Deciding on a Mortgage – 30 Year or 15 Year?

Hello! This is my first post on a blog I created a couple of weeks ago, and it was prompted by a friend posting a question on Facebook. This question demanded far too long an answer than a Facebook post could deliver: “Should we get a 30 year mortgage or a 15 year mortgage?” I’m a math and engineering type (spreadsheets soothe me), so I hope I don’t scare too many people away with numbers and calculations!

It depends

It’s a common question for a new homebuyer to ask: 15 year or 30 year mortgage?

The answer is, of course, it depends. You probably know the basics – a 30 year mortgage has a lower monthly payment, but you pay more on interest over the life of the loan. What you might not know is just how much more interest. Let’s look at a $160,000 house bought with 20% down for an example. A 30-year loan might have a 4.39% interest rate and a 15-year loan might have a 3.39% interest rate (these rates are today’s rates from the bank where I have my mortgage). Closing costs are irrelevant for the sake of this discussion, since we are only looking at 15-year vs. 30-year and not considering whether it’s worth paying points. If people are interested, I can get into that in another post.

Here’s some data about the options:

30 year loan 15 year loan
Monthly Payment $640.22 $908.15
Interest Paid over Full Loan $102,478.51 $35,467.17
Interest Paid First 5 years $26,899.54 $18,807.64

For a 30 year loan, your monthly payment will be $640.11. You will pay $102, 478.51 in interest over the life of the loan. Of that, you will pay $26,899.54 in interest in the loan’s first 5 years.

For a 15 year loan, your monthly payment will be $908.15. You will pay $35.467.17 in interest over the life of the loan. Of that, you will pay $18,807.64 in interest in the loan’s first 5 years.

A home buyer who picks a 30-year loan pays almost triple the interest that the 15-year borrower pays. I don’t know about you, but I don’t want to pay $65,000 extra in interest if I can help it.

The monthly payment

“But I can’t make that kind of monthly payment,” some are surely saying. “What if you lose your job?” others may ask. And to be sure, these are legitimate concerns. If there’s one thing that 2008 taught us, it’s that buying a house and taking out a mortgage is nothing to be done lightly.

If you are not saving at the very least 20% of your income (we shoot for 50%), DO NOT BUY A HOUSE. If you do not have at least a couple of months worth of costs in the bank that you can draw on in case of an emergency, DO NOT BUY A HOUSE. If you have never tracked your spending and cannot give an accurate picture where your money is going, I would recommend getting that in order before buying a house.

Also, keep in mind all of the costs associated with a house. You don’t just have that mortgage payment. You also have property taxes, homeowner’s insurance, repair/maintenance costs (estimates put this between 1-3% of your home’s price, per year), and mortgage insurance if you can’t put 20% down. That’s not even counting more complicated costs like the opportunity cost of money tied up in home equity or transaction costs for buying and, later, selling the house. Jim Collins, one of my favorite financial bloggers, has a great post talking about these costs.

Spreadsheets!

To get a good idea of the total costs of owning a house, and a comparison of various loans, I’ve created a Google Drive spreadsheet that you can look at. If you have a Gmail account, you can go to File > Make a copy… to create your own copy that you can edit to fit your individual needs. If you don’t have a Gmail account, create one! It’s free! Only tan fields should be edited, and I will warn you that delving into the second sheet and making changes there could throw off all the calculations, but you can see the amortization schedules there. In a future version, I hope to add some more calculations to account for the effect of inflation.

The two most important lines are highlighted in yellow at the bottom of the first sheet: your true cost of homeownership, and your cash outflow. For a better explanation of the differences between these, read the article I linked above.

Looking at the spreadsheet, considering the first 7 years of the loan, we see the following:

30 year loan 15 year loan
Monthly Payment $640.22 $908.15
Average interest paid per month $439.35 $292.28

As long as you can afford the extra $267.93 per month while still stashing 20% of your paycheck away in an IRA, 401k, and/or high-yield bank account, picking a 15 year loan over a 30 year loan saves $147.07 per month in interest. For the extra  $267.93 per month you put towards your mortgage, that’s a guaranteed 54.9% return on investment! Sounds like a clear winner to me.

Because this is dragging on so long, I’m going to have to leave the discussion of paying a 30-year loan on a 15-year schedule and Adjustable Rate Mortgages for tomorrow. Spoiler alert: in defiance of conventional wisdom, I don’t like the former, and I do like the latter, provided you will either move out within 5-7 years or you will aggressively pay down the principal of the loan. Since we’ll probably be moving out in 5-7 years, the 5/1 ARM saves us interest and gives us a lower monthly mortgage payment. But I’ll talk more about that later.

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