Fixed rate mortgages versus adjustable rate
Before we dive into the details of mortgage lengths, let’s look at the two main categories of mortgages. The most common home loan is a fixed rate mortgage. With a fixed rate loan, your interest rate and payment are locked for the entire duration of the loan. Whether your loan is 5-years, 7-year, 15-years, 30-years, or something else, you can expect few surprises with a fixed mortgage.
Alternately, you can get an ARM loan, or adjustable rate mortgage. Many lenders offer 5-year and 7-year ARM loans. PenFed Credit Union is unique in offering a 15/15 ARM. But how do you decode what that means?
Unlike a fixed loan, where the years indicate the entire life of the loan, with an ARM the years stand for the term the interest rate and payment is fixed before it begins to float with market interest rates. For example, with the PenFed 15/15 ARM, you have a fixed rate for the first 15 years and then an adjusting rate for the next 15 years. You know exactly what you will pay each month for the fixed period, but your payment can go up or down with interest rates after the fixed period ends. In the current rising interest rate environment, borrowers with an adjustable rate mortgage can count on a higher payment when the fixed period ends.
There are more customizations that can make your payments confusing or lead to a higher payment. With a balloon mortgage, the payment is very low for an introductory number of years before the payment goes way up. Interest only mortgages allow you to payment only the interest on your property without paying into the principle, which is generally a bad deal for borrowers.
Because fixed rate loans are most common, we will focus on those from here on.
Your payment size is a factor of the loan term
With a fixed rate loan, your monthly payment is decided by the amount you borrow and the term of the loan. The interest rate is another factor, but because you have less control over the rate, we are going to focus on the loan value and term.
When you have a 30-year loan, you are spreading out the cost of your home over three decades. Because you are paying over such a long period of time, the monthly payment can be quite low compared to the price of the home. Because they offer the lowest payments, the 30-year fixed mortgage is the most popular type of home loan.
However, you can cut that payback time down by half or more to shorten the length of time it will take before you are debt free. But that only works because the monthly payment is higher. The way the math works out, your monthly payment with a 15-year fixed is typically a little less than half of a 30-year fixed due to how interest is charged. Because the payment is higher, many borrowers can’t afford a 15-year fixed even though the interest costs are much lower over the life of the loan.
Increase your down payment to lower your monthly payment
The next level you can use to control your monthly payment is your down payment. With both 30-year and 15-year mortgages, you can lower your payment by lowering the amount you borrow.
For example, let’s say you are looking to buy a $250,000 home and have 20% saved for a down payment. In this case, you would borrow $200,000. But if you increase your down payment to 30%, you put down $75,000 and only need to borrow $175,000. By borrowing $25,000 less, your monthly payment is lower.
If you want to pay off your home in 15-years but can’t afford the monthly payment when you use the same down payment as a 30-year mortgage, you could put a higher payment down when buying to lower your loan amount.
My first home was a condo in Denver that I purchased with a 30-year fixed mortgage loan. After living there a couple of years, I was able to refinance to a 15-year fixed loan with a lower interest rate and slightly higher monthly payment. This put me on track to save thousands of dollars in interest compared to the 30-year loan.
A 15-year mortgage is best if you can afford it
Just like my refinance to a 15-year loan offered massive interest savings, the same applies to any 15-year loan when compared to a 30-year loan. There are two reasons a 15-year loan is better than a 30-year loan.
The first reason is the interest rate. As a general rule, the longer the length of a loan the higher likelihood a borrower is not going to pay the bank back. Because of the higher risk involved, banks charge a higher interest rate on longer-term loans than shorter-term loans.
The next reason 15-year mortgages are better is how interest is charged. Regardless of the interest rate, borrowing for a longer period costs more than a shorter period. Because the payments are spread over a longer period of time, you have to pay interest for a larger number of years, in this case twice as many. Because mortgage loans are so large, the difference in interest costs between a 15-year loan and a 30-year loan is in the tens of thousands of dollars.
When a 30-year mortgage make the most sense
Just because a 15-year mortgage charges less interest than a 30-year loan does not mean a 15-year loan is best 100% of the time. In fact, there are a couple of arguments that a 30-year loan is better for several reasons.
- Lower monthly payment – While the interest costs are higher, a lower monthly payment might mean the ability to purchase a more expensive home. This is not best in all circumstances, but if you have a family and need the space, a larger home may be worth the additional interest cost on top of the higher home price.
- Investable assets – When you have a 15-year loan, you are pouring your cash into your home each month to increase your equity and lower your debt. However, when interest rates are lower than investment returns, you could be better off with more debt than less. For example, if you can expect a 7% return on the stock market and have a 4% loan, you could hypothetically invest and have a slower loan payback period but come out about 3% ahead. If you have $50,000 in the stock market rather than home equity, that could be a $1,500 annual benefit if you can invest at a 3% higher return than your interest rate.
Do the math before you decide
Ultimately the decision to get a 30-year mortgage versus a 15-year mortgage is your decision. But don’t rush to choose one over the other, this decision has a large impact on your finances.
Do the math or ask your mortgage lender or real estate agent to help you assess the various scenarios. Or use an online loan calculator to quickly compare monthly payments and interest costs when you switch from a 30-year loan to 15-years.
There is no right or wrong answer for everyone, just what is right for you in your current financial situation. I recently moved to Southern California where real estate prices are sky high. For my family, a 30-year loan made much more sense even though I have had 15-year loans in the past.
Make it a 30-year loan, or not, the choice is yours.