So you’ve decided you want to buy a house, and that a conventional mortgage is the best way to go. But which is better to suit your goals: a 15-year mortgage term or a 30-year mortgage term?
While 15-year and 30-year mortgage terms have different costs and monthly payments to consider, there’s other important factors too. For instance, you’ll also want to take into consideration which is best given your retirement savings and your future plan for the house.
Here, we’ll break down everything you need to know about 15-year and 30-year mortgage terms so that you can determine which is right for you:
- Breaking Down Conventional Mortgage Costs
- Costs of a 15-Year vs. 30-Year Conventional Mortgage
- Managing Your Mortgage with Retirement and Other Savings
- 15 vs. 30 Years: Which Mortgage is Right for You?
- How to Save Thousands on Conventional Mortgages
Breaking Down Conventional Mortgage Costs
There’s a few ways that the length or “term” of the mortgage affects the cost of a mortgage. Before we can dive into those details, let’s take a look at what factors determine the cost of a mortgage payment.
There’s four main costs when it comes to conventional mortgages: principal, interest, taxes, and insurance. In the mortgage world, these four costs are referred to as PITI for short. First, we’ll look at principal and interest, and how they work together. Then, we’ll address real estate taxes and insurance.
Understanding Amortization: Principal and Interest
The principal of a mortgage is how much you owe the lender. When you first take out your mortgage, the principal is the total amount you borrowed. As you start paying down your mortgage, the principal reduces.
Mortgage Interest Rate
The interest rate on a mortgage is the cost of borrowing money. The riskier you are to lend money to, the higher your interest rate will be. Since you only have to pay interest on what you owe, the amount of interest you pay decreases over time. As you pay down your principal, you also reduce the amount of interest.
How Amortization Works
The principal and interest rate of a mortgage are both key players in what’s called an amortization schedule. Amortization schedules are also used for other types of loans, like auto loans.
Thankfully, you don’t have to be able to calculate an amortization schedule to understand the basics behind it. Here’s a few basic tenets of amortization that’ll help you understand what’s happening:
- What It Does: The amortization schedule on your mortgage determines how much of your monthly payment goes towards the principal and how much goes towards interest each month. The more principal you pay off, the less interest you’ll owe.
- The Goal: Amortization allows you to make the same payment each month until the mortgage is paid off, even though the amount of interest and principal you owe decreases over time. Without amortization, your payments would be different each month.
- The Process: Amortization makes it possible to have regular monthly payments despite changing amounts of principal and interest owed. To make this possible, your early mortgage payments go largely towards the interest, and only a small amount goes towards the principal. By the time you’ve almost finished paying off your mortgage, things are reversed. Towards the end of your mortgage, most of your monthly payment will be going towards the principal.
Each month, a higher proportion of your money will be put towards your principal than the last month. That happens because each time you pay off some of the principal, the new interest is calculated using the lower principal. Because you’re paying the same amount overall each month, a smaller amount going towards interest means a larger amount goes towards the principal.
Other Mortgage Costs: Taxes and Insurance
While the principal and interest are the main parts of a mortgage, we must not forget property taxes and insurance.
Depending on the state you live in, real estate property taxes can be a drop in the bucket or a serious expense. To give you an idea, the average American household pays $2,149 in property taxes each year.
You pay property taxes whether you have a mortgage or own the house outright. Your property taxes will be the same whether you have a 15-year or 30-year mortgage term.
There are two types of insurance you’ll pay alongside your conventional mortgage payment: property insurance and private mortgage insurance.
Most lenders require that you have property insurance to cover the house in case it’s damaged. Depending on the house, property insurance can include homeowners insurance, flood insurance, and earthquake insurance.
Because property insurance is based on the probability that something unfortunate will happen to your house, your property insurance will be the same whether you have a 15-year or 30-year mortgage term. However, you can choose to stop paying for property insurance once you own the home if you wanted.
