The duration or life of the loan for a mortgage is referred to as its “term.” It's how many years it will take to pay off your home loan if you make every scheduled loan payment. Most common are 15-year terms, 20-year terms or 30-year terms. A 30-year fixed-rate mortgage is perhaps the most popular option, but the longer term comes with some pros and cons for homebuyers.
How a Mortgage Works
You have $20,000 in savings. You’ve found your dream home and it’s listed at $200,000. You take out a mortgage for the balance: $180,000. You must pay back that $180,000 – plus interest – over a period of years. The interest is your lender’s way of making money in exchange for loaning you the money.
Each monthly payment you make will take a bite out of that principal balance – the amount you borrowed. It will also include interest and possibly money toward escrow for things like property taxes and homeowners insurance.
Read More: What Does an Escrow Payment on a Mortgage Mean?
Your payments will be mostly composed of mortgage interest in the beginning because interest is charged on your outstanding loan amount. This is obviously going to be larger right after you take out the mortgage. The interest payments that are a portion of each of your payments will decrease gradually as you pay down the loan.
Your Term’s Effect on Interest
Your lender would prefer to have its money back in 15 years rather than wait 30 years for full repayment, and this doesn’t even take into consideration the fact that borrowers are more likely to default at some point over 30 years rather than 15.
There’s less risk for the lender with a 15-year mortgage, so it will most likely charge you a lesser interest rate in consideration for a shorter term. You might pay a lower interest rate - as much as 1 percent less - with this shorter-term mortgage, according to the Consumer Financial Protection Bureau. You should receive at least a 0.25 percent break in your total interest because of the short term.
The Effect on Mortgage Payments
You might think that a lesser interest rate will reduce your monthly mortgage payments, but this isn’t the case. You will have higher monthly payments that are much steeper over 15 years rather than 30.
Remember, your mortgage payment includes taking a monthly bite out of the principal amount you borrowed. This process is known as amortization. Divide that $180,000 by 180, or 12 months over 15 years. That works out to $1,000 a month. Now divide it by 360, or 12 months over 30 years. The number drops by half to $500 a month.
Of course, these are simplified equations because you’re paying more toward interest and less toward principal in the earliest months of the mortgage loan. But what you’re saving on interest won’t make up for the difference in your mortgage payments. Your payments over 15 years will be somewhere in the neighborhood of two-thirds more than the lower monthly payments you would have with a 30-year loan when you take a reduced interest rate into consideration.
Read More: How to Figure Out Amortization of a Mortgage
The Mortgage Insurance Requirement
Private mortgage insurance, or PMI, is a policy that protects your lender in the event that you default on your mortgage loan. The insurer will pay off your balance if this occurs. Your lender is the beneficiary of the policy, but it won’t pay for it. You must pay the mortgage insurance premiums, and these can be added on to your mortgage payment as well.
Mortgage insurance is almost universally required if you make a down payment of less than 20 percent, and FHA and USDA loans require it as well. These premiums can be higher for 30-year mortgage terms because you have an additional 15 years to default.
Read More: What Is PMI?
The Overall Cost
A mortgage taken out over fewer years is going to cost you significantly less overall than a 30-year loan. Not only will you pay a higher interest rate on a 30-year mortgage, but you'll be paying it for three decades. It's going to add up to a lot of interest when you add on those 15 additional years. This can make a very significant difference to your bottom line – what homeownership is ultimately going to cost you before you own your home free and clear.
What’s the Best Mortgage for You?
It’s possible that your monthly budget simply won’t stretch to accommodate those higher mortgage payments that come with paying your principal balance off in just 15 years or so. Foreclosure is obviously the worst-case scenario, so you might be better off taking the extra years offered by a 30-year loan if you think there’s any possibility that you won’t be able to swing those steep monthly payments. This can depend not only on your present income, but on your employment forecast for years to come. You’ll save more overall with a 15-year loan, but that won’t matter if you no longer have a house to show for it.
Then there’s the fact that you might be able to buy a home with a higher home price if you’re stretching out the principal payments over 30 years rather than 15. This could alter the affordability of your dream home in a real estate market where home buying options are tight. You might be limited to a $125,000 mortgage rather than a $180,000 loan if you’re going to cram all that principal into just 15 years.
A 30-year mortgage with reduced principal payments would also allow you to put the money you’re saving monthly on principal to other good causes that align with your personal finance goals, such as a retirement fund or paying for your kids’ college educations.
But maybe you’re not planning to stay in your home for 30 long years. Maybe it’s likely that you’ll want to sell and move on or up before that time comes. That double principal you’re paying monthly means you’re building home equity more quickly. You’ll almost certainly get those higher principal payments back when you sell without waiting for 30 years. Think of it as something of a forced savings account.
You Have Another Option
You have some control over when you pay off and retire your loan, even if you opt for a 30-year term. You don’t absolutely have to take 30 years to satisfy your mortgage, although the rules for this can be a bit tricky.
Nothing stops you from throwing a little extra money in the form of extra payments at your principal balance in addition to your monthly mortgage payments if you want to pay the loan off sooner than 30 full years. You’d ultimately be cutting down on all that interest you would pay otherwise. But – and this is a big but – some mortgage loans come with prepayment penalties.
You’re generally OK if you make separate, extra principal-only payments occasionally, but you could be hit with a prepayment penalty if you pay off your entire mortgage early, or at least too early. These penalties usually only apply for the first five years or so of the loan term, so they’d mostly be a concern if you want to refinance prior to this time or if you somehow managed to pay off your entire principal balance in 60 months or less.
The bottom line is that even if you take out a 30-year mortgage, you're not necessarily obligated to wait all that time before you pay off the loan.
- Consumer Financial Protection Bureau: Mortgages Key Terms
- Consumer Financial Protection Bureau: Understand Loan Options
- Gateway Mortgage: 15 vs. 30-Year Mortgages and How to Choose Which Is Right for You
- Debt.org: 15-Year Fixed Mortgages
- Freddie Mac: Why America’s Homebuyers & Communities Rely on the 30-Year Fixed-Rate Mortgage
- Consumer Financial Protection Bureau: What Is a Prepayment Penalty?
- Consumer Financial Protection Bureau: What Is Mortgage Insurance and How Does It Work?
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.