With all the recent fancy loan programs, the 15-year fixed-rate loan has become a forgotten option to the typical 30-year. If you can spare the extra per month, you can save on interest paid as well as pay the loan in a shorter amount of time.
Recently, people have been interested in many of the more exotic loan programs, from no-interest loans to negative amortization. There have been some negatives associated with these loans with the changes in the mortgage industry. Therefore, I wanted to take some time to talk about the almost forgotten 15-year loan. Some people see the 15-year loan as drab and boring compared to all the fancy loans out there, but there are several benefits to the 15-year fixed-rate loan.
For one, you pay the loan off in half the amount of time you would with a 30-year loan. Therefore, if someone were currently 30 years old, he or she would pay off the loan at age 45 instead of 60. Because it takes half the time, people frequently think that the payment on a 15-year loan is twice as much as on a 30-year loan, but this is far from the case. For instance, if we look at Compass Bank today, a 30-year $160,000 loan will have a monthly payment of $1037.75. On the other hand, a 15-year loan is $1382.80 a month.
This shorter loan life translates to paying significantly less interest over the life of the loan. To figure out the interest, we take the total payments per year over the life of the loan and subtract the original amount of the loan, which is 160k. So for the 30-year loan we use the formula ($1037.75 x 12 x 30 yrs.) - $160,000 = $213,590. You pay a total of $213,590 in interest over the 30 years. On the other hand, for a 15-year loan using the same formula ($1382.80 x 12 x 15 yrs.) - $160,000 = $88,904, you end up paying only $88,904 in interest, which is a 59% savings.
The details of why you pay less overall interest, but somehow do not have a huge increase in monthly payments, get a little involved. Since the $160,000 is amortized over 15 years, more of your monthly payment goes towards the principal amount of the loan than in a 30-year, so your next month's interest is calculated based a smaller loan principal.
For example, after 3 years, your principal balance is $154,351 on a 30-year and $138,279 for a 15-year. Since your balance is reduced each month, your total interest is significantly less, so when you spread it out over 15 years, it does not double the 30-year monthly payment. Another factor in paying less each month is that most lenders will give you a better interest rate for a 15-year loan than a 30-year loan. In our examples, the Compass interest rates were 6.375% for a 15-year and 6.75% for a 30-year.
Are there any downsides to a 15-year loan? The biggest is probably inflation. If we went through a period of rapid inflation, then for the last 15 years of the loan, the payments would effectively be less because of inflation.
I am not saying that everyone should get a 15-year loan. Frequently, people cannot spare the extra money per month and need to put that money into getting a larger house because of children or other needs. I would also never expect a 15-year loan to be the most prevalent mortgage used. However, before picking a mortgage, it is probably a wise move to consider the 15-year mortgage and weight its advantages.
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