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Which mortgage is better?

Which mortgage is better?

When getting a mortgage, homeowners often run into this question: “Should I choose a 15-year mortgage or a 30-year mortgage?

It is an mportant to answer. If you make the right choice at this stage, you can possibly save significantly over the life of the loan.

And to make the right choice, it’s quite important to understand the scenarios in which one is better than the other. Once you do, you’ll make an informed decision. And that’ll set you apart.

Many homebuyers lean towards the 30-year mortgage

Most homebuyers lean towards the 30-year mortgage. The reason is not always because it is better for them.

Rather, it’s more because that’s what they hear most of their friends and colleagues went with. “If so many people picked that option, it is likely the better choice” is how they go about making that decision.

That’s a very irrational way of thinking. For first-time homebuyers though, there is so much information to absorb and so much knowledge to gather. 

And when the learning curve is so steep already, it’s very natural for us to not want to make another decision. “Let’s just go with what most others are doing” can’t be too wrong.

That could be true. It may not be too bad in the end. But when making the biggest purchase of your life, one should lean heavily towards “better” or “the best”, instead of “not too bad”. 

After all, it’s a big commitment one is making. A little more due diligence can help one save a lot.

Why do so many people choose the 30-year mortgage?

Mortgages are available for a range of terms. Many lenders offer mortgages from 8-year to 30 year duration.

Ideally, most people don’t like to have any debt. The lower it is, the larger the share of their monthly income that they can keep to themselves (to be used for other purposes) instead of having to make loan payments every month.

But when debt is necessary, such as in a big purchase like a home, people do want to get out of it as early as they can.

For that reason, one would think people should choose a 10-year or a 15-year mortgage over a 30-year mortgage.

But counter to intuition, a fixed 30-year mortgage is the most popular choice even though it keeps the debt for the longest period amongst them all. 

The main reason for that is the lower monthly payment with a 30-year loan (vs the rest). Most people prioritize having free cash flow every month (over how long they have to pay the debt for).

But that does not mean your priorities are the same. It all depends on your situation.

Why is the monthly payment for a 30-year mortgage lower?

Most mortgages originated in the US are amortizing. What that means is that a fraction of the monthly payment goes towards paying the interest and the remaining portion is used to pay off the principal gradually every month.

At the end of the loan term, the borrower doesn’t have to pay any big principal balance because they’ve paid that off little-by-little all along. Read more about that in this article.

What that means is that with a 30-year mortgage, one gets 30 years to pay off the principal. When that same time period is shorter, say 15 years, the same amount of principal needs to be paid in half the time.

As a result, the monthly payment comes out to be much higher with a 15-year loan.

Is the monthly payment double for a 15-year loan (vs. 30-year)?

Given the same amount of principal has to be paid off in half the time with a 15-year loan, one might guess that the monthly payment would be double. 

But in reality, the payment for a 15-year loan is often significantly less than double that of a 30-year loan. There are two main reasons for that:

Lower rate: Firstly, the interest rate for a 15-year mortgage is typically lower than that of a 30-year loan. And when the rate is lower, the interest paid in actual dollars would be smaller as well.

Smaller principal balance: Because a 15-year loan is paid much quicker, the outstanding principal balance every month reduces faster.

That means that the principal balance at the beginning of any given month in a 15-year mortgage is lower than that in a 30-year one.

And when the principal balance in any given month is lower, the interest charged for that month is also lower, thereby reducing the total interest paid further.

The combined effect of all of this is that the monthly payment is often about 60-70% higher with a 15-year mortgage (compared to 30-year), and not twice as big.

Can we summarize the comparison between 15-yr and 30-yr mortgage?

We’ve provided quite a bit of information about both so far. Let’s try to summarize it in a table and list who the winner in each category is.

15-yr vs 30-yr mortgage

15-year 30-year
Interest rate Lower
Total Interest paid Lower
Loan paid off Sooner
Monthly payment Lower
Debt-to-Income ratio Lower

Should I choose the 15-year mortgage if I can afford the higher payment?

In most cases, yes. The only big downside of a 15-year mortgage is the higher payment. If you can afford it, there’s very little reason to not choose that.

There is one situation, however, in which you might consider not getting the 15-year mortgage even when you can afford the payment. That happens when you can invest your cash at a rate that is higher than the interest rate on the mortgage. As Stem Lending is not licensed to provide financial advice, you might want to consult a duly licensed financial advisor for feedback. Feel free to contact us if you need introductions with financial advisors. 

That way, you are effectively making a higher return on your cash and paying off a lower amount in the form of interest towards the loan. The difference between the two is for you to keep as extra income.

When doing that, do take into account your marginal tax rate and consult your financial advisor. This strategy of generating extra income only works when the income is net positive after taking into account income taxes.

I can afford the higher payment today. But what are my options if in a few years, I cannot?

