A 15-year mortgage is a loan for buying a home whereby the interest rate and monthly payment are fixed throughout the life of the loan. Some borrowers opt for the 15-year versus the more conventional 30-year mortgage since it can save them a significant amount of money in the long term.
Pros and Cons of a 15-year Mortgage
There are several types of mortgage products available on the market today. The 15-year mortgage has some advantages and disadvantages when compared to the 30-year. However, both products share similarities such as the interest rate can be impacted by the borrower's credit history and credit score.
A credit score is a numerical representation of how likely a borrower will pay back money owed. Timely payments, length of credit history, and how many open credit accounts are all factors that impact a credit score. Of course, both a 15-year and 30-year loan also require ample monthly income to cover the potential mortgage payment as well as other debts.
The Pros of a 15-year Mortgage
Below are the advantages of a 15-year mortgage versus a 30-year. Both have fixed rates and fixed payments over their terms.
Less in Total Interest
A 15-year mortgage costs less in the long run since the total amount of interest payments are less than a 30-year mortgage. The cost of a mortgage is calculated based on an annual interest rate, and since you're borrowing the money for half as long, the total interest paid will likely be half of what you’d pay over 30 years.
For example, a mortgage amount of $250,000 over 30 years at a rate of 4% would cost $429,674 in principal and interest payments by the end of the term. The total interest would be $179,674 for borrowing for 30 years.
The same loan amount and interest rate over 15 years would cost $332,860 by the end of the term. Total interest would be $82,860 for borrowing for 15 years. At 4%, you'd pay only about 46% of the total interest for a 15-year than you'd pay for the 30-year. The higher the interest rate, the greater the gap between the two mortgages.
Lower Interest Rate
Since short-term loans are less risky and cheaper for banks to fund than long-term loans, a 15-year mortgage typically comes with a lower interest rate. The rate can be anywhere between a quarter point to a whole point less than the 30-year mortgage.
If your mortgage is purchased by one of the government-sponsored companies, like Fannie Mae, you will likely end up paying less in fees for a 15-year loan. Fannie Mae and the other government-backed enterprises charge what they call loan-level price adjustments that often apply only to, or are higher for, 30-year-mortgages.
These fees typically apply to borrowers with lower credit scores who make smaller down payments. The Federal Housing Administration charges lower mortgage insurance premiums to 15-year borrowers. Private mortgage insurance or PMI is required by lenders when you put a down payment that's smaller than 20% of the value of the home. PMI protects the lender in case you can't make the payments. PMI is charged as a monthly fee added onto the mortgage payment, but it's temporary, meaning it ceases to exist once you pay off 20% of your mortgage.
It's important to note that although most borrowers will have lower upfront fees with government-sponsored products, they'll likely pay these costs as part of a higher interest rate.
Since the monthly payment is higher for a 15-year mortgage, financial planners tend to consider it a type of forced savings. In other words, instead of taking the monthly savings from doing a 30-year and investing the funds in a money market account or the stock market, you'd be investing it in your house, which over the long run is also likely to appreciate in value.
The Cons of a 15-year Mortgage
Despite the interest saved with a 15-year mortgage, there are a few considerations and disadvantages that borrowers should think about before deciding on the term of their loan.
Higher Monthly Payments
A 15-year mortgage has a higher monthly payment than a 30-year since the loan needs to be paid off in half the time. For example, a 15-year loan for $250,000 at 4% interest has a monthly payment of $1,849 versus $1,194 for the 30-year. In other words, the 15-year monthly payment is 55% higher than the 30-year for the same amount at the same rate.
The higher payment might limit the buyer to a more modest house than they would be able to buy with a 30-year loan. Using our example above, let's say the mortgage lender will only approve a maximum of $1,500 per month. The borrower would need to buy a cheaper house—a $200,000 mortgage at 4%, for 15-years, results in a $1,479 payment. The borrower could also opt to make a larger downpayment ($50,000) bringing the total mortgage loan amount from $250,000 to $200,000, which would also get the payment below the $1,500 per month maximum.
On the other hand, a 30-year loan (for $250,000) would result in a $1,194 monthly payment—well under the $1,500 maximum. Also, the 30-year loan allows the borrower to buy a bigger home or take on a larger mortgage. For example, a 30-year mortgage for a $300,000 home would cost $1,432 per month. The 30-year loan brings the payment under the $1,500 maximum and allows the borrower to take on a larger loan—presumably getting a bigger home or a better location.
Less Money Going to Savings
The higher payment requires higher cash reserves—as much as one year’s worth of income in liquid savings. Also, the higher monthly payment means a borrower may forgo the opportunity to build up savings or save for goals such as college tuition for a child, or retirement. Also, both college savings' and retirement accounts are tax-deferred while 401k retirement accounts have an employer contribution. Also, a savvy and disciplined investor would lose the opportunity to invest the difference between the 15-year and 30-year payments in higher-yielding securities.
A 15-year mortgage costs less in total interest versus a 30-year
A 15-year usually has a more favorable interest rate
A 15-year is a forced savings since the extra money paid is invested in the home instead of spent
15-year loans have higher monthly payments
Less affordability with 15-year mortgages
Less money going to savings or retirement
Financial hardship might result if the borrower can't pay the higher 15-year loan amount
The Bottom Line
A 15-year mortgage can certainly save you a lot of money in the long run. However, it's important to consult a financial planner to discuss what you can handle for monthly payments. Although the 15-year can pay off a mortgage sooner, if you lose your job or your income changes, that higher monthly payment versus the 30-year loan could cause you to go into financial hardship.