30-Year vs. 15-Year Mortgage: Which Should I Pick?
by Matthew Frankel, The Motley Fool
The industry standard mortgage product in the United States is the 30-year fixed-rate mortgage, which is used by more than 85% of homebuyers. However, the 15-year fixed-rate mortgage has been gaining traction, as it can be a smart way to save thousands in interest charges over the term of your loan. Here's a comparison between the pros and cons of each loan term, so that you can decide which is best.
A 30-Year Mortgage Can Minimize Payment and Maximize Your Budget
The obvious reason to choose a 30-year mortgage is that it allows you to buy a home, and pay less per month than you would with a 15-year mortgage. For example, based on the current average interest rates, you can expect to pay roughly $1,420 per month on a $200,000 15-year mortgage, while the payment on a 30-year loan of the same amount would be just $956.
This can also help you maximize your homebuying budget, as lenders qualify you based on your debt as a percentage of your income. One common rule says that your mortgage payment should be no more than 28% of your gross (pre-tax) monthly income. If you earn $5,000 per month, this means that you can afford a $1,400 mortgage payment, including principal, interest, taxes, and insurance. This monthly budget will translate to the most house if you use a longer-dated mortgage.
But a 15-Year Mortgage Can Save You Lots of Money
The most obvious advantage of a 15-year mortgage is that you'll pay off your home in half the time it would take with a 30-year mortgage. You'll build equity faster, and be debt-free quicker than you otherwise would. However, the advantages to a 15-year mortgage don't stop there.
Despite the higher monthly payment, a 15-year mortgage has two money-saving advantages over its 30-year counterpart. First, 15-year mortgages represent a somewhat lower risk to lenders, so their interest rates tend to be lower. For example, as of this writing, a borrower with a 720 FICO score (good credit) can expect a 30-year mortgage APR of 4.10%. On the other hand, the same borrower could qualify for an APR of 3.40%. Interest rates fluctuate constantly, so check the current rates to see the difference at the time you're reading this. (Note: Click the "advanced" link in the menu to select only 30-year or 15-year mortgages.)
In addition, the mathematics of mortgage amortization work in your favor in terms of the interest you accumulate. Frankly, the details of how this works are a rather complex mathematical equation, but because of the amortization, more of your payments will start to pay down the principal right away with a 15-year mortgage.
For example, let's say that you need a $200,000 mortgage, as in our earlier example. Sure, the 30-year loan has a lower monthly payment, but just look where those payments are going, early in the loan's term.