15 Year Versus 30 Year Fixed Rate Mortgages – How to Determine Which is the Better Option

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As mortgage rates continue to hover at 30 year lows, many people are wondering whether a 15-year or a 30-year mortgage term is a better option. After all, even though payments on the 15-year option would be higher, the lower interest rates on the shorter term loan are keeping payments, in many cases, at very manageable levels.

With the average 15-year interest rate near 3.5 percent for those with good credit, versus around 4.5 percent for a 30-year mortgage, it’s hard not to at least consider the shorter term mortgage option. Further the higher payments, lower interest rate, and shorter repayment term of the 15-year mortgage option allows people to pay down their principal much faster, too.

Apparently quite a number of homeowners have jumped to 15-year mortgages lately. In fact, according to data from CoreLogic, for the first half of this year, over 25 percent of homeowners who refinanced went with a 15-year option. This is a drastic increase over past years, when only about 9.4 percent of home owners went that route.

Not For Everyone

Even with all of the positives of the 15-year mortgage option, it may not be a good move for everyone. Typically younger homeowners with many additional expenses tend not to be the best candidates for the higher payment 15-year loan. With income fragmented towards numerous other payments, even a slight increase in monthly expenses could cause financial hardship.

As a rule of thumb, you should look at your current and planned debt-to-income ratio (DTI) to determine if you can afford a 15-year mortgage. Generally if your DTI is expected to be below 30 percent for the foreseeable future, a 15-year mortgage may be a viable option. However, homeowners with ratios above this amount may not be well suited for the 15-year mortgage when they can get a 30-year loan with lower and more affordable monthly payments. For example, someone who earns a gross monthly income of $4,000 should only get a 15-year mortgage if they have less than $1,200 per month going to their monthly debt which includes mortgage, taxes, insurance, auto, student loans, and credit card debt.

Furthermore, in the current economic environment with much lower job security many two-income families face the risk of turning into one-income households. This makes a 15-year mortgage too risky for these families because apart from the difficulty of managing repayments on one income, refinancing to a 30-year loan may not be possible if the job loss causes their personal finance position to change drastically.

What About First Time Homebuyers?

First time homebuyers are in a unique situation. Firstly, on average, first time homebuyers typically only live in their initial home for between five and ten years. This is because they tend to upgrade as their family grows, or move to a more expensive home as their household income rises.

However, if first time homebuyers were to decide on a mortgage payment they are comfortable with, they will generally find that they can buy a much more expensive home using a 30-year mortgage than they could for the same monthly payment using a 15-year loan.

Another benefit of a 30-year mortgage for this group includes that of a larger tax deduction, as a larger portion of the payments are considered interest. This is especially true if the homebuyer is in a high tax bracket.

And, although a 15-year mortgage will likely leave a first time homebuyer more equity to roll over into a new home when the time comes, the fact that a larger home could initially be purchased using a 30-year mortgage may leave the homeowners wanting to stay right where they are. This is especially true given that transaction costs associated with selling a home typically drain away roughly 10% of the home’s value. Therefore, if using a 30-year mortgage increases the likelihood that the homeowner will stay in their home longer, this option could not only provide instant gratification through lower payments, but could also provide future benefits as well.

Another Option To Pay Off Your Mortgage Faster

Although some homeowners are better off with a 30-year mortgage, there are still options for paying off your loan quicker. For example, you could make extra payments to the principal each month. And, in months where money is tight, you have the option of not making that extra $100 principal payment. Making an extra mortgage payment every year for a 30 year fixed rate mortgage will result you paying off your mortgage 7 years earlier. Similarly, making bi-weekly payments instead of monthly payments could knock 4-6 years of your mortgage term. These accelerator options, for some people, could actually provide the best of both worlds.

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{ 1 comment… read it below or add one }

Jeff Godl October 14, 2010 at 12:17 pm

Mortgage interest rates continue their descent into record territory – 1951 levels, with the 30-year fixed-rate loan dropping to an average of 4.19% this week from 4.27% a week earlier,
Fifteen-year fixed-rate loans fell from 3.72% to 3.62%, the giant home finance company said Thursday. The rates were being offered to low-risk borrowers who paid 0.8% of the loan amount in upfront lender fees on the 30-year loan and 0.7% on the 15-year mortgage.

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