The difference in numbers between a 30-year and 15-year mortgage
When buying a home, many people instantly gravitate to the 30-year conventional fixed-rate mortgage. This allows them to stretch out a very large debt over the maximum number of years, which results in a lower monthly payment. For many, using a 30-year mortgage justifies the purchase of a more expensive house than using a 15-year loan.
But as the following examples demonstrate, choosing a 15-year loan will more than likely save you money in the long term.
Less money per month, but more overall
In this first comparison, two buyers are looking to purchase a $250,000 home with a 20 percent, $50,000 downpayment. That means the mortgage loan is for $200,000.
Buyers A want a smaller monthly payment, so they opt for a 30-year mortgage at 5 percent interest. Their monthly principal and interest payment was $1,074.
During the first year, the monthly payments reduced the principal on the mortgage by less than $3,000. Interest payments, on the other hand, will total nearly $10,000.
If the buyers chose to sell the home in 10 years, they would have paid $91,520 in interest and $37,316 in principal. They would, therefore, have equity of $87,000 (the $50,000 downpayment plus the $37,000 reduction in principal), plus however much the home appreciated in value, at the time of sale.
Buyers B went with a 15-year mortgage for the same house with the same downpayment. Only with a 15-year term, the lender offered a 4-percent interest rate. The monthly principal and interest payment was $1,480.
During the first year, the monthly payments reduced the principal on the loan by almost $10,000, or more than three times the principal paid on the 30-year mortgage. The interest payments in the first year totaled just over $7,800.
If these buyers chose to sell the home in 10 years, they would have paid $57,850 in interest, roughly two-thirds what the buyers with the 30-year mortgage paid after ten years. With the 15-year mortgage, the amount of principal left on the loan after ten years would be just over $80,000. That means $170,000 plus appreciated home value in equity at the time of sale.
Why it pays to pay more per month on a mortgage
What the return on the investment of opting for the 15-year mortgage?
The buyers’ payments over ten years were $48,720 more for the 15-year mortgage than the 30-year mortgage.
But in exchange for the higher payments, they pocketed $83,000 more in home equity ($170,000 = $87,000) after ten years than they would have had with the 30-year mortgage. That’s a return on investment of just over 70 percent.
But what if I can’t pay more per month
Many buyers opt for homes based on the monthly payment they can afford within their current budget. Therefore, since the 30-year mortgage will provide the most amount of home for the lowest monthly payment, they base their decision on what they can pay per month for the longer term.
But what would happen if a buyer settled for a lower-priced home so that they could afford a 15-year mortgage?
In this example, Buyers A purchased the same house as the above example: a $250,000 home with a $50,000 down payment on a 30-year mortgage at 5 percent interest. The monthly P&I payment on their $200,000 mortgage is $1,074.
To have an equivalent monthly payment on a 15-year mortgage, Buyers B would have to borrow no more than $145,000 at 4 percent interest. This would create a monthly P&I payment of $1,073.
Assuming the buyers still had $50,000 to apply to a down payment, they could buy a home for as much as $195,000. They would be putting down more than the required 20 percent and building up far more equity in the process.
Also, keep in mind that the lower priced home will likely have lower property taxes and lower insurance costs, meaning the overall monthly payment will be lower than that of the $250,000 home bought with the 30-year mortgage. But for the sake of comparison, assume the two buyers have the same monthly payment.
Now let’s compare what happens in 10 years when both buyers want to sell.
The buyers of the $195,000 home paid $42,000 in interest over ten years and have only $58,200 left on the mortgage balance. That means their home’s equity is $136,800 plus any appreciated value when they go to sell.
The buyers of the $250,000 home, on the other hand, paid $91,520 in interest and only $37,316 in principal. Their equity, therefore, would be just $87,000 plus however much the home appreciated in value at the time of sale.
So buying the more expensive home over 30 years resulted in paying more than double the amount of interest and having less equity after ten years. In all likelihood, the homeowners who settled for less house over a shorter term initially can afford a more expensive home the second time around than the buyers who paid more over 30 years.