Comparing Terms
When preparing to buy a home, a borrower needs to decide what type of mortgage best suits their needs. If the prospective homeowner plans to stay in the home for more than five years, and wants payments that will remain constant over the life of the loan, he or she may be interested in a fixed-rate mortgage.
The following article discusses the two most commonly chosen types of fixed-rate mortgages: the 15-year and the 30-year. It also illustrates the differences between them, so that a borrower can weigh the advantages and disadvantages of each.
As the payment comparison table in this article shows, the 30-year loan has smaller monthly payments, but ultimately costs more in interest. The 15-year loan has larger monthly payments, but because more of each payment goes to principal than to interest, it builds equity faster and the borrower can pay off the home more quickly. Choosing the 30-year or the 15-year will depend on financial needs and goals.
When preparing to buy a home, there are many important decisions to make. One of these decisions concerns financing - in particular, what kind of mortgage suits the prospective homeowner's needs?
The answer to this question largely depends on the individual circumstances, needs, and goals. For example, if a borrower is thinking of staying in the home for more than five years, and want payments that will remain constant over the life of the loan, they may wish to consider a fixed-rate mortgage.
A fixed-rate mortgage amortizes over a certain period of years. Its interest rate and monthly payment are "locked in" and do not change during that time. A portion of each monthly payment covers the interest due on the loan, while the rest of the monthly payment applies toward reducing the principal balance. Each monthly payment reduces the loan balance until the loan repayment is complete.
If choosing a fixed-rate mortgage, one must choose a type of fixed-rate mortgage.
The most common fixed-rate mortgages are the 30-year and the 15-year. If the main goal is to have an affordable monthly payment that will remain constant over the life of the loan, then the 30-year fixed-rate mortgage may be of interest. Or, if the main concern is rapid equity build-up and pay-down of principal, consider the 15-year fixed-rate mortgage. Which fixed-rate mortgage one chooses depends largely on financial capabilities, needs, and goals.
This article discusses which Fixed-Rate Mortgage meets one's financial needs and goals by answering the following questions out each:
- What is a Fixed-Rate Mortgage?
- How does it work?
- What are the pros and cons?
What is it?
30-year fixed-rate mortgage
For generations, when people thought of a mortgage, they thought of the 30-year fixed. This loan has been a traditional favorite for people looking to finance a home. While this thinking has changed more recently because of a wide variety of other options open to borrowers (such as many different types of adjustable-rate mortgages), the 30-year fixed-rate mortgage remains an industry standard.
The 30-year fixed-rate mortgage offers the lowest monthly payments of fixed-rate loans, because the payments cover a long period. With the 30-year loan, as compared to the 15-year loan, an individual can buy a bigger house or keep payments on a smaller house affordable.
15-year fixed-rate mortgage
The other common fixed-rate mortgage is the 15-year. As its name implies, the 15-year fixed-rate mortgage's amortization schedule is half that of the 30-year. Additionally, a 15-year fixed-rate mortgage's interest rate is typically one-quarter to one-half a point lower than that of the 30-year.
Despite the fact that the 15-year fixed-rate tends to be lower than that of the 30-year, the 15-year loan's monthly payment is higher because of the shorter amortization schedule. However, this loan enables the ownership of the home sooner, because more of each payment goes toward principal rather than toward interest.
The 15-year fixed loan has tended to be popular with two very different groups of borrowers (one does not have to fall into either of these groups to take advantage of a 15-year fixed-rate mortgage):
- Homebuyers just starting out who have enough income to meet the higher monthly payments. Their goal is usually to pay off the house before their children start college.
- Established homebuyers who also have enough income to meet the higher monthly payments. Their goal is usually to pay off the house before they retire.
How does it work?
30-year fixed-rate mortgage
In a 30-year fixed-rate mortgage, the entire principal is paid down in 360 equal monthly payments.
Due to the long loan period, the monthly payments are the lowest of the fixed-rate loans, but pay-down of principal occurs slowly. Note that:
- More than 84% of the monthly payment applies to interest during the first ten years of the loan, and...
- It is not until the 22nd year that 50% of the principal balance is paid off.
Given this, the 30-year fixed-rate mortgage is appropriate if the main concern is an affordable monthly payment rather than the rapid reduction of principal and the rapid buildup of equity.
15-year fixed-rate mortgage
In a 15-year fixed-rate mortgage, the borrower is paying down the entire principal in 180 equal monthly payments.
Compared to the 30-year fixed-rate mortgage, the shortened loan term allows for a quicker pay-down of principal, and the payment of less interest over the life of the loan. Note that:
- The interest rate on a 15-year fixed tends to be about 1% lower than on a 30-year, and...
- The monthly payment tends to be 15-20% higher than on a 30-year, so...
- About 50% of the principal balance repayment occurs in the first nine years of the loan.
The 15-year fixed-rate mortgage is appropriate if the main concern is rapid equity build-up and paying off the home faster.
Payment comparison
This table compares payments on a $100,000 mortgage with terms of 15 and 30 years. In this illustration, the 15-year rate is one-quarter of a percent lower than the 30-year rate. As noted above, this is a typical delta between 30- and 15-year interest rates.
| Terms | 30-year at 8 percent | 15-year at 7.75 percent |
|---|---|---|
| Monthly principal and interest payment | $733.76 | $941.27 |
| First-year interest cost | $7,969.81 | $7,621.32 |
| Mortgage balance at end of year one | $99,164.64 | $96,326.01 |
| Fifth-year interest cost | $7,655.39 | $6,291.09 |
| Mortgage balance at end of year five | $95,069.86 | $78,432.70 |
| Total principal and interest payments over life of loan | $264,155.25 | $169,429.64 |
| Additional monthly costs with 15-year fixed | $207.51 | |
| Interest saving compared to 30-year fixed | $94,725.61 |
As this example shows, on a $100,000 mortgage, a 30-year loan would cost almost $95,000 more in interest than would a 15-year loan.
Prospective buyers should weigh a variety of factors in order to decide whether a 30-year or 15-year fixed-rate mortgage is right for their financial needs and goals.
What are the pros and cons?
30-year fixed-rate mortgage
The 30-year fixed-rate mortgage is an appropriate choice if the borrower's primary concern is an affordable monthly payment that will stay the same over the life of the loan.
| Pros | Cons |
|---|---|
| Smaller monthly payments | Pay more in interest over the life of the loan |
| Ability to afford “more house”, since payments are smaller | Loan takes longer to pay off |
| Flexibility – if desired, borrowers can make extra payments when they have the resources to do so, and pay off the mortgage in fewer than 30 years |
15-year fixed-rate mortgage
The 15-year fixed-rate mortgage is an appropriate choice if the goals are rapid equity build-up and rapid payoff of the loan.
| Pros | Cons |
|---|---|
| Loan is paid off more quickly | Larger monthly payment |
| Faster equity build-up | Borrower probably can’t afford to buy as large or as expensive a house, since the payments are larger |
| Borrower pays less in interest over the life of the loan |
Choosing the 30-year or the 15-year depends on financial needs and goals. The 30-year loan has smaller monthly payments, but ultimately costs more in interest payments. The 15-year loan has larger monthly payments, but because more of each payment goes to principal than to interest, it builds equity faster and a home is paid off more quickly. The decision depends on whether the management of monthly payments or the building of equity and rapid payoff takes precedence.