Many of my clients have taken advantage of the significant savings offered by a 15-yr mortgage as opposed to the more traditional 30-yr loan. For those that can afford it, it’s a great way to pay off your home in half the time and save tens of thousands of dollars in interest, but borrowers need to consider their financial standing and options before committing themselves to this type of mortgage.
What is a 15-yr Mortgage?
A 15-yr mortgage (we’ll just call it a “15-yr”) is a fixed-rate mortgage that is amortized (the process of paying a loan down in equal payments over a certain period of time) over 15 years instead of 30 years. The interest rates are normally lower than 30-yr mortgage rates (that’s the incentive to pick a 15-yr loan). Because of the way amortization works, even though the loan is paid off in half the time, the mortgage payment is not twice as much.
The Pros of a 15-yr
Fifteen-year mortgages have the following main benefits-
· Lower interest rate than a 30-yr – How much lower depends on the market. There have been times when the rates for a 15-yr and a 30-yr have not been that far apart, but historically, 15-yr rates have averaged 0.625% lower than a 30-yr. So for example, if the going 30-yr mortgage rate is 4%, you can expect a 15-yr mortgage rate of about 3.375%.
· Pay off the mortgage in half the time without paying twice as much – The payment for a 15-yr loan will be about 48% higher than the a 30-yr for the same mortgage balance. Even if you factor in the increased payment for the 15-yr loan, you pay over 60% less interest over the life of the loan.
· Mortgage Insurance is cheaper – If mortgage insurance (not to be confused with homeowner’s insurance) is required (it’s mostly required for FHA loans and mortgages with less than 20% equity), it’s normally less expensive than 30-yr mortgage insurance.
The Cons of a 15-yr
Although they’re normally great, beware of the following downsides of a 15-yr loan-
· You can’t buy as much of a home – Because the amount that you can borrow is determined in large part by the size of the mortgage payment compared to your income, many borrowers will not be able to purchase as large of a home with a 15-yr as they could with a 30-yr. For example, if it’s determined that the maximum mortgage payment your income can support is $1200/month (principal & interest, assuming 4% for a 30-yr and 3.375% for a 15-yr), then you could buy a home for $251,000 with a 30-yr mortgage, but your max purchase price would be $169,000 with a 15-yr mortgage.
· The interest rate is not always much better than a 30-yr – Anybody can pay down their loan faster by paying more each month, so if there isn’t much of a difference between a 30-yr interest rate and a 15-yr interest rate (I would say less than 0.5%) then there isn’t as much of a benefit with picking a 15-yr with a higher payment.
· You don’t get a “do over” – You can always make a 15-yr payment on a 30-yr loan, but you can’t make a 30-yr payment on a 15-yr loan (lenders tend to frown/foreclose on that). If you think a 15-yr could be a stretch, don’t risk it.
Main Consideration – What Else Can I do with my Money?
So, is a 15-yr good or bad? Usually good, but you MUST consider the opportunity costs, i.e. what else could you do with that money? In my opinion, the following items are a better use of money than putting it towards 15-yr mortgage payment:
· Emergency Savings – If you don’t have a rainy day fund, get one before you put extra towards your mortgage. If you got a 15-yr loan and weren’t able to save money otherwise, what would happen in the case of an emergency? You would be forced to use debt, likely at a higher interest rate than your 15-yr loan, which would negate the whole purpose of getting a 15-yr loan (to save money).
· Higher Interest Debt – What sense does it make to pay extra towards 4% debt (the current 30-yr mortgage rate) while only making the minimum payments on 15% debt (the average rate for credit cards)? A 15-yr is all about paying less interest, but if you do it at the expense of having other high interest debt, you’ve shot yourself in the foot. Before you pay more towards your mortgage, pay off your higher interest debt (usually credit cards).
· Retirement Savings – I meet with a fair amount of people that are 15 years from retirement and really want refinance to a 15-yr so that they can own their home by the time they retire. However, these same clients have often not saved for retirement and won’t be able to do so if they get a 15-yr loan. What will they do for income when they retire? They’ll have to either sell or re-mortgage the home they just paid off! Make sure that you are sufficiently funding your retirement savings before you pay extra towards your mortgage.
Bottom-line
Fifteen year mortgages are a great way to save on interest, but make sure your other ducks are in a row and that it really make sense before you make that irreversible commitment. I’d be happy to help you with that analysis!
