Spoiler alert: It is the 15-year mortgage.
The first house I bought was a two-bedroom, two-bath condo that I got for only $67,500 in 2002. I was excited when my offer was accepted and I could finally stop renting.
I put $2,400 down, as the Federal Housing Administration loan allowed for a mere 3.5 percent down payment, and received a 5.5 percent interest rate on my mortgage. While the principal and interest was only $370, all in — with tax, insurance, private mortgage insurance and homeowner association fees — my monthly payment on a 30-year fixed mortgage was $584. It was much less than a comparable apartment at the time.
I was happy, but I never once thought about, nor do I recall my mortgage broker mentioning, a 15-year option.
I regret that non-decision decision.
Solely Focusing on Monthly Payments
As of last year, the average car loan lasted 72 months. As long as dealers can get customers to focus on the monthly payment, they can get away with longer loan terms and collect more interest from the additional years.
The same is true with mortgages.
All things being equal, banks and mortgage investors likewise prefer longer-term mortgages, as they get paid more interest. There is a higher cost for borrowing the same amount of money for a longer period of time. The math is striking.
Running the Numbers
Taking out taxes, insurance, homeowners association fees and private mortgage insurance, all that is left is simple principal and interest: P&I. Realtor.com reported the median asking price of a house now stands at $375,000, the highest on record. With $25,000 down and a 30-year fixed conventional mortgage at the current rate of around 3 percent, the P&I on a $350,000 mortgage would be $1,476 each month.
On a 15-year mortgage, the interest rate is better since the loan term is shorter. NerdWallet reported an average of 2.189 percent. The monthly P&I for the same scenario on a 15-year mortgage would be $2,283 — $807 more.
Notice that although the term was cut in half, the payment did not double. That is the benefit of less time interest and a lower rate.
And just like customers should not focus on monthly payments when buying a car, the real number homebuyers should look at is the total cost of P&I for the mortgage.
On the above 30-year mortgage, the homebuyer would pay a total of $531,221 over 360 payments. The 15-year version? $410,916.
That is a savings of a whopping $120,305.
Already in a 30-Year Mortgage?
Last November saw the lowest rates ever, with an incredible 2.72 percent annual percentage rate on a 30-year mortgage. Homeowners who have not refinanced should take a hard look today, as rates have only increased about 25 basis points.
And it makes a great deal of economic sense to refinance with a new 15-year mortgage for all the reasons listed above.
Building Equity Faster
Pretty much no one lives in their home long enough to pay off the mortgage, so it can be a mistake to look at the two options and focus solely on paying a home off faster. The website iPropertyManagement estimated the average length of homeownership is only 8.17 years.
Instead, focus on building equity faster — much faster.
After eight years in the above 30-year mortgage scenario, the loan balance would be $285,686. But, for the 15-year mortgage, the loan balance would be only $225,470 — a full $60,000 difference.
A good rule of thumb is that the total mortgage payment should be no greater than 28 percent of the owner’s gross income. A husband and wife making a combined $100,000 per year should seek to keep their mortgage payment under $2,400.
With that in mind, prospective homebuyers should look at their income, decide what amount they can afford with a 28 percent cap and go home shopping with a 15-year term in mind.
Your future self will thank you.
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