Private Mortgage Insurance
If you put less than 20% down on your house, you’ll be saddled with private mortgage insurance, or PMI. PMI is insurance for your lender. If you stop making mortgage payments and foreclose on the house, PMI helps your bank cover the loss incurred. Once you’ve paid off 20% of the house, you can request to stop paying PMI. Legally, lenders have to stop charging you for PMI once you’ve paid off 22% of the house, whether or not you say something to them.
Because you can get rid of PMI once you’ve paid off 20% of your house, the length of your mortgage does have an effect on how much you’ll pay in PMI.
Costs of a 15-Year vs. 30-Year Conventional Mortgage Term
Now that we know what costs factor into a mortgage, let’s look at how those costs change with the length of the mortgage. Because property taxes aren’t affected by the length of the mortgage, you won’t hear more about them here. However, we will touch on the principal, interest rate, property insurance, and private mortgage insurance.
How the Mortgage Term Affects Interest
There’s three ways the length of your mortgage affects your mortgage interest. One has to do with how long you are paying interest while the other two have to do with the interest rate itself.
Loan Length and Total Interest Paid
Each month that you’re borrowing money on a loan, you pay interest. That means the longer you borrow money, the longer you pay interest. Thus, it’s more expensive to pay 30 years of interest than 15 years of interest given the same interest rate.
Lower Risk Typically Means Lower Interest Rate
The length of your mortgage affects your interest is in the interest rate itself. You’re typically more likely to get a lower interest rate with a 15-year mortgage term than a 30-year mortgage term. Why? Because a shorter-term loan has less risk and are less costly to lenders.
Loan Length and Tax-Deductible Interest
While you’ll be paying more interest on a 30-year mortgage term than a 15-year mortgage term, it’s important to remember that the mortgage interest is tax deductible. This makes the gap between how expensive 30-year and 15-year mortgage terms are much smaller.
For instance, if you had a $200,000 mortgage at current market rates and assumed inflation was 4%, you would pay around $32,400 more in taxes on the 30-year version than the 15-year version. However, once you take into account about $18,700 in tax deductions, the difference paid between the 15-year and 30-year mortgage term is only around $13,700.
Loan-Level Price Adjustments
Loan-level price adjustments, or LLPAs, are fees added to conventional mortgages based on borrower risk. LLPAs can be paid upfront in a lump sum through “points” with each point being equal to 1% of the mortgage. However, it’s more common that LLPAs are rolled into higher interest rates on mortgages.
Here are factors that can affect your LLPAs:
- Credit score: The higher your credit score, the better, but a credit score above 740 is ideal. Your credit is looked at in conjunction with your loan-to-value ratio to determine the adjustment made.
- Loan-to-value ratio: Your loan-to-value ratio, or LTV, is the mortgage amount divided by the appraised value of the property. For instance, if you put 10% down on a house and borrowed the other 90%, your LTV is 90%, assuming that the house sold for the appraised value. The less you have to borrow, the lower your LTV, and the less risky you are to lenders. Higher LTVs mean higher LLPAs. Lenders look at your LTV and credit score together to determine this loan-level price adjustment.
- Investment property: If you’re not buying a house with the intention to live in it, it’s probably an investment property. Investment properties earn money, whether that’s through renters, future resale, or both. Buying a house as an investment property will trigger an LLPA.
- Multi-unit property: A home that’s two, three, or four units is considered a multi-unit property, which affects your LLPA.
- Condo with less than 25% equity: You’ll find that condos are often treated differently than houses when it comes to mortgages since they’re considered riskier. If you get a mortgage on a condo with less than 25% equity in the condo, this will affect your LLPA.
- Piggyback mortgage: If you take out two loans on one house, it’s called a piggyback mortgage. Usually people take out piggyback mortgages to avoid paying private mortgage insurance, but piggyback loans come with their own costs and risks. Because of the risk involved, having a piggyback mortgage affects your LLPA.
