As a buyer in the housing market, there is one principle that stands above all others when it comes to financing.
Not all home mortgages are created equal.
With a dazzling array of mortgages available for financing the purchase of a home, the 30-year fixed-rate mortgage represents the standard-bearer in the home financing industry. However, a growing number of homeowners are realizing that a 15-year fixed-rate mortgage might be the better financing instrument to land the home of their dreams.
Although both types of mortgages are structured in the same manner (fixed rate), the difference of 15 years in the terms for each type of mortgage can make the ultimate difference when choosing which mortgage is the best option to finance the purchase of a house.
Why the Term of a Mortgage Affects the Overall Cost
A term mortgage requires the borrower to pay interest on the amount of money left on the home loan. Borrowers pay a fixed rate for both the principal and the interest levied on the mortgage.
For the first several years of a fixed-rate mortgage, the high loan balance means a borrower pays more of the share of the home loan in interest. As the mortgage advances to the end of the term, the vast majority of the financing costs is paying off the principal.
A shorter-term mortgage such as the 15-year fixed-rate home loan appears to make the financing instrument less affordable, as monthly payments are higher because of the shorter term. However, because of the risk involved in lending money over a longer period, banks typically charge a higher interest for the longer 30-year fixed-rate mortgage.
The Differences Between a 15-Year Mortgage and a 30-Year Mortgage
The balance due on a 30-year fixed-rate mortgage decreases much more slowly than it does for a 15-year fixed-rate home loan. What a homebuyer does is borrow the same amount of money that is spread out over a period that is twice as long as a 15-year fixed-rate mortgage. The higher the interest rate, the greater the financing disparity between a 30-year and a 15- year mortgage. For example, if the interest rate is four percent for both types of fixed-rate loans, the borrower pays more than two times the amount of money in interest for taking out a 30-year fixed-rate mortgage.
Longer fixed-rate mortgages allow borrowers to pay less per month to finance a home loan. A 30-year fixed-rate mortgage makes financial sense for a borrower that is buying a home for the first time and expects to raise a family in the home for decades to come. For borrowers that can afford to make large monthly home loan payments, then the shorter 15-year fixed-rate mortgage is the way to go for financing the purchase of a house.
Advice for Homebuyers
The lower monthly payments for a 15-year fixed-rate mortgage does not mean you should lock into the shorter-term home loan. With a 30-year fixed-rate mortgage costing you less per month, you can take the money saved and invest it in an interest generating account or a retirement plan that generates compound interest returns. The difference between a 15-year and a 30-year fixed-rate mortgage does not have to be the lower monthly payments for the shorter term home loan. It can come down to knowing how to maximize the returns on the money saved by making lower monthly payments.
There is not a cut and dry correct decision when it comes to choosing the term on a mortgage. The bottom line is you have to choose the term that makes the most financial sense. If you can afford higher monthly payments on a home loan, go with a 15-year mortgage. On the other hand, a 30-year mortgage makes sense for homebuyers that operate on tighter budgets.