30-Year Mortgage vs. 15-Year Mortgage -- Which Is Right for You?

By Matthew Frankel Markets Fool.com

The most popular choice for home financing is the 30-year fixed-rate mortgage, which has been the industry standard for a long time. In fact, more than 8 out of 10 homebuyers choose this option. Many people never even consider the 15-year variety -- even when they should.

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Let's go over the pros and cons of each type of mortgage so you can make a fully informed decision when the time comes to finance your next home.

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You can afford more house with a 30-year mortgage

The most obvious reason to choose a 30-year mortgage is affordability. Your monthly payment on a 30-year mortgage will be considerably lower than the payment on a 15-year loan, which means you'll be able to afford more house.

When lenders qualify you for a mortgage, the main factor that determines how much you can borrow is your debt-to-income ratio, or DTI. Most lenders use two DTI numbers, known as the front-end and back-end ratios. The front-end ratio refers to your new mortgage payment relative to your monthly debt obligations, and many banks want this to be under 28%. In other words, multiply your pre-tax income by 0.28, and this is the monthly payment you can handle, based on the front-end ratio.

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On the other hand, the back-end ratio includes all of your monthly debts. This ratio generally needs to be 36% or less, but it's not uncommon for lenders to stretch this limit to 45% for otherwise well-qualified borrowers. Your maximum mortgage amount is limited by the lower of the two calculated payments.

As a simplified example, let's say you're approved for a maximum monthly payment (principal and interest) of $1,200. Assuming national averages for property taxes and insurance, with the current rates, you could afford to borrow $167,285 with a 15-year mortgage. Choose a 30-year mortgage, and your borrowing ability jumps to $242,487. This could mean a big difference in the kinds of houses you can consider.

...but look at the difference in interest

Here's the biggest misunderstanding when it comes to 15-year mortgages: Many people assume that because a 15-year mortgage is half the duration of a 30-year, borrowers will simply end up paying half as much interest. However, the reality may surprise you.

Let's say you want to buy a $250,000 house with a 20% down payment, so you'll need a $200,000 mortgage. Based on the current average interest rates of 4.32% for a 30-year and 3.55% for a 15-year, $200,000 fixed-rate mortgages with these terms would have monthly payments (principal plus interest) of $992 and $1,435, respectively. Notice how the 15-year mortgage's payment is just 45% more, even though it will pay off the loan twice as fast.

These monthly amounts translate into total payments over the loan's term of $357,120 (30-year) and $258,300 (15-year). With the 15-year mortgage, you'll end up paying $58,300 in interest -- that's 63% less than the $157,120 you'll end up paying with the 30-year. In other words, a 15-year mortgage allows you to avoid nearly $100,000 in interest, thanks to the combination of the lower interest rates and the mathematics of loan amortization.

Reasons to get a 15-year mortgage

Aside from the advantages of each type of mortgage that I already discussed, there are situations in which a 15-year mortgage may be a good choice. If any of the following reasons apply to you, it may be a good idea to consider a 15-year mortgage for your next home purchase:

  • You can afford a higher payment, relative to the amount of "house" you need.
  • Your job is stable, and you're confident in your long-term ability to make higher payments.
  • You're close to retirement age and don't want to retire with mortgage debt.

Reasons to get a 30-year mortgage

  • Your job is relatively unstable; if you become unemployed, the lower payments of a 30-year mortgage could be easier to handle.
  • You don't have any emergency savings; lower mortgage payments could allow you to build up your reserves.
  • You want to save more aggressively for retirement instead of putting more of your income toward housing.

What should you do?

The vast majority (86%) of homebuyers opt for a 30-year, fixed-rate mortgage. Apparently, the lower monthly payments and the ability to stretch their budget appeal to most people, and understandably so.

I'm not saying the 15-year mortgage is the best choice for every homebuyer, but it deserves to be part of the conversation. If you're in the homebuying process, weigh the pros and cons carefully -- maybe you could live with a higher payment (or a less expensive home) in exchange for massive interest savings, faster equity buildup, and an earlier payoff.

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