15- vs. 30-Year Mortgages: What You Need to Know
When you buy a new house, you’ll have an enormous array of mortgage options to choose from. Your down payment, interest rate, and term can all make a huge difference to your monthly payment and the total amount you pay toward your loan, but one of the most common choices you’ll have to make is between a 15-year and a 30-year mortgage. Here’s what you need to know.
Should You Buy a House With Cash?
Many high-net-worth individuals have considered paying cash outright for a new house. At first, the appeal is understandable — if you have the cash on hand, you can just write a check and be done with the entire process. There’s no loan process, no payment to keep track of, and no interest adding up over the next several decades.
Generally speaking, however, paying cash for a house isn’t a good use of your money. If you spend $1 million on a house, you’ll have a $1 million house that will appreciate at roughly 4% per year, depending on zip code. Since you don’t have a mortgage payment, you can put the $3,819 per month that you would have put toward a mortgage in an index fund instead. If you do so every month, by the end of 30 years, that portfolio will be worth roughly $8.6 million.
Instead, imagine you put $200,000 down on a house at 4% interest on a 30-year mortgage. Over 30 years, you’ll pay $800,000 in principal and another approximately $575,000 in interest for a total of $1.375 million.
In the meantime, you could have put your remaining $800,000 in index funds, which return roughly 10% in the long term. By the end of 30 years, if you don’t touch it, that portfolio will be worth nearly $14 million. By paying cash for the house up front, you’re leaving nearly $6 million on the table. One of the primary advantages of real estate as an investment is that you can leverage your wealth, purchasing a valuable asset for a down payment rather than buying it outright, as with stocks or other investments.
The Difference Between a 15- and 30-Year Mortgage
There’s a practically infinite number of mortgage configurations available, but a 30-year fixed-rate loan is the bread and butter of the lending industry, accounting for the vast majority of mortgages.
Most mortgage lenders will offer a 15-year fixed-rate mortgage with the exact same terms as their 30-year offerings, with the obvious difference being the term of the loan. All else being equal, a 15-year mortgage will require a higher monthly payment, but result in less total interest being paid to the bank. The higher the interest rate, the greater the gap between the two loans:
- On an $800,000 loan at 3.5% over 15 years, you’ll pay $229,430 in interest.
- On an $800,000 loan at 3.5% over 30 years, you’ll pay $493,248 in interest — roughly $270,000 more than on the 15-year loan.
- On an $800,000 loan at 5% over 15 years, you’ll pay $338,742 in interest.
- On an $800,000 loan at 5% over 30 years, you’ll pay $746,046 in interest — roughly $408,000 more than on the 15-year loan.
In this case, the difference between a 15-year loan at a low interest rate and a 30-year loan at a slightly higher rate is that you’ve nearly tripled the total amount you’ll pay over the lifetime of the loan. If you don’t like the idea of giving money back to the bank, a shorter-term loan might be the best choice.
Of course, the shorter-term loan also comes with a much higher monthly payment. In the case of an $800,000 loan at 3.5% (a particularly low rate already), the monthly payment increases from $3592 to $5719. If you don’t have the cash flow to cover a higher payment, it might not be the best option for you.
There’s also the question of what else you could be doing with the money. The extra $2127 per month that you’re spending on your 15-year mortgage payment could easily be invested in another property that you rent out or put into index funds, generating better returns or extra income.
The Best of Both Worlds
If you sign onto a 30-year mortgage, you still have the option of paying it off in 15 years — just make higher monthly payments and you’ll finish paying off the loan sooner. If your financial situation changes and you can’t afford the high payment anymore, you can always fall back on the lower 30-year minimum payment.
The potential downside of this approach is a prepayment penalty. The nature of the penalty will depend on the specific loan, but a typical penalty might be around 4%. If you take out an $800,000 loan at 3.5% over 30 years and then pay it off in 15, you’ll have to pay $32,000 in penalties. That might seem like a drop in the bucket compared to the several hundred thousand you’re saving on interest, but if you have the means, you can save that $32,000 by just starting with a 15-year loan in the first place.
Talk to First Western Trust Bank
Any mortgage is a major decision that shouldn’t be taken lightly — with such high amounts and long terms, any tiny adjustment in the structure of your loan can make an enormous difference over time.
With the help of the experienced financial planners at First Western, you can determine how a mortgage fits into your budget and your long-term plans, as well as which type of mortgage is best suited to your unique financial needs. If you’re considering another property purchase, get in touch with First Western Trust Bank today.