If you are halfway good at math then you understand that, assuming all else equal, a 15 year mortgage will always beat a 30 year mortgage. This is a fact that many financial planners and talking heads latch onto when they tell you that a 15 year mortgage is better than a 30 year loan. And when you run the numbers, it’s easy to see why they say that. 15 year mortgages have lower interest rates than their 30 year counterparts, and they drag the interest payments out over fewer years. The interest savings on a 15 year mortgage can easily be close to $100,000 compared to a 30 year loan. On paper, it sounds great.
But I’m going to tell you that despite what the raw numbers tell you, and despite what the financial gurus say, a 30 year mortgage is better for most people. And here is why…
It’s All About Cash Flow
Cash flow is probably the most underrated aspect of personal finance. But just because the media doesn’t mention it frequently doesn’t mean it’s something you can ignore. Let this example play out, then take the test at the end of the article to determine if a 15 year mortgage is something you should shoot for, or if you should go for the 30 year mortgage and increased cash flow and financial flexibility.
Running the Numbers:
Here are some recent national averages I found on fixed rate mortgages: 15yr @ 3.14%; 30yr @ 3.85%. Using a mortgage calculator at BankRate, I ran the numbers. Assuming all associated closing costs are identical and with the following mortgage assumptions:
- $250,000 house value
- $50,000 down payment (20% down to avoid PMI)
- $200,000 mortgage (finance 80%)
- all related costs are equal (property taxes, insurance, etc.)
Monthly principle and interest payments will be:
- 15-year: $1,394.67
- 30-year: $937.62
Payment difference: $457.05/mo.
Total Interest Paid:
Let’s assume you take the mortgage to term and follow the amortization schedule completely. At the end of your loan, you will have paid the following amounts of interest on your home:
- 15 year mortgage: $51,040.53
- 30 year mortgage: $137,541.93
A 15 year mortgage would save you $86,501.40 over the life of the loan. That isn’t chump change, and is likely to convince many people to go with the 15 year mortgage “if they can afford it.” But we’re not done playing with numbers yet.
Let’s assume you choose the 30 year mortgage, but make the same monthly payment you would have with a 15 year mortgage. Using the same loan assumptions as above, you would pay $68,356.31 in interest on a 30 year mortgage when making the same size payment as the 15 year mortgage (the spread on the interest rates between the 15 and 30 year loans accounts for the difference).
Verdict: Prepaying a 30 year mortgage at this schedule would take an additional 13 months of payments, and $17,315.78 in interest payments vs. the 15 year mortgage. Suddenly the gap isn’t so large. Granted, $17k is a lot of money, but so is the value of flexibility.
Back to the Importance of Cash Flow…
When you run the numbers, the 15 year mortgage still comes out ahead of prepaying a 30 year mortgage. The difference amounts to about $90 per month (total interest savings of 15 year mortgage, divided by the 193 months it would take to pay off the 30 year mortgage with additional payments). Yes, $90 per month is a lot of money, but here is the difference:
you are required to pay the full amount of the 15 year mortgage each month, you can scale back on the 30 year mortgage without penalty at any time, so long as you meet the monthly minimum.
This flexibility equates to financial insurance in the event something happens to your financial situation – such as a job loss, decrease in income, unexpected expenses, emergencies, etc.
What you can do with the additional cash flow
My final argument against the 15 year mortgage centers on opportunity cost, or what other things you can do with your money other than sink it into a mortgage. With $450 extra cash flow per month* you can:
- Fully fund an IRA
- Increase 401k contributions
- Save for college
- Fully fund an emergency fund
- Pay off other debt
*additional cash flow will vary by each loan
The 15 Year Mortgage Test
I’m not here to tell you not to get a 15 year mortgage. If you can afford it, and it won’t stretch your budget or put you in a bind if something happens to your cash flow, then by all means go for it. But I will tell you there is more to comparing 15 and 30 year mortgages then just reading the bottom line. I would use the following as a litmus test to determine if you should go for the 15 year mortgage, or the 30 year and prepay:
- Are you maxing out your 401k, IRA and other retirement accounts?
- Do you have any additional consumer debt (credit cards, car loans, student loans, etc.)?
- Is your job or income stream stable?
- Do you have a 6 month emergency fund?
- Do you have an excess of cash flow each month when accounting for all other fixed payments (loans, bills, utilities, insurance, investments, etc.)?
- Are you fully prepared for any large expenses which may come your way soon (children in college, paying for a wedding, etc.)?
If you answer “no” to one or more of these questions, then strongly consider getting a 30 year mortgage and prepaying what you can afford. Use your extra cash flow to take care of these other areas first, and build security into your financial situation.