15 vs. 30-year mortgages

When you buy a home in the U.S., you get a bank loan that you pay back over either 15 or 30 years.  Most people choose the 30-year loan, because the monthly payments are lower, and because it lets them buy a more expensive house.  But if you can afford it, choosing the 15-year loan would let you pay off your house in half the time, and save a lot of interest.  So which should you choose?  The answer depends on your situation and goals, but here's my summarized advice:

1. Take the 30 if it's your only option.  Most people can't afford a 15-year loan and so a 30-year loan is their only choice.  If that's your case, then at least that's one less decision you have to make.
2. Take the 30 if the interest rate is very low (<4%), or if you're getting a good rate on your investments (>6.5%) and will actually invest the money you'll save courtesy of the lower monthly payments on the 30 vs. the 15.
3. Take the 15 if:
1. you can easily afford the biggest house you want with a 15-year loan, and
2. interest rates are higher (>4%), or your prospects for investing aren't so hot.

Now let's look at how much you can save by taking a 15 instead of a 30.  The idea is that you save a bunch of interest by paying off the loan in half the time, with the tradeoff being that your monthly payments are a little higher with the 15.  However, when interest rates are very low, then a 15 actually doesn't save that much vs. a 30, because of inflation.  With a 30 you have to make payments for 15 extra years, but each year you're paying back with dollars that are worth less and less, because of inflation.  My calculator at left compares 15 vs. 30-year loans, and it's the only one I know of which takes the important step of accounting for inflation.

Note that even if you take the 30, you can still make prepayments (extra payments) to pay it off in 15 years, and save on interest just like you would with a real 15-year loan.  An advantage of doing it this way is that your monthly obligation is low, so if money gets tight, you're not locked into a higher payment.  In other words, your money is more liquid.  With a 15-year loan you have to make the higher payment every month whether you want to or not.  But with a 30-year loan it's up to you whether you'll make the extra payment each month.

So why wouldn't you always just take the 30 and try to pay it off in 15?  Two reasons: First, the interest rate on the 30 is higher.  And second, if you're not diligent about making the extra payments, there goes your interest savings.  I recommend the 15 for those who can afford it because the savings are automatic, and you can't blow it by failing to make the prepayments.

So in summary:

Taking a 30 and investing the difference

Since the payments on a 30 are lower, you could get the 30, take the money you're saving each month from the lower payments, and invest it in something else.  In fact, that's usually a better deal than taking a 15-year loan, as long as you invest the difference religiously.  But whether or not taking the 30 and investing the difference is a better deal, an advantage of doing so is that it keeps your investment liquid, so if you run into hard times you can stop putting the extra money towards your investment, and you can easily withdraw all the money you'd saved to date.  If you'd taken a 15-year mortgage your investment would be locked up in your house, and it wouldn't be easy for you to turn that equity into cash.

Here's an example:  Let's say your payment would be $1100/mo. on a 30-year loan vs. $1500/mo. on a 15-year loan. Instead of taking the 15-year loan for $1500/mo., you take the 30-year loan for $1100/mo., and invest $400/mo. separately somewhere else (mutual funds, high-yield CD's, socially-responsible stocks, etc.).

By doing this your investment remains liquid.  Your house is an investment, sure, but you can't eat your house. Any money you put into your house is money you can't easily get back out. The only way to monetize that investment is to sell the house or borrow against it (refinance or home equity loan). And if times get tough (like you lose your job), then ironically no bank will let you borrow against your home because they're worried that a jobless person won't be able to pay them back.  By contrast, if you invest your cash in mutual funds or other similar investments, it's always easy to sell them to access your cash.

This strategy is similar to getting a 30 and making prepayments, as we covered above.  Downsides are the higher interest rate on the mortgage, and the fact that you take a financial hit if you fail to invest the difference diligently.

While the "30 and invest the difference" idea is usually a better deal, two commonly-overlooked things keepi it from being a goldmine every time.  First, by taking a 15, you pay off the loan in half the time, so suddenly you have a lot of free cash to invest starting in year 16.  Second, your gains from taking the 30 and investing the difference are taxable, while the interest you'd save by going with the 15-year mortgage is not.  (And no, the mortgage interest deduction doesn't really come into play here, because it's essentially negligible in most cases.)  Most proponents of the "30 and invest the difference" idea seem to overlook these two things.  I didn't, and I account for them in the calculator below.

So by popular demand, here's the calculator that shows you whether a 15 or a "30 and invest the difference" is a better deal.

I'm not 100% confident about the real dollars calculation.
If you identify any errors, please let me know!.

Calculator notes

1. The bottom line shows how much cash you laid out, after subtracting the after-tax value of your cash investments.  So the bigger loss loses the 15vs30 battle.
2. Investments.  The amounts shown for the cash investments has been reduced by the taxes you'd pay on the sale.  It includes the principal.
3. Total Cash Out is the money that left your hands to pay your mortgage, PMI, property taxes, and to build your investment, less the tax benefit you got from home ownership.  They're the orange-shaded columns in the big table.
4. Taxes.  The columns that are part of the Housing Deductions are shown in green type.   The tax savings calculation is simple, and doesn't account for some limits that may be imposed on your mortgage interest deduction. The calculator doesn't consider appreciation or capital gains tax on the house, because it's the same on both sides.
5. Running (cumulative) balances are shown with a light-gray background, to differentiate them from the other values, which are the values for just that year.
6. Only the difference in payments is invested.  Nit-picking pedants will insist that the amount invested should also account for the difference in PMI and income taxes, but in real life homeowners don't have easy access to the detailed numbers and will simply invest the difference in payments.

Assumptions:

1. Property taxes are 2% of purchase price, and increase at the rate of inflation.
2. PMI is applicable on loans with less than 20% down (i.e., loan is not FHA).  Credit score is median-range (680-719, for calculating PMI cost).  PMI is canceled automatically when loan balance falls below 78% of purchase price.
3. Closing costs are paid in cash, are not rolled into the loan, and aren't significantly different for 15- vs. 30-year loans.
4. Standard Deduction and Non-Housing Deductions increase at the rate of inflation.

Related topics:

• Prepaying a mortgage
• Understanding mortgage interest
• Figuring your monthly payment 

Last Update: August 2014

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