I participated in a discussion over at the Get Rich Slowly forums about mortgages today. Strangely enough there was a lot of talk in my office about refinancing mortgages because of the Fed rate cut. (Even though rate cuts don’t necessarily guarantee lower mortgage rates.) I try to be the voice of reason in my office, which can get pretty frustrating with all of the random financial ignorance that gets thrown out.
But anyways, let’s talk about mortgages. To start, at no point will I ever support anything other than a fixed, regular mortgage. None of the adjustable rate mortgage (ARM), option-ARM, or interest-only crap. Get a fixed mortgage, get a fixed payment, and pay it on time. Simple enough.
The only question that remains then is payback period. The 30-year fixed rate mortgage is the standard in the industry. Your parents likely had one, and their parents before them. The close cousin to the 30-year fixed is a 15-year fixed rate mortgage. Your payments are higher, but you are paying more principle back with each payment than a 30-year fixed payment. You save interest (slightly lower interest rate and shorter term) and cut your time with the mortgage in half.
Running the math: 30-year fixed versus 15-year fixed
I’ll use data that is current as of yesterday evening. Bankrate publishes national averages for various types of mortgage rates. As of yesterday a 30-year fixed comes in at 5.53%, a 15-year fixed comes in at 5.26%.
With both mortgages we will assume:
- $250,000 home value
- $50,000 down payment (20%)
- $200,000 mortgage (80%)
- all other costs identical (closing, fees, etc.)
Now let’s run the math on the monthly payment.
Note: I made a typo in my original calculations when this was posted in December 2008. The old, incorrect values have lines through them and the correct numbers are added directly to the right. Updated April 2009.
- 30-year: $1,339.35 — $1,139.35
- 15-year: $1,608.81
Difference in payments? $269.46 – $469.46
What if you pay the 30-year fixed like it was a 15-year fixed?
If you get the 30-year fixed and apply the pay the additional $269.46 $469.46 each month that you would have spent on the 15-year (and do it consistently, every single month) you shave off 10 years and 9 months 14 years and 6 months on the loan. That brings the total length down to a little more than 19 years 15 years (actually 15 years and 6 months).
This may seem to point toward getting the 15-year fixed. You’re saving more than 4 years worth of payments (and additional interest) by locking your payment in for 15 years.
(This now heavily favors my original opinion of getting the 30-year mortgage and paying it like a 15-year mortgage. You pay it off in nearly the same amount of time while getting payment flexibility. Granted, if you don’t add the extra into every payment your payoff date will be expanded out further than calculated.)
But I disagree. While you will save money with the 15-year mortgage, I prefer the flexibility of a 30-year mortgage. The lower payment builds in a tad bit more of a buffer for your finances in case you lose your job or some other emergency comes up. You can choose to add to your payment each month if you are able to — act like it’s a 15-year mortgage. But if something comes up that’s a little bit less stress on the budget. You aren’t forced to make that higher payment every month.
Let me finish by saying if you can afford a 15-year fixed… then by all means, do it! The above advice is for the people that would be over-extending themselves by going the 15-year route.
To all of you with mortgages, what are you in? ARM? 30-year? 15-year? I’m curious to see how many are on the 15 versus the 30-year. Leave comments!
***UPDATE:*** An awesome reader informed me of a serious typo in my calculations.
Originally I had the 30-year mortgage payment at $1,339.35. That is incorrect. The correct payment is $1,139.35. The difference in payments is $469.46.
That’s a $200 difference and it makes a huge difference in the payoff of the 30-year loan is significant.
I re-ran the calculations and if you applied the difference in the 30-year and 15-year mortgage to the 30-year loan, the payoff is 15 years and 6 months. You end up losing 6 months worth of payments, not 4 years and 3 months as I originally calculated.
This further confirms my belief that the 30-year (if you are disciplined) is the better option. The savings between the two is nearly $500 and could make a significant difference in your budget if you got into a pinch. Yes, paying off the loan faster with a 15-year mortgage would be great. But a well disciplined payoff of a 30-year mortgage will work almost as well.
(And isn’t it amazing what a difference $200 makes!)
Another point this makes: don’t trust everything you read. Don’t trust my numbers. Trust your own. Do your own math. Call me out on mistakes.