15 or 30 Year Mortgage? Here's the Math

I have gotten some positive feedback on recent posts about topics on mortgages and basic personal finance so would like to throw a few more posts out there keeping this theme.  This week let's look at the difference between a 15 year mortgage and a 30 year mortgage.  Most of us understand the basic difference being that a 15 year mortgage generally has a lower interest rate but higher payment due to the shorter amortization period (length of time to pay off).  There is a lot of mixed advice out there regarding whether the 15 or 30 year mortgage is better.  Some sources highlight the lower total interest cost of a 15 year mortgage and the quicker buildup of equity.  Other sources say always take the 30 year mortgage for the lower payment and pay extra when you can.

As with most financial advice, there isn't a definitive right or wrong.  Each individual's best path will be determined by their financial goals, risk tolerance, and personal situation.  This analysis is merely a hypothetical scenario to see what the actual differential in costs would be to allow you better insight as to which choice might be right for you.

In this scenario, we'll use realistic numbers based on where the markets currently are in December 2020.  Here's the scenario:

Jack and Jill are looking to purchase their first home and trying to make sense of the numbers.  The house that fell in love with is a 3 bedroom / 2 bathroom home in the suburbs.  They have saved up some money for a 20% down payment and are trying to choose a mortgage.

Home Price = $319,000 (median national home price in 2020)
Down Payment (20%) = $63,800
Mortgage Amount (Home Price less Down Payment) = $255,200

They have been offered the following interest rates (for simplicity, I am not including points, fees, etc,)
30 year fixed mortgage = 2.9%
15 year fixed mortgage = 2.3%

Based on the loan amount, interest rate and loan period, their Principal and Interest payments would be:
30 year mortgage payment = $1,062/month
15 year mortgage payment = $1,678/month

At this point, the big question becomes; do Jack and Jill want to pay $616/month to get their home paid off in 15 years instead of 30 years.  Obviously, this will depend on their goals and current financial ability to pay the higher payment.  But what if they took the 30 year mortgage and paid the 15 year mortgage payment, applying the extra payment amount to reduce the principal but reserving the option to pay the lower payment if they ran into some difficulties or needed those funds for a better opportunity?

30 year fixed rate loan with additional $616/month principal paid
Loan Payoff = 190 months (15 years and 10 months)
Total Interest Paid = $63,280 

15 year fixed rate loan with $0 additional principal paid
Loan Payoff = 180 months (15 years)
Total Interest Paid = $46,790

With the true numbers in front of them, Jack and Jill can now make an educated decision as to what is best for them.  If they think that making the higher payment could become difficult in the future then the 30 year loan makes more sense even though the overall cost of doing so will be $16,500 over the life of the loan.

Another argument that I like to consider is the opportunity cost of the funds used to make the higher payment of the 15 year mortgage.  Borrowing money at 2.9% (30 year loan) is so cheap that I don't mind paying the additional interest in order to keep $616 per month in my pocket to invest elsewhere.  My other investments can easily earn a minimum of 8-10% per year (often much higher than this) so it makes sense to invest that extra money, pay the mortgage loan interest, and keep the profits cycling into new investments. 

By having a well thought out financial plan and taking a little time to run through the calculations, decisions like choosing a mortgage term become much easier.  Compare the outcomes of different variables to see how they align with your goals and you can jump with confidence.

Next week I will analyze the potential earnings of investing that $616/month savings and compare that to the additional interest cost of the 30 year mortgage.

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