Locking yourself to a 15-year loan does put you in a situation where you have to make the higher monthly payment for the life of the loan.

However, there are situations where you think you can afford the higher payment associated with the 15-year loan but are not sure if that’ll change in the future. 

What if five years down the line, you have some sudden need for the extra cash that a 30-year mortgage allows you to save every month. How do you deal with that? The answer to that depends on the likelihood of that need arising:

If the scenario is totally unforeseen:

If you are quite confident you’ll be able to afford the higher payment, it’s not too unwise to go with the 15-year loan.

In case of completely unforeseen circumstances, you can potentially refinance into a 30-year loan if you want to reduce your payment later. You’ll end up paying the closing costs twice and may not potentially qualify for a 30-year loan in the future, depending on future income levels, so think through it carefully.

If the scenario is likely enough:

If there is a reasonable chance that your affordability (with respect to a higher payment) might go down in the future, you can go with a hybrid strategy. 

The hybrid approach captures some advantages of both. So let’s discuss that:

The hybrid approach — Pre-paying

The hybrid approach is, as the name suggests, a mix of features of both the 15-year and the 30-year mortgage. This strategy picks up some good aspects of both, thereby offering some advantages associated with each one.

Here is how it would work:

  • Qualify for a 30-year mortgage that doesn't have pre-payment penalty
  • Start out with extra monthly payments towards principal as if it’s a 15-year loan
  • When need for extra cash flow arises, resume paying the lower monthly payment of a 30-year loan
  • You can make the higher payment again when the need for extra cash flow goes away.

While the extra pre-payments reduce the total interest paid (as lenders charge interest on unpaid principal balance) and thereby help you become debt-free sooner, home equity might be difficult to liquidate depending on your future income levels, so please consult your licensed financial advisor for proper planning.

If need for extra cash flow never arises:

You can continue to pay as if it’s a 15-year loan. Yes, the rate of interest is that of a 30-year loan, i.e. a bit higher. But because you are paying the principal faster, the outstanding principal balance every month will be comparatively lower (than a 30-year loan). As a result, the total interest you pay will be lower.

If need for cash flow arises at any point:

You have the flexibility to slow down your payments and pay the rest of the loan as a 30-year loan. This is possible because the minimum payment signed up for was that of the 30-year loan (which is lower).

What about qualifying for the loan? Is one better than the other?

For loan qualification, a borrower’s DTI (Debt-To-Income) ratio has to be below a certain threshold. Read more about DTI here.

When doing the DTI calculation, the payment for the mortgage in process is also taken into account. Given the loan payment for a 30-year is lower, it results in a lower DTI. Therefore, chances of qualifying are higher.

This is only binding when your DTI is high enough to be close to the threshold. When it’s sufficiently low, you’ll qualify for either of them equally and there is no difference between the two in such a situation.

What about other terms: 10-year, 20-year, 25-year?

For terms other than 15 years and 30 years, the same logic applies. 

The lower the mortgage term:

  • The lower the rate (typically)
  • The higher the payment will be (just as you saw above with the 15-year). 
  • The lower the total interest paid over the life of the loan.

The tradeoff here is monthly payment vs. total interest paid.

What should I do if the 15-year rate is lower than a 10-year rate?

In some uncommon situations, the rate for a 15-year loan can be lower than the 10-year loan. 

The reason for that is that most mortgages are sold to investors in the secondary market as a pool (i.e. collection of a few hundred mortgages, say). And depending on the need to complete the required pool when the lender is short a few, they can sometimes offer discounts by offering lower rates for those. These inventory imbalances can then lead to short-term anomalies like that.

Also, because the 15-year is a very commonly chosen term, those mortgages are very liquid (i.e. easily sellable). For that reason, lenders can offer better rates for those than for terms adjacent to it such as 14 and 16 years.

If the 15-year rate is lower than a 10-year rate, say, and there is no prepayment penalty associated with the mortgage , you can choose the 15-year loan to get the lower rate (even if you want to pay the loan off in 10 years).

 Once you do that, you can pay the loan off by making the higher monthly payments of a 10-year loan, albeit at the lower (15-year) rate. In the end, you’ll pay less total interest because of the lower rate. Remember, a lender can charge interest only on the principal balance remaining.

When you are making that choice though, do carefully review your closing disclosures to confirm that there is no prepayment penalty.

What if I am still not sure whether to go with 15-year or 30-year?

We covered the major advantages and disadvantages of both loan types. Not only that, we reviewed many different situations which people commonly think about or run into.

In spite of that, it’s possible that you are still not sure about your decision and/or are not sure which one to go with.

If that’s the case, please feel free to reach out to us. At Stem Lending, our goal is to help you make the most informed mortgage decision. If you are already sure about it though, you can start right away at: stemlending.com/apply

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