You're all ready to buy your new home! You've found an affordable home or two that you really like. You've saved up a bundle of money for your down payment. You've built up a strong credit score so that you can get offered low interest rates from lenders. Maybe you've even been pre-approved for your mortgage. What's next?
Well, you need to decide exactly what kind of mortgage you should take on. It's a big decision, because home loans last for many years and are probably the most costly expenses you'll ever take on. Take the time to learn all about your options. One critical choice is deciding between a 30-year mortgage and a 15-year one.
Most mortgages that home buyers take on are either 30-year or 15-year ones, with 30-year fixed-rate loans being the most common by far. Here's a closer look at both.
Advantages of 30-year mortgages
The main advantage of the 30-year mortgage over a 15-year one is that it features much lower monthly payments. Here are some simplified examples using a constant interest rate:
15-Year Monthly Payment
30-Year Monthly Payment
The same table reveals a related benefit of a 30-year loan: It lets you buy more home for your money. For example, you might pay about $1,200 per month for a $200,000 house with a 15-year loan, but that same payment on a 30-year loan gets you a $300,000 home.
Lower payments also leave you with more money in your pocket -- or they can, if you haven't taken on too much risk by buying more home than you can safely afford. More money in your pocket means more money that you can sock away in critical retirement savings accounts or more money for your college savings account or money for an emergency fund. (Emergency funds are particularly important if you're carrying a mortgage, as you don't want some sudden unexpected expenses to leave you unable to make your mortgage payments and at risk of losing your home.)
Another perk of a fixed-rate 30-year loan is that thanks to inflation, your fixed monthly payment will cost you less and less as the years go by. Yes, it may stay at $1,200 per month for 30 years, but after 25 years, if inflation has been at its long-term average of about 3% annually, it will be like paying just $573 per month. That's because incomes and prices will have risen over the years. So while $1,200 might have been 25% of your monthly pay 25 years ago, it might only be 15% of your monthly pay years later.
Advantages of 15-year mortgages
Interest rates for 15-year fixed-rate loans tend to be about half a percentage point to a full percentage point lower than those for 30-year loans. That means you'll pay less in interest. You'll actually pay far less in interest over the life of the loan, simply because you'll be making payments for half as many years. Consider this example from a Bankrate.com calculator: Imagine you took out a $200,000 mortgage at the recent national average interest rates of 4.27% for a 30-year fixed-rate loan and 3.49% for a 15-year fixed-rate loan. You'd pay a total of $57,181 in interest over the life of the 15-year loan and $155,040 over the life of the 30-year loan. That's almost $100,000 more!
A 15-year loan will help you build equity faster, as you'll be paying less in interest. It's always good to have equity in a home, as that's the value you can hope to recoup when you sell, and it's the value that counts if you need to take out a home equity loan in the future.
If you're older, a 15-year loan can be preferable as you'll be more able to pay off your home before you enter retirement. Being mortgage-free in retirement can help you sleep better at night.
What to do
So what's the right choice for you? Well, if you know you can afford the payments for a 15-year loan now and in the future, that option will save you the most money. It's also best if you're approaching retirement. If you're younger, though, with more financial uncertainty in your life -- and other pressing financial needs and goals -- opt for the 30-year mortgage.
Don't stop there, though. Make sure the loan you take on permits extra prepayments. If it does, you can aim to make bigger monthly payments than what's required. If you pay, say, $1,800 per month instead of the $1,200, you can shave many years off the life of your loan and pay tens of thousands of dollars less in interest. Best of all, if you're financially pinched for a few years, you can just revert to paying the $1,200 per month until you're back on your feet. This strategy offers the best of both worlds.
Consider an adjustable-rate mortgage (ARM), too -- but only if you're not expecting to be in the home for many years. An ARM will typically charge you a very low rate for the first three, five, or seven years, before starting to be adjusted annually according to prevailing rates. (As interest rates are expected to rise in the years ahead, an ARM is rather risky for a long-term tenure.) If you think you'll be in the home for decades, it's probably best to lock in a low rate for the entire long life of the loan.
The more you know about mortgages, the more home you can get for your money, and/or the less money you can spend on interest. Be a savvy home buyer and you can probably save tens of thousands of dollars.
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