ($161,070 less in this example) if you chose the 15-year mortgage.
Conventional Wisdom – Choose the 15-Year Mortgage
The conventional advice is to choose the 15-year mortgage if you can afford the higher monthly payment. Here are the main reasons:
- A 15-year mortgage pays down principal on a loan much faster. The higher monthly payment on the 15-year mortgage actually means you are paying down the loan faster and therefore paying yourself in the form of equity buildup in your home. Here is a comparison of the equity buildup (i.e., amount of loan paid-down) with a 15 and 30-year mortgage using the example above:
Amount of loan paid-down
After 5 years
After 10 years
After 15 years
- You will pay much less in interest payments to the bank. In the example above, you would save over $160,000 in interest payments on a $400,000 loan.
- You will have paid-off what is likely your largest form of debt in half the time. I’ve seen the benefit of this first hand as I chose to pay-off my mortgage as part of my plan to achieving financial independence. See my article here. Once the mortgage is paid off and you no longer have a monthly mortgage payment it feels like you have a lot more money in your pocket to invest or spend and it feels safer to move on to the next phase of your life (if that is what you want to do).
The Alternative – If you are Disciplined Then Choose the 30 Year Mortgage to Increase Flexibility
One thing I like to add to my life is the ability to adapt and be flexible. This goal of flexibility applies to different parts of my life including my investments and expenses. I like my investments to have liquidity and I prefer expenses that I can reduce quickly over long-term commitments.
By choosing a 30-year mortgage you can add flexibility to your monthly expenses. This does not mean taking the lower monthly payment and spending it! If you are disciplined you can use the lower monthly payment to actually help you achieve financial independence earlier. In the example above, you can take the $958 difference in the monthly payment between the 30-year and 15-year mortgages and do either of the following:
- You can pay an extra $958 each month against your 30-year mortgage and pay-off the 30-year mortgage early. In the example above, you would still get most of the benefits from a 15-year mortgage by paying-off the 30-year mortgage in a little under 16 years and only paying $130,000 in interest (still saving you approximately $137,000 in interest versus if you paid-off the 30-year mortgage over the full 30-year period).
- You can take the extra $958 each month and invest it in investments that yield a greater return than the effective return you can by paying-down the mortgage. There is a potential tax benefit to paying interest on a home mortgage, and combining the tax benefit from the higher interest you pay on a 30-year mortgage with investing the extra funds available to you each month can be a better way to optimize your overall returns. At some point I will do a separate post on paying-down your mortgage versus investing the same amount of money.
By having a 30-year mortgage, you also create the flexibility to pay a lower monthly payment in the case of an emergency (e.g., you lose your job or you have a big unexpected expense that cannot be covered by your savings). Again, emergency does not mean paying-off the maxed credit cards from vacation or being able to get little Johnny his new car when he turns 16.
Finally, it is easier to qualify for a 30-year mortgage than a 15-year mortgage because of the lower minimum monthly payment. That might be important depending on your situation. You also establish a lower expense-to-income ratio with a 30-year mortgage which can be meaningful to you if you want to purchase a second property down the road and need to qualify for another loan.
It All Comes Down to Discipline
Most people do not have the discipline to select a 30-year mortgage and use the difference in a lower monthly payment to either pay extra on the mortgage or to invest the difference in quality investments. If you fall in that camp then you should consider a 15-year mortgage as a fixed savings vehicle that will help you pay less interest, save more money, and reduce your debt more quickly.
If you have the discipline to use the lower monthly payment wisely then I think the 30-year mortgage gives you additional flexibility that you can use to your benefit.
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