A 30-year fixed-rate mortgage is the most popular option for home purchases. However, you probably have seen some advertisements that encourage you to refinance your 30-year mortgage into a 15-year one. If you are a Dave Ramsey fan, you know that he is against taking out a 30-year loan and encourages you to use cash for your home purchase. In the worst case, he said a 15-year mortgage is superior to a 30-year mortgage. Is a 30-year mortgage really that bad?
15-Year Mortgage vs. 30-Year Mortgage
First, let’s take a look at the difference between a 15-year mortgage vs. a 30-year mortgage assuming you’re buying a $250,000 house (the median home price in the United States). Both loans will have the same amount for the home price, down payment, and loan amount.
|15-Year Mortgage||30-Year Mortgage|
We calculate the monthly payment, total interest payment, and total payment using our free amortization calculator.
The Key Differences Between 15-Year vs. 30-Year Mortgage
The main difference between the 15-year mortgage and the 30-year is
- You pay a lower interest rate for the 15-year mortgage
- You pay a higher monthly payment for the 15-year mortgage
- You pay less total interest through the lifetime of the loan using the 15-year mortgage
Based on this information alone, it is no surprise that most people jump to the conclusion that the 15-year mortgage is better than the 30-year mortgage.
Four Reasons When a 30-Year Mortgage is Better
In general, a 30-year mortgage is a much better product when the rates are low (like it is now).
1. Improved Cash Flow
The number one reason a 30-year mortgage is better because it is more affordable to most people. The lower monthly cash flow is quite significant. As you can see from the table above, you pay about $500 less per month for a 30-year mortgage. That is a substantial amount of money for most people.
Since most 30-year mortgages do not have a prepayment penalty, the lower monthly payments give you much greater flexibility.
You can decide to prepay the mortgage to shorten the loan length and save some money on interest. You can do this on a regular basis or only when your budget allows you to. You can also choose to do other things with your money.
Further, you don’t have to decide to do one thing or another for the entire length of the loan. You can change what you do whenever you choose to best meet your financial needs and goals.
3. Small Difference in Inflation-Adjusted Total Payment
Using the numbers above with an average inflation rate of 2.5%, the inflation-adjusted total payment for the 15-year loan is $214,995 vs. $232,965 for the 30-year loan — a tiny difference of $17,969 over the course of 30-years.
Remember your principal and interest payment do not decrease each year. Assuming your income keep pace with the inflation rate, the impact of that monthly payments decrease each year. The table below illustrates how a 2.5% inflation rate reduces the impact of your monthly payment.
For example, 10 years from now, your $17,010 yearly mortgage payment will feel like $13,544 in today’s dollars because by that time you will most likely earn about 20% more than what you earn today due to inflation.
|15-Year Mortgage||30-Year Mortgage|
4. Invest the Difference
Even if you don’t invest the difference, a 30-year loan is much better than a 15-year mortgage when the interest rate is low. Now let’s look at what happens if you invest the difference and get an average gain of 9% per year by investing in the S&P500 Index.
After 15 years, you will have $178,075 in your investment account!
Now, let’s look at the next 15 years. After the 15-year mortgage is paid off, you invest the monthly payment that you no longer have to pay to the mortgage company in the stock market for the next 15 years. At the end of 30 years:
- 15-year mortgage and invest for 15 years result in an investment balance of $499,436
- 30-year mortgage and invest the difference for 30 years result in an investment balance of $826,711!
In fact, the 30-year mortgage and invest the difference option is better for an investment that returns on average 4% or more. At 4%, both scenarios are the same at about $340,000 in the investment account.
|Invest 15 Years||Invest 30 Years|
5. Mortgage Interest Tax Deduction
Also, remember that on average, the person who is paying a 30-year mortgage is enjoying a slightly higher tax deduction each year. For example, here is the tax savings after the first year assuming a marginal tax rate of 22%:
- 30-year Mortgage: Interest Paid is $8,625.58 and tax savings is $1,897.63
- 15-year Mortgage: Interest Paid is $7,907.75 and tax savings is $1,739.71
It is a fairly small saving, but it is worth mentioning. However, remember how much tax deduction you can take from your home mortgage is highly dependent on your tax situation. You may not be able to take full advantage of this deduction.
Three Reasons When a 15-Year Mortgage is Better
The 30-year mortgage is NOT always a better choice. There are conditions in which a 15-year mortgage is better.
1. Less Expensive When Interest Rates are Higher
Assuming that you can achieve a 9% return on investment, the break-even point is around a 6% interest rate for the 15-year and 6.5% for the 30-year.
But to be more conservative, we can say that once the mortgage rates go above the 5.5% level, the vast majority of people are better off with the risk-free savings the 15-year mortgage offers.
2. Investing Skills and Risk Tolerance
Also, your investing skills and experience play an essential role. If you are neither a proficient investor, nor motivated to take the extra risks, then you’re almost always better off with a 15-year mortgage. When you use a 15-year mortgage, the money you save from a lower interest rate is guaranteed, and you do not have to take investment risks.
3. Financial Goal
Lastly, if your goal is to pay off the mortgage as soon as possible, a 15-year mortgage is most likely a better choice. If you want some added flexibility, you can take out a 30-year mortgage and prepay when you’re able.
Paying Cash for Home Purchase
I know Dave Ramsey’s fan will hate it when I say this: paying cash for a home purchase is just plain old stupid. Of course, this statement assumes that we are talking about the current interest rates and that you don’t have enough cash to make an outright purchase.
- If you are already sitting on enough cash to buy your next house, then I feel it is not a wrong decision at all and that it is your choice to do so.
- Secondly, there is going to be a point where the interest rate is so high that it doesn’t make any sense whatsoever to take out a home mortgage, but we are not even close to being in that situation.
Here are why I think paying cash for your home right now is dumb:
- Interest rates are very low. Inflation is already erasing the majority of the interest you’re effectively paying. For example, at 2.5% inflation and a 3.75% interest rate, you are effectively paying 1.25% for your loan. That’s a fantastic deal!
- High probability of getting better returns elsewhere. Since the rate you’re paying is so low, your chance of getting a better return by taking investment risks is much higher than the risk-free rate of paying down your debt. If you pay for your house with cash, your opportunity cost is the amount of money you could’ve made if you were to invest the money instead of having it stuck in the house as home equity.
- Saving up takes forever. If you don’t have enough cash right now, trying to save $250,000 from zero will take you many years. There are many problems with this:
- Home prices are likely to continue to climb while you’re saving up.
- Risk-free savings cannot keep up with the inflation rate, so your purchasing power goes down each year even while you save up.
- Investing your money is not recommended since the market fluctuates, and you could lose your principal when you are just about ready to make your purchase.
The key point is: unless you already have the cash to pay the full price for your home purchase right now, saving up to buy a house with cash is a poor choice.
- A 30-year mortgage is better than a 15-year mortgage when the interest rate is low as it is right now.
- If you’re a proficient investor and willing to take on some investment risks, a 30-year mortgage is better until the interest rates start to hit a 5-6% range.
- Above the 6% interest rate, the 15-year mortgage is a better product if you can afford the higher monthly payment.
- Paying cash for a home purchase is perfectly fine if you already have the cash.
- Saving up to buy a house with cash simply to avoid debt is a bad idea because home appreciation and inflation are continually working against you. You may never reach a point where you can purchase a house.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.