Shopping for a dream house is exciting. You look through listings, check out pictures, and imagine everything you would do with the home. I’m just as guilty. My wife and I regularly look at homes, even when we have no interest in moving. It’s a fun activity to pass the time, though the two of us enjoy moving around, so we know one day we’ll end up making a purchase.
But, here’s the thing. When you’re looking to buy a dream house, you may be tempted to take out the first mortgage that a bank offers. This might be an FHA loan or a 30-year mortgage. An FHA loan has the seeming advantage of a very low down payment requirement, and a 30-year mortgage has an affordable monthly payment.
In this post, I’ll show you how much a 30-year mortgage is really costing you, and why I recommend a 15-year mortgage instead.
The Difference in Interest Rate Between a 30-year fixed-rate mortgage vs. a 15-year fixed-rate mortgage
You might think that a 30-year mortgage costs twice as much in interest payments because the term is twice as long, but that’s far from the truth. Aside from paying more in interest due to the term of the loan, 30-year mortgages have higher interest rates than 15-year mortgages, averaging 0.5% higher.
You might not think half a percent means much when it comes to mortgages, but the truth of the matter is, even when comparing two 30-year mortgages at 0.5% apart, you will save tens of thousands of dollars over the course of paying off your loan.
Differences in the Monthly Payment For a 30 Year Mortgage vs. a 15 Year Mortgage
As you may imagine, because a 15-year term is half that of a 30-year term, you have to pay the balance of your mortgage in half the time. Using a $240,000 mortgage loan example assuming a 3.5% interest rate on the 30-year loan and a 3% interest rate on the shorter-term 15-year loan, let’s look at what your monthly mortgage payments would be. This would be your base mortgage payment, not including taxes, insurance, or other fees.
A 30-year mortgage with a 3.5% interest rate would run you $1,077.71 per month. On the other hand, a 15-year mortgage with a 3% interest rate would run you $1,657.40 per month, approximately a 50% higher monthly payment.
To qualify for the 15-year mortgage, your income would need to be significantly higher. The 30-year mortgage would require an approximate monthly take-home pay of $3,848 if you had no other major debt (and not considering taxes and insurance), and the 15-year mortgage would require $5,919 take-home pay per month, also not including taxes and insurance.
It would seem one should simply get a 30-year mortgage so they can buy the house that they want. But how much does that interest actually add up? Let’s take a look.
How Much Interest Adds Up
To get an accurate measure of how much interest adds up, let’s assume you never pay extra money toward your mortgage. The example will be the same as above: A $240,000 mortgage with the 30-year version having an interest rate of 3.5% and the 15-year version having an interest rate of 3%.
As a quick refresh, the 30-year mortgage, without taxes and insurance, would run you $1,077.71 per month. Here’s the thing. Over those 30 years, you would pay $147,974.61 in total interest payments over the life of the loan. That’s significant!
Now, if we look at a 15-year mortgage, without taxes and insurance, remember that you would pay $1,657.40 per month. Any thoughts on how much interest you’d pay? Here it is: $58,331.27.
That’s pretty fascinating. By dropping your interest rate by 0.5% and reducing your term in half, you are saving approximately $90,000 in interest payments!
Why I Recommend a 15-year Mortgage
I’m not rock-solid on this recommendation as I do see advantages of having a 30-year mortgage at times, but most of the time, I recommend a 15-year mortgage. As you can see above, saving over 60% on interest payments is a reason alone for going for the shorter mortgage.
Being a proponent for getting out of debt sooner than later, I feel a 15-year mortgage cuts a minimum of 15 years off your house debt. Sure, you will suffer a bit in the interim, but your retirement nest egg will thank you when you have tens or hundreds of thousands of extra cash in it because you didn’t get eaten up by long-term interest payments.
If you buy your first house when you are 25, you will potentially be in debt to the bank until you’re 55 if you get a 30-year mortgage versus a 15-year. That’s a lot of time where something can go wrong, or things can change. By having a 15-year mortgage, not only are you cutting down the interest by over 60%, you’re also limiting the risk of time. Additionally, you gain home equity much sooner.
When to Use a 30-year mortgage
I’d much rather suggest that you (or anyone) get a 15-year mortgage and get out debt faster, however, I know some people will ask when it’s a good idea to get a 30-year mortgage.
If you live in an area where rent is high and house prices are low, and you believe your income will rise soon, then getting a 30-year mortgage to secure a well-priced home may work. From there, I recommend aggressively paying down the mortgage by adding at least 25% of the monthly payment toward prepayments.
This will simulate getting closer to a 15-year payoff. If you can’t do this right away, work towards it. You may wonder if you should simply invest your extra money since mortgages have low interest rates compared to what you can earn on the stock market.
In short, I recommend a 50/50 split of paying down the mortgage and investing once you’re out of debt. Here’s a post with the math.
Wrapping It Up
Your financial future will be brighter when you get a 15-year mortgage and pay it off sooner, with approximately 60% less interest paid. While you may be tempted to get into the 30-year mortgage because it seems like a better deal and that you can afford a home quicker, remember the hidden cost of time.