The 30-year vs. 15-year Mortgage

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Ed Pinto, co-director of the International Center on Housing Risk at the American Enterprise Institute, recommends retiring the 30-year fixed rate mortgage. He posits that this mortgage type “fails to build up wealth for the most disadvantaged Americans”. His comments are in response to a proposal by five economists to reformulate taxpayer backing of Fannie Mae and Freddie Mac to keep the 30-year fixed rate mortgage alive.

Pinto believes a shorter term loan would especially benefit low-income and minority households because of the earlier payoff. He says benefits would extend into the mortgage market by reducing mortgage debt and eliminating the need for a taxpayer-backed government guarantee, thus bolstering the financial system.

See New Mortgage May Increase Home-Ownership Rate

What do you think, should the 30-year mortgage go the way of dinosaurs and dodos?

There are pros and cons to getting a 30-year or 15-year mortgage. Consumers should carefully weigh these pros and cons against their unique financial situations.

The pros and cons of getting a 30-year mortgage

According to the Mortgage Bankers Association (MBA), the 30-year mortgage is America’s most popular type of mortgage. As of a year ago, the 30-year mortgage commanded more than two-thirds of all mortgage loan applications.

Here are the pros of going with a 30-year mortgage.

The 30-year mortgage’s main advantage is a lower monthly payment. For example, a 30-year loan for $300,000 at 4 percent interest carries a monthly payment of $1,432. This is about a third less than what a 15-year mortgage monthly payment would be with the same interest rate.

The lower payment is a savings incentive, allowing the borrower more to save for college tuition in a 529 plan or in a 401(K).

The borrower may be able to afford more house for the same monthly payment as a 15-year loan.

A knowledgeable investor could invest the difference between 15-year and 30-year mortgage payments into high-yielding securities.

Over the 30-year mortgage lifetime, the borrower will pay much more than a 15-year mortgage, much of it interest.

Here are the cons of going with a 30-year mortgage.

A borrower will pay at least twice as much for a 30-year mortgage, because the mortgage’s cost is calculated as an annual rate and the money is borrowed for twice as long. The gap between the 30-year and 15-year mortgages increases as the interest rate increases. For example, a borrower with a loan with a 4 percent interest rate will pay nearly 2.2 times more in interest with a 30-year loan than they would with a 15-year loan.

Longer-term loans are more expensive and riskier for lenders, with interest rates typically a quarter point to a whole point higher than for a 15-year loan.

A borrower may pay more fees if their 30-year loan is purchased by Fannie Mae or Freddie Mac. These loan level price adjustments fees often apply only to 30-year mortgages and the borrowers typically have lower credit scores or smaller down payments or both.

Higher mortgage insurance premiums are charged by the FHA to borrowers of 30-year mortgages, with the interest rate increasing rather than as upfront fees.

The pros and cons of getting a 15-year mortgage

Few borrowers apply for 15-year mortgage loans. MBA figures from over a year ago show that only 5 percent of home buyers and 20 percent of people refinancing, seek a 15-year mortgage. The number of borrowers seeking 15-year mortgages have fallen in recent years and this is mostly due to being turned off by higher monthly payments.

Here are the pros of going with a 15-year mortgage.

The cost of a 15-year mortgage is much less than a 30-year mortgage. For example, a borrower with a 4 percent interest rate will only pay about 46 percent of the interest costs of a 30-year loan.

Shorter-term loans are cheaper for lenders and less risky, interest rates are typically lower (between a quarter point and one point less) than a 30-year mortgage.

If a mortgage is purchased by Fannie Mae and Freddie Mac, the borrower is typically charged either no or lower loan level price adjustment fees and the FHA charges lower mortgage insurance premiums.

Financial planners consider the 15-year loan as a forced savings plan because of the higher monthly payment. Instead of investing the difference between this and the lower monthly 30-year mortgage payment, the borrower is investing in a home that is likely to appreciate in value.

Here are the cons of going with a 15-year mortgage.

Shorter-term mortgages have higher monthly payments. For example, a 15-year mortgage for $300,000 with a 4 percent interest rate has a monthly payment of $2,219, 55 percent higher than the monthly payment on a 30-year loan with the same interest rate and borrowed amount.

A borrower might be limited to less house than the one they could get with a 30-year loan.

Higher cash reserves are required, as much as a year’s worth of income in liquid savings.

The borrower may be unable to save towards other goals such as 401(K), college tuition in a 529 plan or invest.

The bottom line:

A borrower with a $300,000 30-year loan with a 4 percent interest rate, would pay $215,609 over the term of the loan, wherein a borrower with the same loan amount, with a 15-year loan term and a 3.25 percent interest rate, would pay $79,441.

A borrower with a 30-year loan could buy more house than they could afford with a 15-year loan. They could also build up their savings, set goals that have incentives such as a college tuition 529 plan, and a 401(K). A savvy investor could take the difference between a 15 and a 30-year loan and invest it into high yielding securities.

If the savings and incentives are not as important as paying off the mortgage in a short period of time, a borrower in a 30-year mortgage could pay off their mortgage in 15 years by making larger payments (assuming there’s no prepayment penalty) and directing the payments to the principle. The borrower could always go back to the 30-year payment schedule if money gets a little tight.

Resources:
Forbes. The 30-Year Fixed Mortgage Should Disappear

Investopedia. The Pros and Cons of a 15-Year Mortgage

Investopedia. The Pros and Cons of a 30-Year Mortgage

Quicken Loans. Pros and Cons of the 15-Year Fixed Mortgage

Photo credit: Lending Memo

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