Many homeowners with a 30-year mortgage don’t realize how much they are paying in interest. This is the problem. The solution for many is to accelerate the payment, either by paying more principal each month or by entering into a shorter repayment contract. The best-known among these is the 15-year term.
An example: If your mortgage balance starts out at $100,000 and your loan is written at 5% interest, the 30-year term requires a monthly payment of $536.83. Over 30 years, the total of all payments adds up to just under $193,259. That’s a 93% premium in interest payments — on top of the mortgage balance.
It gets worse. It takes more than 20 years to pay off half of the debt. The other half is paid over the last 10 years. In fact, a 30-year term amortizes so slowly that after five years (60 payments), you still owe 92% of the original balance. When you consider that the average first-time buyer keeps that home less than five years, this further makes the case that a 30-year mortgage is too expensive.
The Advantages of a 15-Year Mortgage
Now think about a 15-year term. That $100,000 mortgage at 5% repaid over 15 years costs $790.80 per month, which is $253.97 more than the 30-year term. A 15-year mortgage is harder to qualify for because you have to make a larger payment every month, which could make your DTI ratio too high. So, you have to be able to make that higher payment. For many, though, the comparison between house payments and rent makes this higher payment easier to bear. This is especially true when you also take into account the federal and state tax benefits of deducting interest. If your combined federal and state tax rates add up to 32% percent, for example, your after-tax cost for the 15-year mortgage is reduced to $538. This is about the same as the 30-year payment and comparable to a $538 rental each month with no tax benefits.
Over 15 years, the total of your payments on a $100,000 mortgage comes out to $142,344 – or about $50,900 lower than the cost of a 30-year mortgage. And the acceleration is much better as well. After five years, you will have paid off about one-fourth of the debt, compared to only about 8% with the 30-year term.
Another advantage is that lenders often will offer a lower interest rate on the 15-year than on the 30-year contract. A one-quarter percent reduction is worth about $14 per month. Over 15 years, that equals $2,500. However, the faster payoff has to be practical. If you cannot afford the higher payments even after tax benefits, it will not make sense for you to agree to the shorter term. But as long as that is affordable, it makes sense and saves money.
If you cannot afford to go as low as 15 years, you can enter a 30-year mortgage and add extra payments based on what you can afford. For example, adding $48 per month to the 30-year payment reduces your repayment term five years. It also saves about $18,000 in interest expense. If you increase the 30-year payment by $123 per month, you cut 10 years off the repayment and save nearly $35,000 in interest.
Michael C. Thomsett is author of over 60 books, including Annual Reports 101 (Amacom Books Press), Trading with Candlesticks (FT Press) and the recently released new book, Getting Started in Stock Investing and Trading (John Wiley and Sons). He lives in Nashville, Tennessee and writes full time.