The kicker with LLPAs is that they don’t apply to mortgages that are 15 years or less. If you have a 30-year mortgage term, you’re likely to have some LLPA fee on your mortgage. Unless you have superb credit and are buying a single-family, detached home with 40% down, you’ll have to pay some LLPAs. With a 15-year mortgage term or shorter mortgage terms, you can escape being assessed for LLPAs. They’ve been government mandated for conventional loans since 2008 to keep banks from being overexposed to risk.
How the Mortgage Term Affects Insurance
As discussed above, there’s property insurance and private mortgage insurance, or PMI.
Loan Length and Property Insurance
Your lender will require you to have property insurance while you have a mortgage with them. Once you’ve paid off the loan, you could cancel your property insurance. That means you could be paying 15 years less property insurance with a 15-year conventional mortgage term over a 30-year conventional mortgage term.
However, your house wouldn’t be covered by things like floods and earthquakes without property insurance. Since a house is such an expensive asset, property insurance is very common for homeowners who own their home outright. Thus, while you could save money by cancelling your property insurance once the loan is paid off, it’s not recommended.
Loan Length and PMI
If your down payment is 20% or larger, you won’t need to pay PMI, so the loan length won’t have an effect. If your down payment is less than 20%, that’s a different story. Since you can make PMI go away once you’ve paid off 20% of the house, it’s intuitive that paying off your loan faster means PMI goes away faster.
Saving on PMI depends on how much you put down and if you make more than the minimum monthly mortgage payments. In general though, you can get rid of PMI faster with the shorter 15-year mortgage term than the 30-year mortgage term.
How the Mortgage Term Affects Monthly Payments
Up until now, we’ve been looking at the long-term savings you can get, which are so far stacked in favor of the 15-year mortgage term. But, it’s also necessary to consider the short-term costs you can afford.
Because you have to pay off the principal balance for a 15-year conventional mortgage term in half of the time as a 30-year conventional mortgage term, your monthly payments will be significantly higher. With a 30-year mortgage term, you have much longer to pay off the principal. The trade-off for more time to pay the loan is more money in your lender’s pocket.
Managing Your Mortgage with Retirement and Other Savings
While you can save more overall with a 15-year conventional mortgage term than with a 30-year conventional mortgage term, there are other costs in your life to consider. Even if you can afford to make the higher monthly mortgage payments that come with the shorter 15-year loan, it might not be the best use of your money.
Balancing a Mortgage with Emergency Savings
Having a solid emergency savings is a must for everyone, and especially for homeowners. Being able to cover lost income if you lost your job is one thing, but covering unexpected housing costs is another. You may have to repair a leaky roof, a fallen fence, or a broken water heater with little to no notice.
Finance experts recommend having three to six months worth of living expenses saved up, and more for unexpected homeowner expenses.
Balancing a Mortgage with Retirement Savings
They key to saving for retirement is to start early. Money put in your retirement accounts now will have more time to compound than money put in later.
If you have a 401k employer match, you should max it out. For instance, if your employer offers a 3% employer match, you should be contributing 3%. If you don’t, you’re leaving free money on the table.
Once you’ve maxed out your 401k employer match, you should max out your Roth IRA. You can only put in $5,500 each year if you’re under 50 and $6,000 if you’re older than 50 with a qualifying income as of this writing.
If you’ve reached the contribution limits of your Roth IRA, you can head back to your 401k and make contributions there. As of this writing, you can contribute $18,500 each year to your 401k.
Balancing a Mortgage with Other Debt
There’s a good chance you have other debt besides a mortgage to take care of, such as student loans, an auto loan, or credit card debt. It might be better to choose the lower-payment 30-year mortgage term and put any extra cash you have towards these other debts rather than getting a 15-year mortgage term.
It’s always a good idea to compare the numbers side-by-side to see which scenario you’d save more money in. Some debt, such as credit card debt, has really high interest rates. To save the most money overall, it’s always best to pay off your debts in the order of highest interest rate to lowest. If you have other debts with a higher interest rate than your mortgage, you should prioritize paying those off as soon as possible.
