photo credit: woodleywonderworks

Skyrocketing mortgage payments as adjustable rate mortgages (ARMs) reset was a leading contributor to the burst in the housing bubble.  These events reconfirm that fixed rate mortgages are generally the safer course of action for home buyers.  But which type of fixed rate mortgage is the best?  There are many different terms for fixed rate mortgages, but today we’ll be comparing the two most common types: the 30 year fixed and the 15 year fixed.

At first glance, you might expect a 15 year mortgage to have twice the payment of a 30 year, since you’ll pay the house off twice as fast.  In fact, since 15 year loans generally carry a lower interest rate and much of the cost of a mortgage goes out to interest, a 15 year mortgage may only have a marginally higher payment than a 30.

Let’s look at an example: Today’s rates are 5.5% for a 30 Year and 5.0% for a 15 Year.  Assume a loan of $250,000.  The monthly payment would be $1,419.47 on the 30 year loan and $1,976.98 on the 15 year loan.  So for another $557.51 each month you would pay off your loan in half the time with the 15 year term.  It’s actually a little more complicated then that though, since you may or may not be able to afford the extra $557.

If you couldn’t afford it, you might choose the 30 year loan out of necessity.  If you could afford it, you really need to compare the 15 year term to a 30 year mortgage where you prepay an extra $557.51 each month.  Prepaying would allow you to pay off your 30 year loan in 15 years and 10 months.  So in this case, the lower interest rate of the 15 year loan essentially allows you to pay off the loan 10 months faster.  The obvious benefit of going with the 30 year and prepaying is that if you run into financial difficulty, the amount that you are required to pay each month is less.  Also, if alternative investments become more attractive, your lower obligatory payment leaves more cash available to invest elsewhere.  More on that strategy, and prepaying in general, was covered in Is Prepaying My Mortgage a Mistake.

Depending on the actual loan amount and rates for your situation, one loan may be clearly preferred for you.  As you’ve seen in this example though, making a payment equivalent to a 15 year payment on a 30 year loan makes the two quite similar.  I’ve bought a house with both of these types of mortgages and have concluded that for those who prepay a significant amount each month, the two end up being fairly similar.  If you can easily afford the payments of the 15, it probably makes sense to go that route, since you should be able to get a lower interest rate.  If the payments are a bit of a stretch or you can get better returns elsewhere, then a 30 year fixed might be a better route.  That way you’ll obligate yourself to a lower payment but can get nearly the same advantages of having a 15 year loan by prepaying every month that you’re able (and choose) to and also keep the flexibility to allocate the extra money elsewhere when superior opportunities present themselves.