One of the trickiest decisions that prospective homeowners face as they apply for a mortgage is the choice between a 15-year fixed-rate mortgage and a 30-year fixed-rate mortgage.
A lower monthly payment often sways people toward choosing a 30-year mortgage. After all, your monthly bills for the next decade and a half will be lower than they would if you chose the 15-year mortgage, and the argument usually goes that you will likely move or refinance in several years anyway, once you have a better income.
But is that a good reason to choose a 30-year mortgage? For some, perhaps, but not for everyone. Let’s dig a little deeper and find out if a 15-year or a 30-year mortgage is right for you.
15-year vs. 30-year mortgage
A 30-year fixed-rate mortgage is one that you’ll pay off in monthly installments over the course of 30 years, whereas 15-year mortgages take half as long to pay off and 30-year mortgages usually come at a slightly higher annual interest rate than 15-year mortgages. However, their big selling point is that they usually have a lower monthly payment than 15 year fixed rate mortgages – after all, you’re making twice as many mortgage payments.
15-year and 30-year mortgages by the numbers
Let’s say you need to borrow $300,000 to buy a home. Current 30-year fixed-rate mortgage rates are around 3.5%. On that 30-year mortgage, you’ll have a monthly payment of $1,630.47. On the other hand, 15-year fixed-rate mortgage rates are around at 3.1%. On that 15-year mortgage, you’ll have a monthly payment of $2,369.54.
The monthly payment on that 30-year mortgage is $739.07 less than the monthly payment on that 15-year mortgage, so in the short run, that’s clearly better, right? Well, in 15 years, the payments on the 15-year mortgage will vanish, while you’re still paying $1,630.47 a month for the next 15 years after that.
In total, the 30-year mortgage in this example will add up to $586,969.20 in payments, whereas the 15-year mortgage will add up to only $426,517.20, a difference of $160,452.
To put it simply, if you are able to easily handle the payments on a 15-year mortgage, then that’s the option you should choose. You will pay substantially less in interest over the course of a mortgage if you go with a 15-year mortgage instead of a 30-year mortgage, so if the payments aren’t a problem, the typical 15-year mortgage is the best option. You’ll also build equity in your home faster. However, you can still refinance your 30-year mortgage for better interest rates or shorter terms when your financial situation changes, especially if rates are low.
The problem, of course, is that not everyone finds themselves in a situation where the payments on a 15-year mortgage are easy to make.
Evaluate your finances
For many homeowners, buying their first home will be the most impactful financial decision they’ll make in their lives. If there’s a point in your life where you need to make a smart financial decision, it’s this one.
For starters, you need to have an honest assessment of what you can really afford for housing each month. Your new home won’t just come with a mortgage. You’ll also be facing property taxes, homeowners insurance and, in many cases, homeowners association fees. There’s also the expense of property maintenance – fixing all of the little things that will go wrong – and that often adds up to 1% or more of the home’s value each year. That’s a lot of big expenses, and a new homeowner needs to be ready for it.
You also need to be realistic when it comes to your own income. Many people, particularly early in their career, hold a very optimistic view about their income increasing significantly going forward, and that sense of optimism encourages financial risk. People often talk themselves into debt because they believe their “future self” will take care of it. Don’t fall into that “optimistic future” trap. It is a bad idea to burden your future self with debts based on unreasonable expectations.
Instead, focus on your behavior. Do you choose to spend significantly less than you earn? Is this something you actually do in normal practice, or is it a struggle for you? The more difficult you find it in a rental situation to put even a little money away for the future, the harder homeownership is going to be.
The 28% rule in mortgage payments
One rule that is often used to judge one’s mortgage options is the 28% rule. Simply put, the 28% rule states that your mortgage payment should not exceed 28% of your gross household income in a month. Your gross household income is how much you earn before taxes, so 1/12th of your pre-tax annual salary. If you make $60,000 a year, your monthly gross income is $5,000, and 28% of that is $1,400. The 28% rule is a good rough estimator of the high end of what your monthly mortgage payment should be.
If you add into that all of the other expenses of homeownership, your monthly expenses for your home could be as much as 40% of your gross income or half your paycheck. Excluding housing needs, can you live on half of your take-home pay? If that would be a supreme struggle for you, you need to adopt some new spending behaviors or homeownership will be quite difficult.
When should I consider a 15-year mortgage?
Let’s evaluate a 15-year mortgage through the lens of the 28% rule and see how that works out.
In our earlier example, the $300,000 15 year loan at 3.1% caused a monthly mortgage payment of $2,369.54. If you divide that by 0.28, you get $8,462, which is the gross monthly income that would match the 28% rule, or roughly $100,000 a year. In short, if your family’s income is less than $100,000 a year, you should not consider a $300,000 15-year mortgage.
So, should that family consider a 30-year mortgage for that amount? If they earn close to $100,000 a year – say, $80,000 – they’ll be within the 28% rule. This move will get them into that $300,000 home, but it will come with a much higher total amount of interest owed. You shouldn’t borrow more than you can afford under the 28% rule with a 15-year mortgage, even if you decide to go with a 30-year mortgage. The biggest mistake you can make is to wind up in a house that you can’t afford because you’ll lose far more money that way than if you had simply remained a renter.
How do you calculate that? Start by figuring out how much your monthly gross income is (if you’re unsure, look at your gross income for last year on your tax filing and divide it by 12), then multiply that number by 0.28. You should aim for that as your maximum monthly payment. Then, find the current best rates for a 15-year mortgage and plug that percentage into this calculator to see how much you can borrow.
Too long, didn’t read?
If you can afford the monthly payments on a 15-year mortgage, then it’s the better option for long-term financial planning. Even with the higher monthly payments, you end up paying less in interest over time. However, even if you take out a 30-year mortgage on a house, you can still pay it off faster or refinance your mortgage for better rates to avoid the long-term interest costs that come with it.
Updated July 15, 2020 – Added new insights on mortgage rates in 2020.
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