Balancing a Mortgage with Investments
Once you have a solid emergency savings, retirement savings, and high-interest debts paid off, you’ve gotten yourself out of the red and may be looking to make more green. Now, you’re in a position to ask whether you should pay off your mortgage or invest your money.
Just like when you’re figuring out which debts to pay off first, look at the interest rates. If you can make more through investing than you’d be losing to a mortgage, it’d make more sense to invest your money.
For instance, if your 30-year conventional mortgage had an interest rate of 3.5% and you’re looking at investing in some mutual funds with a steady history of 6% average annual returns, then it makes more sense to invest extra money rather than putting it towards paying down the loan. Plus, the earlier you start investing, the better since it has more time to grow and compound on itself.
Considering investments, the 30-year mortgage term takes the cake over the 15-year mortgage term. Because less of your money will be tied up in the monthly payments of a 30-year mortgage term, this allows you to the potential to earn more than with a 15-year mortgage term.
15 vs. 30 Years: Which Mortgage Term is Right for You?
Now that we’ve looked at the hard costs that differ between 15- and 30-year mortgage terms, it’s time to take a holistic overview.
Recap: 30-Year Mortgage Term
The 30-year conventional mortgage term is the most common and accessible mortgage on the market. If you can’t afford the higher payments of a 15-year mortgage term and plan on owning the house for a long time, the 30-year conventional mortgage term is a great choice.
Some benefits of a 30-year mortgage term over a 15-year mortgage term include:
- More money freed up to:
- Pay off debt
- Make an emergency savings
- Build wealth through investing
- Can choose to pay more than the minimum to gain similar savings to a 15-year mortgage term
- Tax deductions over a longer period of time
Given the tax deductions and the other ways your money could be working for you besides paying down a mortgage, you could save more money with a 30-year mortgage term than with a 15-year mortgage term. To do this, always pay off the highest interest rate debt first to pay off debt the fastest, no matter the debt balance. Likewise, put extra cash towards investments if the rate of returns will be better than your debt interest rate.
Recap: 15-Year Mortgage Term
While the 15-year conventional mortgage term is less common, the savings on interest can be hard to ignore. If you can consistently afford the higher monthly payments and if you might sell the house soon (retirement, short sale, etc.), a 15-year mortgage term might be for you.
Some benefits of a 15-year mortgage term over a 30-year mortgage term are:
- Savings on interest through:
- Fewer months of interest paid
- Typically a lower interest rate depending on qualifications
- No LLPAs
- Peace of mind with mortgage paid off sooner
If you can afford to make the higher monthly payments that come with 15-year mortgage terms and have money to spare, you will pay less in interest than with a 30-year mortgage term. However, it’s not smart—and potentially not cost-effective—to be putting all of your money towards your mortgage.
Consider the 15-year home loan term if you have an emergency savings, retirement savings, and low debt. If you have to skip those items to afford a 15-year home loan term, it’s probably not worth it. Remember, you can actually make more money than you’re losing if you invest extra money you would’ve been putting towards your mortgage.
How to Save Thousands on Conventional Mortgages
No matter which type of conventional loan you choose, there’s a few things you can do to save thousands on your mortgage.
- Make an Extra Payment Each Year: Making one extra mortgage payment each year can save you a lot of money. For instance, with a 30-year term, $300,000 mortgage at 6%, an extra mortgage payment each year would save you almost $71,000 in interest.
- Reduce PMI ASAP: By gaining at least 20% equity in your house, you can stop paying for mortgage insurance entirely. PMI can cost you hundreds to thousands of dollars each year. Besides paying down your mortgage, you can also increase the value of your house to get rid of PMI faster.
- Buy a House Within Your Budget: Simple and easy, buying a house within your means will save you in more ways than one. A smaller house means fewer things, more time, and more money, which all equate to less stress.